In prior posts, we have considered the “plight” of minority shareholders in various contexts. We have reviewed their inability to influence corporate decisions, to compel a dividend distribution or a redemption of their shares.

In spite of these shareholders’ non-controlling status, we have seen situations in which the taxing authorities have, nonetheless, held them personally liable for a corporation’s sales taxes and employment taxes.

Last week, the U.S. Tax Court found that certain distributions by a corporation to its minority shareholders were fraudulent transfers, on the basis of which the Court concluded that these shareholders could be held liable for the corporation’s federal income taxes.

Setting the Stage

During the years at issue, four individuals owned all of Corp’s stock: the two taxpayers (the “Taxpayers”) owned a total of 9.78%, and Corp’s president and board chairman (the “Insiders”) each owned one-half of the remaining shares. distributions

Insiders were involved in all aspects of Corp’s business, and as the majority shareholders they controlled the direction and management of the company. The Taxpayers were not involved in Corp’s financial matters.

Between 2001 and 2007, Corp experienced a period of growth and profitability, but failed to report any income.

Ultimately, the IRS audited Corp and determined that it owed significant tax, penalties, and interest for the years at issue. After trying to collect Corp’s liability but finding that Corp could not pay, the IRS agreed to let Corp pay its liability in installments.

In the meantime, the IRS sought to collect as much of the liability from

other parties. The IRS reached agreements with Insiders to recoup some of the transfers they received during the years to which the liability relates.  The IRS next sought to recover many of the transfers Taxpayers received.

Stripping the Corporation

During the years at issue, Insiders systematically transferred all of Corp’s pretax profits to themselves. As Corp received payment for services, Insiders would transfer cash from its operating account to a secret account, from which they would then transfer the money to their personal accounts or to the accounts of corporations they owned. Corp’s accounting staff recorded the amounts as loans receivable and eventually wrote them off as operating expenses.

While Insiders were transferring money from Corp, they also made sure that Corp did not file accurate income tax returns. Corp filed returns for 2003 and 2004, but fraudulently reported losses. Corp did not file returns for 2005, 2006, or 2007.

In addition to the dividends they received, Insiders received “interest” payments from Corp in 2005, 2006, and 2007.  The interest was based on a fictitious loan Insiders had recorded on Corp’s balance sheet in their names. These interest payments were separate from the dividend payments all four shareholders received.

Taxpayers received several transfers during the years in which Insiders stripped Corp including, in addition to their usual salaries, certain “advances” and dividends.

Until 2003, Corp had a bonus program, under which Taxpayers earned significant compensation. Their bonuses depended on their performance, and petitioners routinely received significant income under the program. Corp  suspended the bonus program for 2003 and 2004. However, because Insiders understood that Taxpayers had become accustomed to receiving significant bonuses, they decided to give them bonus “advances” in 2003 and 2004. When Taxpayers asked Insiders how they should report the advances on their returns, they were told that they were loans and did not have to be reported. Insiders told Taxpayers that they would eventually have to repay the advances. Taxpayers did not sign loan agreements or discuss loans terms with Insiders, nor did they pay interest on the loans. Corp forgave the loans in 2009.

In 2005, 2006, and 2007 Corp declared and paid dividends to its shareholders. Each shareholder’s dividends were based on his percentage of stock ownership. Corp issued Forms 1099-DIV reflecting these amounts, and Taxpayers reported these amounts as dividends on their individual returns.

Corp was a thriving business until 2007, but by the end of 2007 it had become insolvent. Because Insiders hid a number of transfers, Corp’s financial statements did not reliably indicate when Corp became insolvent. Although Insiders left enough cash in the business to allow it to pay its usual creditors on time, Corp did not pay its federal or state income tax during the period.

Corporate Shield? Not Always

In general, the creditors of a corporation cannot recover the corporation’s debts from its shareholders—the shareholders enjoy the benefit of limited liability protection.

However, a creditor may be able to “pierce the corporate veil” in appropriate circumstances, as where the corporation’s shareholders do not respect it as a separate entity, or where their withdrawal of funds from the corporation renders it insolvent.

The IRS is a creditor of a corporation that owes federal income taxes. In the right circumstances, the IRS may pursue the corporation’s shareholders in order to satisfy a corporate tax liability. Indeed, the Code provides a procedural tool by which the IRS may collect taxes from shareholders to whom “transferee liability” for corporate taxes has attached as a matter of state law. While the Code does not create the substantive tax liability as to a transferee-shareholder of a transferor-corporation’s property, it does provide the IRS with a remedy for collecting from the transferee-shareholder the transferor-corporation’s existing tax liability.

Stay tuned tomorrow to find out how these minority shareholders fared when the IRS came after them.