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When investing in a business venture, one may often hope to profit off the venture without having to play an active role in its business affairs. This line of thinking may be too good to be true. Investors must determine whether circumstances dictate that more than just a contribution of their capital is required.

 

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Investors whose business arrangements require more than just contributions of capital must be wary of the affairs of the corporation and be diligent in the pursuit of their interests. Otherwise, the oblivious business investor may find themselves the investor of a failing business arrangement and personally liable for the unpaid taxes of the business. This was the situation In the Matter of the Petitions of Peter Pappas for Revision of Determinations or for Refund of Sales and Use Taxes under Articles 28 and 29 of the Tax Law for the Periods from March 1, 2004…through November 30, 2005, Dkt. Nos. 822124; 822125, New York Division of Tax Appeals, Administrative Law Judge Determination (Aug. 21, 2014).


Background


Peter Pappas (the Petitioner), was issued 11 notices of determination assessing sales and use taxes due, plus interest and penalties from the New York Division of Taxation dated for various periods from March 1, 2004 through Nov. 30, 2005. According to the notices, the Petitioner was the person responsible to collect and remit sales and use tax as a shareholder and officer of two corporate entities. For the periods at issue a sales tax return was not even filed and for others the tax stated due on the returns was not paid.


The Petitioner invested in two donut shop franchises in the Bronx with another investor, Mr. Papamichael. In commenting on Mr. Papamichael’s interest in investing in the franchises with him, the petitioner stated that Mr. Papamichael was “a Wall Street guy and…I don’t know what happened…but he came out of being a Wall Street guy” and asked the Petitioner if he wanted to invest with him. Mr. Papamichael formed two corporations, Double Papas, Inc. and W. Pappas, Inc., for the franchises and the Petitioner obtained a 45 percent ownership interest in each corporation.


In exchange for his ownership interest, the Petitioner invested $250,000 in the businesses and contributed a lease for one of the shops. The Petitioner’s business partner, Mr. Papamichael did not acquire an ownership interest in the businesses. Mr. Papamichael’s wife held another 45 percent and the remaining 10 percent of the stock was sold to a minority business owner. The Petitioner stated that Mr. Papamichael “couldn’t sign his name on things, I guess, so he put his wife instead.” The Petitioner signed the franchise agreements along with a personal guarantee of liability. The Petitioner was not alerted to anything troubling by the facts that Mr. Papamichael was no longer a “Wall Street guy” and couldn’t sign his name to documents.


The Petitioner did not participate in the day-to-day operations of the two donut shops, but was listed on several of the corporations’ documents as the president and did have signature authority over the corporation's bank accounts. Mr. Papamichael assumed control of the franchises and the daily operations of the businesses. The Petitioner devoted his time to his own business, and his only involvement with the donut shops was the occasional signing of checks and tax returns...or stopping in for a coffee or donut.


The Petitioner received returns on his investment for the first four or five months, but after that payments ceased. The Petitioner was told that “there was no money,” but failed to inquire of the book or records of the corporations or step in to turn the business around. The Petitioner left those responsibilities to his business partner.


In the middle of 2004, the Petitioner and Mr. Papamichael had a falling out and no longer spoke to each other. Mr. Papamichael took various measures to exclude the Petitioner from the business, and litigation ensued more than a year later.


New York division of tax appeals determination


§ 1133 (a) of the New York Tax Law “imposes upon any person required to collect the tax imposed by Article 28 of the Tax Law personal liability for the tax imposed, collected or required to be collected.” Corporate officers under a duty to act for a corporation in complying with New York’s tax laws pursuant to Article 28 are persons required to collect tax. NY Tax Law § 1133[1]. Whether an officer can be held personally liable for tax is determined on a case-by-case basis.


The court stated that the inquiry of the case was whether the petitioner, Mr. Pappas, possessed sufficient authority and control over the affairs of the corporations to be considered a person under a duty to collect and remit the unpaid sales and use taxes. One who is responsible for collecting taxes cannot escape their obligation by delegating this responsibility to others. Mr. Pappas’s defense is that he was merely an investor in the corporations and was not involved in the day-to-day operations.


The court found, based on the following factors, that the Petitioner maintained a level of responsibility to the businesses exceeding that of mere outside investor. The Petitioner invested a significant amount of money, contributed a leasehold as a storefront for one of the franchises, signed the franchise agreements along with a guarantee of personal liability to the franchisors, held the title of president, was one of two majority stockholders, had signature authority over the corporations’ bank accounts, and had authority to sign documents, such as checks and tax returns.


The court stated that the Petitioner had made a decision to rely on others in running the daily operations of the businesses, and this decision did not relieve him of personal liability for unpaid taxes. The court noted that the Petitioner could have exercised sufficient authority and control over the corporations' affairs to ensure that the taxes were paid, but failed to do so. For example, the Petitioner never asked to see the corporations' financial documents, or inquired as to why Mr. Papamichael couldn’t sign documents or hold stock in the corporations. The court explained that the Petitioner’s failure to make further inquiries, assume any responsibility for the management of the corporations' operational and financial concerns, and reliance on others to pay taxes does not excuse him from personal liability for unpaid taxes.


Advice for business investors


When investing in a business:

  1. Determine the level of involvement required: Know the difference between being a mere investor and an active participant in the business, and take the appropriate action to protect your interests. A mere investor may only lose their investment, but an active participant in the business may be held personally liable for obligations of the business, such as unpaid taxes.
  2. Make inquiries: Ask to see business and financial records on a regular basis. If something sounds questionable or raises suspicion, look into it further.
  3. Know when to take action: If the business is failing and taxes aren’t getting paid, seek the advice of tax and legal professionals to determine if there are certain steps you need to take in order to protect yourself from any personal liability of the business. Otherwise, like the Petitioner in this case, you’re the one who could be responsible for unpaid taxes.
  4. Develop an exit strategy: If the business arrangement isn’t working, seek the advice of tax and legal professionals regarding an exit strategy to try to limit your losses and any additional obligations you may have to the business, such as personal liability for unpaid taxes.
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