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Tax planning beats tax cheating

September 19, 2011

When people start to cheat on their taxes, they often tell themselves that it is a no-lose game. If they get caught, they figure, well, they just pay the tax, and things are no worse than they would be otherwise.

That's wishful thinking. Aside from the potentially awful non-tax consequences -- jail, ruin, and so on -- tax evaders often end up much worse off strictly in terms of the taxes they pay. Jack Townsend tells the story of a Missouri orthopedic surgeon convicted of trying to evade taxes through the Aegis trust program. Earnings were diverted to offshore companies controlled by the orthopedist as fake "management fees."

The IRS treated the diverted amounts as non-deductible dividends, taxable to the surgeon. That meant the income was taxed twice -- once at the 35% top personal service corporation rate, and again as dividend inocme to the doctor.

The surgeon argued that he should be allowed to treat the amount as wages, deductible to the corporation, to avoid the double tax. If he hadn't cheated, that's almost certainly what he would have done. The Eighth Circuit appeals panel told him that he made his bed, so he gets to lie in it:

Although the corporation likely could have paid him more for those services and properly deducted that amount as a business expense — with [the surgeon] then paying income tax on his additional compensation — the Ellefsens did not structure Brian's income in that way. They instead decided to utilize the Aegis system and falsely deduct management fees from [the corporation's] corporate tax returns. The income was not taxed at all — despite the fact that [the surgeon] was spending the money — until after the government subpoenaed documents from [the accountant] and [the surgeon] decided to amend his personal tax returns. In these circumstances, we conclude that the so-called management fees were properly considered constructive dividends

The moral? Once the IRS criminal investigators are sniffing around, don't expect to get a mulligan.

Cite: Ellefsen, CA-8, No. 10-2857

Tags: Jack Townsend.mulligans.personal service corporations.tax crime.