Many owners are surprised, therefore, to find that the IRS can hold business owners responsible for the tax liabilities of the business under certain circumstances.
A recent tax court case found not only that shareholders were liable for tax debts of the business, but that several minority shareholders who had nothing to do with the financial fraud relating to the unpaid tax debts were liable for the taxes.
Although this type of transferee liability is relatively rare, business owners must bear in mind that the IRS does have the authority to hold them responsible for unpaid corporation taxes under certain circumstances.
In general, the IRS is able to hold shareholders responsible for corporate tax debts if there is a basis to do so under applicable state creditor law.
If the state law relating to fraudulent transfers would allow a creditor to pursue a shareholder for monies transferred to the shareholder, then the IRS is also able to do so.
In the recent tax court 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 million 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 longer than 150 years to complete the payment program.
The IRS therefore turned to the minority shareholders to recover a portion of these taxes.
The IRS asserted 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.
If the transfer is fraudulent under state law such that a creditor could recover transferred funds, the IRS can also recover.
The issue under Florida law (the state involved in this case) was whether the corporation received a reasonably equivalent benefit in exchange for the payments to the shareholders.
If not, the transfers would be fraudulent if the corporation was insolvent at the time of the payments, or became insolvent as a result of the payments.
With respect to the bonuses and loans, the tax court decided that these were payments for services rendered by the shareholders and that the corporation had therefore received reasonably equivalent value for the transfers.
The dividends were another matter; under Florida law, dividends are not a transfer in exchange for reasonably equivalent value.
The tax court then determined (based on experts’ reports) that the corporation was insolvent at the time of the dividends, which was no surprise given the unpaid tax liability.
The dividend transfers were therefore fraudulent under Florida law and the IRS could recover.
The shareholders also argued that the IRS had entered into a payment plan with the corporation, and therefore could not hold them responsible until it had exhausted its remedies against the corporation.
However, Florida law provides that a creditor need not exhaust its remedies against the transferor before proceeding against the person who received the fraudulent transfer.
Normally a corporation provides complete protection of shareholders against liabilities of the corporation.
In situations such as the case discussed above, where the corporation is not adequately capitalized (and particularly where the undercapitalization is caused by fraud), 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 also are employees.
Mr. Grassi is president of McDonald Hopkins LLC.