Sole Shareholder Received Constructive Distributions from Fraudulent Transactions

(Parker Tax Publishing October 2022)

The Tax Court held that the sole shareholder of a C corporation, that purported to engage in sale-and-leaseback transactions involving a third party, received constructive distributions of payments made by the C corporation that ultimately ended up with the shareholder. Further, the court concluded that because the shareholder failed to show that the C corporation lacked sufficient earnings and profits, the constructive distributions constituted dividends within the meaning of Code Sec. 316(a) and were thus taxable as ordinary income. Fabian v. Comm'r, T.C. Memo. 2022-94.

Background

From March 2001 to July 2004, Alan Fabian, once a CPA, caused two companies that he formed, Strategic Partners International LLC and Strategic Partners International, Inc. (collectively, SPI), to enter into approximately 50 sale-leaseback transactions to purportedly purchase $32 million in computer hardware and software, when in fact SPI either never purchased such equipment or purchased substantially less expensive equipment. Fabian diverted millions of dollars provided to SPI by the leasing company and used those funds for his personal benefit, including the purchases of beachfront properties in North Carolina, paying for private jet travel, and forming and operating Centre for Management and Technology, Inc. (CMAT), a not-for-profit entity located in Baltimore.

In July of 2004, Fabian defaulted on all outstanding leases. The following month, two of the funding sources filed a petition forcing SPI into involuntary bankruptcy. In an effort to keep the millions of dollars that he pocketed from going back to SPI's creditors, Fabian falsely testified under oath in the bankruptcy case and filed a false Statement of Financial Affairs with the Bankruptcy Court.

After leaving SPI, Fabian worked full-time at CMAT and eventually formed several additional related entities. Beginning in April 2005, he obtained lines of credit and equipment loans from two banks. Between April 2005 and June 2007, Fabian made misrepresentations and submitted false documents to the banks to support periodic increases to the loans and credit lines. By 2007, Fabian was paying himself an annual salary of $800,000. By July and August of 2007 when the banks demanded payment of the credit lines and loans, Fabian's CMAT entities were unable to pay the amounts owed. As a result, the banks sustained losses totaling $7,322,000. Fabian also admitted to defrauding an invoice discounting company, causing a loss of over $200,000.

Fabian continued to steal money and take loans that he could not repay even after he knew that a federal indictment was looming. He took a lavish family vacation to Israel and Egypt in June 2007, leaving a small concierge service that arranged the trip with more than $100,000 in bills to pay. In late July 2007, he sold a non-existent receivable to a victim for more than $200,000, and in early August he fully drew down on a $1.15 million home equity line of credit from a bank, thereby increasing the bank's losses.

After Fabian had been told that a federal indictment was imminent, he caused CMAT to borrow $500,000 from a fellow churchgoer, although Fabian knew that CMAT could not repay the loan. After Fabian was indicted in early August 2007, CMAT was also placed into involuntary bankruptcy by its creditors, who claimed CMAT owed them approximately $30 million.

In 2008, Fabian pled guilty to one count of mail fraud and one count of filing a false tax return and was sentenced to nine years in prison. Before his guilty plea, Fabian signed a plea agreement and a supporting statement of facts summarizing events that occurred between 2001 and 2004 and that supported his guilty plea. In his plea agreement, Fabian described with particularity the fraudulent nature of SPI's dealings, including the fact that it didn't purchase much of the computer equipment and software that it purported to sell, and how the documentation contained material misrepresentations. As to the proceeds of his fraudulent scheme, he admitted that he used sale-leaseback proceeds, among other things, to purchase real estate in North Carolina, to make donations to his children's private school, and to pay for private jet travel. The agreement expressly stated that the IRS was not a party to it and that the IRS was "free to pursue any and all lawful remedies it may have."

The IRS subsequently assessed tax deficiencies relating to Fabian's 2003 and 2004 tax returns, and assessed penalties under (1) Code Sec. 6663(a) for years 2002-2004 and (2) Code Sec. 6651(a)(1) for years 2003 and 2004. Specifically, the IRS said that Fabian failed to report $3.6 million of income in 2003 and $5.1 million in 2004 as a result of constructive distributions to his personal accounts and such distributions were taxable as dividends under Code Sec. 316. Fabian countered that (1) the testimony of one of the IRS's witnesses improperly disclosed a grand jury matter, (2) the statute of limitations applied to prevent the assessments of tax.

Analysis

The Tax Court held that (1) the IRS's witness's testimony did not improperly disclose a grand jury matter; (2) because the IRS showed that Fabian filed false or fraudulent returns with the intent to evade tax, the statute of limitations had not run for any of the years at issue; (3) because of Fabian's control over SPI, SPI's payments for his benefit were constructive distributions to him; (4) because Fabian failed to show that SPI lacked sufficient earnings and profits, the constructive distributions constituted dividends within the meaning of Code Sec. 316(a); and (5) Fabian was liable for the fraud penalties and additions to tax as assessed by the IRS.

The court noted that, regarding tax years 2002 and 2004, Fabian admitted in his plea agreement that, on the joint tax return filed for those years, he overstated the amount of income tax that had been withheld on his wages. Overstated income tax withholding, the court observed, constitutes an underpayment of tax and Fabian's admissions as to 2002 and 2004 were sufficient to satisfy the IRS's burden of proving that the Fabians underpaid their federal income tax for those years. The court found that because of a prior admission by Fabian that he overstated withholding on the joint tax return for 2003, he failed to prove actual withholding for 2003 in excess of the amount reported.

With respect to the penalties, the court rejected Fabian's argument that he took tax positions that were reasonable and consistent with the law and guidelines in existence at the time he filed his returns. According to the court, Fabian failed to show for any of the years at issue that he had reasonable cause for any portion of the underpayment and that he acted in good faith with respect to that portion.

For a discussion of the statute of limitations rules, see Parker Tax ¶260,130. For a discussion of reasonable cause for avoiding tax return penalties, see ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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