CPA Liable for Taxes and Penalties for Defrauding Investors and Lenders

(Parker Tax Publishing May 2022)

The Tax Court held that a CPA, who owned a business and defrauded investors and lenders to the tune of $35 million, and his wife were liable for taxes and fraud penalties on the unreported $35 million in income. The court rejected the couple's argument that the jewelry they purchased was acquired for the company's benefit, not for their own, after finding testimony about the jewelry being bartered to acquire tea from Tibetan monks "utterly implausible." Podlucky v. Comm'r, T.C. Memo. 2022-45.

Background

Greg Podlucky is a certified public accountant. He graduated from West Virginia University in 1984 with a degree in accounting and finance. After graduating he worked for his father, who owned a brewing company in Pennsylvania. Greg then started his own beverage bottling business, which he subsequently named Le-Nature's, Inc. (LNI). LNI, a C corporation, specialized in bottling waters, teas, and similar beverages. Greg was LNI's chief executive officer (CEO), majority shareholder, and chairman of the board. During its early years LNI appeared to have been successful as it grew rapidly, employing roughly 100 people by 2004. Under Greg's leadership LNI reported steadily rising year-over-year revenues and profits.

During the tax years 2003-2006, LNI had two minority shareholders, Smith Whiley & Co. (Smith Whiley) and George K. Baum Capital Partners (Baum). Both were private equity funds. By 2002, Smith Whiley had invested $15 million in LNI and was given two seats on LNI's board. Baum, the other minority shareholder, held the third outside seat on LNI's board. LNI also secured hundreds of millions of dollars in debt financing from larger financial institutions, including AIG, Wachovia, Wells Fargo, and Merrill Lynch.

In 2005, Smith Whiley considered cashing out its investment. Ms. Fields, one of the outside board members, believed, on the basis of quarterly and annual reports furnished to her, that LNI had enjoyed a sharp incline in revenues and profits. The sale of the LNI stock, she thought, would generate a significant return on Smith Whiley's investment. Ms. Fields coordinated with Baum to investigate the possible sale of their stock (or of the company). They hired an investment banker to estimate LNI's value and look for potential buyers. Ms. Fields received expressions of interest from several buyers, but no deal ever closed. According to Ms. Fields, Greg "sabotaged" the negotiations by refusing to give potential buyers access to LNI's accounting records.

In May 2006, the minority shareholders sued LNI in the Delaware Chancery Court, alleging that Greg had intentionally obstructed their attempts to sell their stock by blocking access to LNI's books and records. A few months later, one of LNI's lenders informed the minority shareholders of its belief that Greg had forged documents in order to secure loans and had used loan proceeds to purchase millions of dollars of assets for himself and his wife.

After receiving this information, the court removed Greg as CEO and appointed a financial restructuring specialist, Mr. LoBiondo, to take control of LNI. Mr. LoBiondo quickly discovered that LNI had maintained two sets of books: one set that reported actual sales and profits, and another that reported fictitious sales and profits. In one year, LNI reported roughly $300 million in revenue, but its actual revenues were closer to $30 million. These findings prompted LNI's creditors to file an involuntary bankruptcy petition against it. By the end of November 2006, Mr. LoBiondo concluded that LNI could not be resuscitated. The company's facilities were closed, and it ceased operations. The minority shareholders lost virtually all of their investments, and LNI's lenders lost more than $600 million.

In December 2006, the Department of Justice, the IRS Criminal Investigation Division (CID), and the Postal Inspection Service began investigating Greg and his wife, Karla, for criminal wrongdoing. CID uncovered evidence that Greg had directed one of his employees to keep accounting records using two different software systems: One system was used to record LNI's actual results, and the other was used to create fictitious (and much more favorable) results. The investigation also revealed that Greg had siphoned money out of LNI by writing checks on LNI's accounts and by wiring funds from those accounts to two shell companies he controlled.

The banking records showed that Greg had siphoned more than $30 million out of LNI to purchase assets for himself and his wife. Roughly 70 percent of the assets thus purchased consisted of luxury jewelry - mostly women's jewelry - including bracelets, necklaces, diamond rings, and watches designed by Chopard, Patek Philippe, and Rolex. Because Greg needed a safe place to store the jewelry, he had a secret room built at the company headquarters. Criminal investigators executed a search warrant and found in the room commercial grade safes stocked with gemstones, necklaces, watches, bracelets, and diamond rings. Greg also used company funds to purchase real estate upon which he built a six bedroom and nine bath house, known as the "Podlucky Gate House," and spent more than $1 million buying Lionel brand toy trains.

In September 2009, Greg was indicted on counts of mail fraud, conspiracy to commit money laundering, and attempting to evade or defeat tax in violation of Code Sec. 7201. The tax charges were based on his failure to report roughly $35 million of income, in the form of constructive distributions from LNI. Greg pleaded guilty to one count of tax evasion, as well as one count of conspiracy and mail fraud. He was sentenced to 20 years' imprisonment. Karla was indicted on money laundering and conspiracy to commit money laundering charges, was found guilty, and sentenced to 51 months' imprisonment. During her trial, a senior vice president of sales for Van Cleef & Arpels (VCA), Mr. Nestor, testified about Greg's jewelry purchases from VCA, explaining that most of the jewelry was custom made for Karla and he personally made trips to Pennsylvania to take Karla's measurements so that the jewelry could be sized to fit her exactly.

Following the criminal investigation, the IRS initiated a civil examination of the Greg and Karla's tax returns. The IRS reconstructed their income and concluded that the couple had received almost $35 million in the form of constructive distributions from LNI. However, the IRS found that LNI had zero earnings and profits (E&P) during 2003-2006 so a portion of the distributions were nontaxable returns of capital to the extent of the couple's stock basis. In the end, the IRS determined that the couple owed almost $4.8 million in income taxes on the unreported income and $3.6 million in Code Sec. 6663 fraud penalties.

Before the Tax Court, the couple contended that the assets they purchased were acquired for LNI's benefit, not for their own. Greg testified that he purchased luxury jewelry because LNI was diversifying its product lines and dealing with Tibetan monks in Asia who wanted hard assets rather than cash. According to Greg, the monks had access to valuable species of tea, which LNI wished to acquire by using jewelry in "bartering transactions." Greg also argued that the "Podlucky Gate House," situated on land zoned for residential use, was intended to be used as a "training facility" for LNI's staff. Additionally, the couple argued that they should be allowed loss deductions for property forfeited pursuant to their guilty pleas.

Analysis

The Tax Court agreed with the IRS and held that the couple owed approximately $4.8 million in income taxes and $3.6 million in fraud penalties. With respect to the couple's argument that the assets they purchased were acquired for LNI's benefit, not for their own, the court found the testimony "utterly implausible" after noting that Greg was unable to tell the court where the alleged monks lived or confirm that the country in which they lived produced tea. He could not explain, the court observed, why the monks would prefer jewelry to the U.S. dollar as a medium of exchange and why Buddhist monks would be eager to acquire women's jewelry, particularly jewelry that was sized to fit Karla's wrist. Further, the court said, Greg could not explain why $22 million of jewelry, if an asset of LNI, was neither shown on its balance sheet nor brought to the attention of its directors.

With respect to the home they had built with LNI funds, the court noted that Greg could not explain why LNI would have chosen to build an employee training facility next door to his house, 12 miles away from the company's production facility and could not explain why LNI needed a separate training center, when the facility at its headquarters had recently been expanded to include ample space for conference rooms and employee offices.

The court also found that the couple failed to prove that they were entitled to loss deductions under Code Sec. 165(a). Assuming arguendo that Greg was ordered to pay restitution, the couple offered the court no evidence that they actually made restitution payments or (if so) how much restitution was paid. And while the couple asserted that their property was forfeited, they offered no evidence to the court to establish which assets were forfeited or the value of such property.

With respect to the fraud penalties, the court concluded that the IRS established by clear and convincing evidence that the underpayments of tax for 2003 - 2006 were attributable to fraud. Greg did not establish, "by a preponderance of the evidence," that any portions of the underpayments were not attributable to fraud.

Finally, while Karla did not argue that she was eligible for innocent spouse relief under Code Sec. 6015(f), the court noted that if she had, her claim would fail for several reasons, including the fact that the tax liability must be attributable to the non-requesting spouse.

For a discussion of the taxation of constructive dividends and the criteria for the assessment of the fraud penalty, see Parker Tax ¶44,120 and ¶262,125, respectively.

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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