You Mess With The Bull . . .
An anonymous thinker, lost to history, is credited with having said that the unofficial motto of the IRS is, “We have what it takes to take what you have.”
In some instances, the truth of the above statement is manifested in what may be described by certain observers as an abuse of governmental power. In other cases, however, like that of the Taxpayers described below,[i] many members of the public will feel vindicated by the outcome, while probably many more will categorically approve of a bad actor’s having received their just deserts.[ii]
Regardless of one’s visceral response to the outcome, one cannot avoid coming away from the District Court’s decision regarding the Taxpayers with a greater understanding of and appreciation for some of the legal theories (and practical “tools”) that the IRS may utilize to collect delinquent taxes.[iii]
With that, let’s see how the Taxpayers got themselves into trouble.
The Road to Perdition
The Taxpayers’ comeuppance was a long time coming; in fact, their journey through the IRS gauntlet began over twenty years ago.
The Taxpayers (H and W) were a married couple when they started on the path to their inevitable downfall by failing to (i) file personal income tax returns and (ii) remit the correct amount of tax for several years.
Quirky Taxpayers?
When the IRS decided to audit the Taxpayers, the agent appointed to their case (the Agent) sent the Taxpayers a letter requesting various records and seeking to schedule an appointment – the letter, however, was returned to the Agent with “returned for fraud” written across its face. Subsequent phone calls and messages went unanswered.
When the Agent tried to deliver a summons to the Taxpayers, they refused to meet with her. The Agent then attached the summons to the door of the Taxpayers’ residence, following which the Agent received a letter demanding payment of $2,000 for trespassing on the Taxpayers’ property.
Finally, the Agent enlisted a U.S. Marshal to help with delivering the summons.[iv]
Shortly thereafter, the exam of the Taxpayers was extended to other tax years and a summons enforcement action was begun.
Notices of Deficiency
In furtherance of their fact-finding mission, the Agent summonsed bank records and used them to perform a bank-deposits analysis of personal and business accounts controlled by the Taxpayers in order to reconstruct their income for several years. The Agent did not receive any documentation or other information from the Taxpayers with respect to deductible expenses.[v]
Upon completion of their analysis, the Agent mailed the audit results and examination reports to the Taxpayers; predictably, the latter failed to respond.
The IRS then issued separate notices of deficiency[vi] to each of H and W for several taxable years. The notices issued to H determined that he had unreported income, including Schedule C (sole proprietor) gross receipts or sales, capital gains, and S-corporation income. With respect to the Schedule C gross receipts, the notice asserted that H had used shell entities, nominees, or other entities to conceal the receipt of income, which the IRS had reconstructed by analyzing bank accounts that H controlled, and delinquent tax returns he had filed.
The notices of deficiency issued to W determined that she had unreported income that included community-property gross receipts, wages, and other income from H; interest income; gross receipts or sales; and capital gains.[vii]
The Taxpayers petitioned the U.S. Tax Court for a redetermination of the deficiencies set forth in the notices of deficiency.
Tax Court and Beyond
During the second day of trial, the IRS and the Taxpayers announced they had reached a settlement, pursuant to which the notices of deficiency were, for the most part, accepted as written. The IRS moved for entry of decision, submitting a proposed decision and supporting computations, to which the Taxpayers failed to respond.
The Tax Court then entered a decision in accordance with the IRS’s motion, and the Taxpayers filed an appeal to the Fifth Circuit Court of Appeals. In an unpublished per curiam opinion, in which it found that the Taxpayers’ arguments were without merit,[viii] the Fifth Circuit affirmed the Tax Court’s decision, stating:
Taxpayers appeal the Tax Court’s judgment based on the settlement of the parties and contest the computation of taxes because not in accord with that settlement. No alternative computations, except for the incorrect zero denial of a tax, was ever explained and proposed. They have had many full opportunities to resolve any error in the taxes they owe or in this judgment, and have always avoided those opportunities. Their argument now, about their settlement as the consequence of their attorney’s ineffectiveness, fits their defense of hide and go seek.
After the Circuit Court’s opinion, the IRS collected from the assets of certain entities associated with the Taxpayers (the “Taxpayer Entities”) approximately $3.2 million of the tax liability owed by H, which the IRS then applied to H’s separate tax debts.
In response, H and the Taxpayer Entities filed an administrative claim for return of the funds collected from the Taxpayer Entities, and subsequently also filed a suit in the federal District Court.
Motion for Summary Judgement
The IRS filed a motion for summary judgment in the District Court regarding the tax liabilities asserted against the Taxpayers, along with the Taxpayer Entities, in which it claimed that H’s individual tax obligations totaled approximately $3.7 million, of which the IRS had already collected approximately $3.2 million. The IRS also sought to establish W’s separate liability for almost $2.3 million of federal income taxes.
In addition, the IRS’s motion endeavored to establish that the Taxpayer Entities were the Taxpayers’ alter egos or nominees, which would enable the IRS to enforce tax liens against the properties held by the Taxpayer Entities.
In response, H argued for the release of the liens against the Taxpayer Entities that were linked to H’s tax liabilities. The Taxpayers also contested the separate liens against W, emphasizing her lack of substantial connections to the Taxpayer Entities, and arguing that the evidence concerning nominee liens against W was insufficient to establish liability on her part.
The IRS acknowledged that $3.2 million of the amount owed by H was collected by the IRS from assets held by the Taxpayer Entities and was applied to H’s separate tax obligations. According to the agency, it sought a judicial determination that the Taxpayer Entities were nominees of H, in which case the funds collected from the Taxpayer Entities in respect of H’s taxes could not be refunded to such entities. The IRS introduced substantial evidence in support of this contention, and further asserted that the Taxpayers held a community property interest in the Taxpayer Entities that allowed the IRS to enforce tax liens for W’s tax liabilities against the Taxpayers’ jointly held community property.
The Taxpayers asserted that the IRS failed to demonstrate that H owed the taxes that were collected. Furthermore, the Taxpayers argued there was insufficient evidence indicating that W met the criteria for the nominee liens filed against her. The Taxpayers also claimed that the Taxpayer Entities were legitimate third-party entities whose assets could not be appropriated to satisfy W’s individual tax liabilities.
The District Court’s Decision
The Court found that the evidence presented by the IRS supported the conclusion that the Taxpayers owed a substantial amount of federal income tax.
The Court was also of the opinion that H’s administrative claim was barred as a matter of law. According to the Court, the IRS’s evidence concerning H’s tax liabilities was overwhelming and undisputed. When given the opportunities to rebut the facts – whether during the audit, Tax Court, or Fifth Circuit proceedings – H refused, essentially defaulting on the claim. Thus, the opportunity to dispute the factual basis for the IRS’s determination was foreclosed, and H was barred from challenging the amounts collected from the Taxpayer Entities.
The Court then noted that W engaged in conduct similar to that of H by refusing to give testimony when confronted with evidence that established that W, too, had engaged in tax evasion. The IRS’s evidence, the Court stated, overwhelmingly demonstrated that W “evaded reporting and paying her taxes through an intricate network of entities aimed at concealing her true income and assets.” Thus, the Court held that the IRS’s evidence concerning W’s liability for the unpaid taxes was factually undisputed.
The Entities
The Court also held that the IRS’s evidence established that the Taxpayer Entities were “an intricately intertwined web of entities that served primarily as an extension of” Taxpayers’ “personal interest and financial dealings.”
For example, according to the Court the evidence established that one entity served as a conduit for Taxpayers’ income and expenses; H had exclusive authority over its bank accounts and the use of the entity’s funds. A second entity, that held the Taxpayers’ residential property and was managed solely by H, served a similar role. W was the sole beneficiary of a trust, which in turn held a mortgage on the residential property. Another entity initially created to hold office equipment evolved into a vehicle that was used by H to manage the financial affairs of other properties. The Court reached the same conclusion with respect to a yet another entity, which had substantial real estate holdings and conducted financial transactions linked to H’s personal accounts. When questioned about this entity’s ownership, H refused to answer questions concerning his control. The undisputed evidence, however, showed that H used the entity to lease office units where the rental income derived flowed into another entity’s accounts for H’s personal expenses. Similar determinations applied to each of the remaining Taxpayer Entities.
Having made the foregoing findings, the Court next considered whether any of the Taxpayer Entities should be treated as the Taxpayers’ alter ego or nominee, thereby subjecting the entity’s property to the Taxpayers’ tax liabilities.
Alter Ego
The alter ego doctrine applies when an individual utilizes a corporate entity as an instrumentality to circumvent the individual’s legal obligations. The assets of an alter ego can be levied upon to satisfy the debts of an individual when corporate boundaries are disregarded.[ix] Boundaries have been disregarded, the Court explained, when there has been a commingling of funds, a failure to observe corporate formalities, and where control over an entity’s affairs is in the hands of an individual who uses the entities for personal financial gain.
The Court stated that, “Without doubt, the evidence established” the Taxpayers’ “extensive control over these entities, including ownership, management, and the intermingling of the finances of the entities for their personal use.”
In short, the alter ego doctrine allows the creditor (the IRS) of an individual owner (the taxpayer) to ignore the owner’s ostensibly separate entity (a corporation) and collect from such entity’s assets the obligation (the taxes) that the owner owes to the creditor.
Nominee
The Court also stated that the evidence revealed “a compelling narrative that the entities” were nominees of the Taxpayers. “Through a detailed analysis of their structure, transactions, and interactions,” the Court explained, the IRS demonstrated that the Taxpayer Entities served “as mere facades, lacking genuine independence or substance.” Among the factors examined in discerning the true beneficial owner of an entity, the Court continued, one determines whether there is “an absence or inadequacy of consideration paid by the nominee for services rendered, whether there is an intimate relationship between a taxpayer and the nominee, and whether there is the retention of control or possession by a taxpayer.”[x]
The Court found a pattern of behavior that demonstrated the Taxpayers sought to “shield themselves from accountability” using the Taxpayer Entities. Considering this evidence,[xi] the Court determined that the Taxpayer Entities functioned as nominees for the Taxpayers for their personal enrichment.
In other words, the assets of the entities were beneficially owned by the Taxpayers – the entities were mere agents of the Taxpayers.
Ruling on the Motion
Consequently, the Court denied the Taxpayers’ responses and defenses and held that the IRS was entitled to summary judgment. Having decided that Tax Entities were nominees or alter egos of the Taxpayers, the Court also ordered the sale of as much of the Taxpayer Entities’ remaining property as was necessary to satisfy W’s tax liabilities.
Be Careful of the Horns
It is not at all unusual for a taxpayer to ask their tax advisers how the taxpayer may best protect their assets from the taxing authorities.
The simplest and most obvious answer: pay the taxes that you owe the government. To determine how much tax one owes the government, one must properly prepare and file a tax return. The only way to defend such a return – and the purported correctness of the tax liability shown thereon – from a challenge by the government is to keep records that support the items of income, deduction, etc., appearing on the return.
In the event the taxpayer’s business or investment activities are of a nature that it may be reasonable for the taxpayer to operate through more than one business entity, each such entity’s principal purpose must be a bona fide business purpose, and any transactions either between the owner and any entity they control, or among these entities, must be motivated by a business purpose and must be conducted on as close to arm-length terms as practicable.
Failing the foregoing, the taxpayer against whom a tax deficiency has been asserted should expect the IRS to bring to bear the examination and collection resources at its disposal.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] U.S. v. Ohendalski, et al., U.S.D.C. Texas, Houston Division, Civil Action No. 4:22-CV-02949, Signed May 9, 2024.
[ii] Can’t you hear the ancient Greek chorus reminding the audience of societal norms and expectations?
[iii] The prudent taxpayer will employ this knowledge to their advantage when planning their own tax strategy.
[iv] It’s unfortunate but true – there are some unhinged folks out there, and assaults on IRS personnel do occur.
[v] Internal Revenue Manual 9.5.9.7. https://www.irs.gov/irm/part9/irm_09-005-009#idm139929131596896.
The “bank deposits method” of proving income utilizes bank account records to establish a subject’s understatement of taxable income. When there is no, or insufficient, direct evidence of income and/or expenses, the IRS can still make its investigation indirectly through the use of circumstantial evidence. The theory behind the bank deposits method of proof is simple. There are only three things a taxpayer can do with money once it is received, i.e., spend it, deposit it, or hoard it. Accounting for these three areas considers all funds available to the taxpayer. If non-income sources are eliminated, the remaining currency expenditures, deposits, and increases in cash on hand will equal corrected gross income.
[vi] IRC Sec. 6212. Which starts the 90-day period within which a taxpayer “must” file a petition with the U.S. Tax Court to challenge the deficiency determined by the IRS. (I say “must” because some courts – notably, the Third Circuit Court of Appeals – do not view the timely filing of a petition as a jurisdictional prerequisite for the Tax Court. Hopefully, the U.S. Supreme Court. IRC Sec. 6213.
Last year the Third Circuit decided that the ninety-day period prescribed by the Code for the filing of a petition with the Tax Court for the redetermination of a deficiency was not jurisdictional and, as such, was subject to equitable tolling. https://www.taxslaw.com/2024/04/missing-the-tax-courts-90-day-deficiency-deadline-now-what/#_ednref19.
[vii] Because W had not elected to file a joint return with H, the notice determined that half of their community-property income was taxable to her, and it computed her tax liability in accordance with community-property laws.
[viii] Ohendalski v. Comm’r, 605 Fed. Appx. 457 (Mem), Jun 5, 2015.
[ix] Where the corporate veil is pierced, to borrow a term from state corporate law.
[x] In general, the following factors are considered in determining whether a corporation is the nominee of a shareholder-taxpayer: (1) whether inadequate or no consideration was paid by the nominees; (2) whether the properties were placed in the nominees’ names in anticipation of a lawsuit or other liability while the transferor remains in control of the property; (3) whether there is a close relationship between the nominees and the transferor; (4) failure to record the conveyances; (5) whether the transferor retained possession; and (6) whether the transferor continues to enjoy the benefits of the transferred property. South Inv. LP v. U.S., 720 F.3d 1058 (9th Cir. 2013).
[xi] Plus, the fact the Taxpayers refused to provide information that, according to the Court, would have established (or not) the government’s allegations.
