Business owners typically operate their businesses as corporations or other separate business entities to protect their personal assets from liabilities of the business. The IRS can, however hold business owners responsible for tax liabilities of the business under certain circumstances.
A Tax Court case this year found that several minority shareholders who had nothing to do with the financial fraud relating to the unpaid tax debts were liable for the taxes. In this case, a corporation failed to file tax returns or pay taxes for a number of years, even though the corporation had been very profitable. During this time, the majority shareholders were essentially embezzling funds from the corporation, unbeknownst to several minority shareholders. The minority shareholders (who were also employees of the corporation) did, however, receive transfers of money from the corporation, including loans that were made in lieu of normal bonuses, and dividends that were paid by the corporation in other years based on their percentage of stock ownership.
Upon audit, the IRS determined that the corporation owed over $120,000,000 in taxes, penalties, and interest. Although the corporation entered into an agreement to pay this liability over time, it was determined that it would take over 150 years to complete the payment program! So the IRS turned to the minority shareholders to recover a portion of these taxes, asserting that all of the amounts transferred by the corporation to the shareholders (other than salaries) were fraudulent transfers and could therefore be recovered by the IRS.
The Tax Court decided that the loans – which were effectively treated as advances of bonuses because no loan documentation was ever prepared – were actually compensation and could not be recovered. The dividends paid to the minority shareholders, however, were found to be fraudulent transfers under state law and, therefore, recoverable.
The ability of the IRS to recover taxes from a transferee such as a shareholder in a corporation is dependent on state law. Under most state laws, a transfer is fraudulent if the corporation did not receive a reasonably equivalent benefit in exchange for the payments to the shareholders and the corporation was insolvent at the time of or as a result of the payments. Dividends are generally not a transfer in exchange for reasonably equivalent value, and so a dividend by an insolvent corporation (including one that is insolvent because it cannot pay its taxes) are recoverable by the IRS.
While normally a corporation provides complete protection of shareholders against liabilities of the corporation, where the corporation is not adequately capitalized, the IRS as well as other creditors can pursue shareholders for funds transferred to them. It is therefore important to consider the corporation’s financial solvency before paying dividends to shareholders or large bonuses to shareholders who are also employees.
This and other tax issues will be the topic of discussion at our upcoming Business Hour event – Top tax issues and planning ideas for 2015. Join us for a discussion on the latest tax updates, strategies, and insights by registering to attend our Business Hour or to watch the live webcast so you can start planning for 2015 taxes now.