Why an Overcomplicated Tax Strategy Can Backfire!

This post is in: Business
No Comments

Something I often see when reviewing client files are very complicated tax strategies that involve moving money from one entity to another. There can be some great tax advantages to these complicated strategies, and I’ve made plenty of similar recommendations.

However … the most fantastic tax strategy in the world is only as good as the people who implement it.

I want to tell you about a couple who started off with a great tax plan – and blew it – to the tune of almost $575,000 in taxes and penalties.

The taxpayer couple operated a concrete business as a sole proprietorship. Early in the business’s life they set up a limited partnership to operate through, with a family trust as the majority limited partner (the husband also held a 1% interest).

The first thing that went wrong was how the couple dealt with reporting income and expenses. Instead of having all of the income and expenses run through the limited partnership and distributing profit to themselves via K-1 forms, the couple claimed the income and deductions from the concrete business on their personal return, as a Schedule C. There was also evidence that the taxpayers continued to flow company funds through the old sole proprietorship’s bank account, adding to the confusion.

The couple then added two more business structures to their strategy. The first was another limited partnership, which was owned by the taxpayers (1%), and a second trust (99%). The depreciable vehicles and smaller equipment assets that the concrete company used for its business were transferred to this second limited partnership … which forgot to file a tax return at the end of its first year of operations.

The second business structure was a third limited partnership with the same ownership as the first one. This business structure held the big, expensive equipment, such as concrete pumps, that were used by the concrete company. Like the first LP, this business structure also failed to file a tax return at the end of its first year of operations.

Next the taxpayers added an employee leasing company into the mix and moved their workforce, some 100-200 employees, over to this employee leasing company. But, even though the leasing company was the employer of record, the concrete company continued to call the shots as far as hiring, firing, supervision and pay scales went. Employees also began receiving two checks per pay period, instead of one. The first check was for the minimum wage required under state law, while the second was called a “dividend” payment and represented the remainder of the each employee’s pay. Payroll taxes and fees were only paid on the minimum wage portion of employees’ checks.

At the end of this very complicated year, the taxpayers’ bookkeeper prepared their 1040. She was in a hurry, because the taxpayers were trying to close on a new home and needed the return in connection with financing. Both the bookkeeper and the taxpayers knew that the amounts were not correct, and knew they would be amending the return later. At the end of the day the taxpayers reported about $15 million in income and an overall loss of $157,000. The bookkeeper tracked expenses of the concrete business using bank statements, check stubs and cancelled checks, all provided by the taxpayers.

Not surprisingly the taxpayer couple were audited, and had about $1.4 million in expenses challenged as unsubstantiated. At trial, the bookkeeper admitted that she had never seen any backup receipts, invoices or other paperwork to substantiate the expenses, other than the material provided by the taxpayers. The taxpayers confirmed that they hadn’t been keeping these records either. The bookkeeper also admitted doctoring the concrete company’s financial statements to make the company look more profitable when it was applying for a license in another state.

Not surprisingly, the taxpayers lost on all fronts. Without any records to back up their claims for deductions, there was just no evidence to support the expenses as being “ordinary and necessary to the production of income.” In fact, there was evidence that some things had been claimed twice, such as labor expenses, which appeared as both a “Cost of Goods Sold” deduction and as a labor expenses deduction. The cancelled checks and check stubs that the taxpayers did produce were not enough to clearly establish the expenses – even though the court didn’t believe that the taxpayers had falsified the payments. The taxpayers were also unable to take the deduction for income paid to the other, equipment-holding limited partnerships, because these entities had not filed a tax return for the year in question.

The couple in question were lucky they didn’t wind up in jail on top of owing the IRS more than a half-million dollars. In addition to the civil proceedings the IRS also tried to press criminal tax-evasion charges. Those charges didn’t stick because the IRS couldn’t prove the taxpayers had intended to defraud the IRS. They simply had really, REALLY bad business practices.

It’s sad – the couple had the right idea. Upstreaming income to companies that hold expensive assets and lease them back to an operating company is a great way to move income. Employee leasing companies can also be a great way to cut payroll costs, and to create additional tax-saving opportunities for business owners (by allowing the owners to establish a Solo 401(k) plan, for example). In fact, I’m guessing they probably paid someone a substantial sum of money to design and implement this complex tax strategy. But what they didn’t do was follow the formalities required when you are running any kind of business, and particularly when you are running a complex network of businesses.

Leave a Comment