FROM TRAGEDY TO BIG TAX SAVINGS FOR SMALL BUSINESS OWNER BY: JEFFREY R. MATSEN

6:13 pm Uncategorized

Several years ago, another attorney for a small closely held company approached me with the fact situation set forth below.

Peter was the President of a small manufacturing company and acted as the General Manager of its operations.  His wife, Helen, was the Executive Vice President and was responsible for all of the Company’s financial and administrative matters.  Peter had just designed a new mixing machine that was used by the Company to produce low grade urethane foam and had been training plant personnel on the use of the machine.  On one occasion, Peter was operating the machine and his sweater sleeve caught on a protruding bolt and his arm was pulled into the machine.  As a result, Peter suffered serious injury including a fractured arm, soft tissue lacerations and second and third degree burns.  The injury required surgery and the installation of a metal plate in his forearm and it was a likely that Peter would suffer some permanent loss of some use of his arm.

Peter and his corporate counsel then consulted me about the possibility of Peter putting in a claim against the Corporation for damages.  The corporate counsel and I recommended that Peter retain a personal injury lawyer to handle his grievance.  The personal injury lawyer and the corporate counsel negotiated a six figure settlement, which at the time (1977), was a very substantial amount.  I recommended that the Company deduct the settlement payment to Peter as a legitimate income tax expense under Section 162(a) of the Internal Revenue Code and that Peter exclude the receipt of the payment on his income tax return under Section 104(a)(2) as compensation received on account of personal injuries.

The IRS subsequently audited both the Company and Peter and Helen’s personal Tax Returns.  They argued that the payment from the Company to Peter was a disguised dividend and, therefore, not deductible by the Company and not excludable from Peter’s income.  Peter and the Company vigorously objected to the IRS position and they hired me to fight the battle for them in the US Tax Court.

Of course, the whole position of the IRS was based on the fact that the transaction in question was between a closely held corporation and its President who along with his wife, Helen, were the controlling shareholders.  Accordingly, under these facts, Peter and the Company were, obviously, not dealing at arm’s length.  This engendered a greater burden on Peter and the Company to show the legitimacy of the transaction.  I argued that the Court should compare the actions of Peter and the Company with what would have occurred if the transaction had been between parties who were dealing at arm’s length. Corporations, by definition are independent entities, separate from the owners yet the IRS was treating them as one in the same.   If Peter had been an employee of the Company who was not a controlling shareholder and had suffered this injury, he more than likely would have hired an independent attorney to pursue his claim, just as we had recommended that Peter do.  The Company’s attorney and Peter’s personal injury attorney negotiated a reasonable settlement just as probably would have happened had Peter been a typical employee with the Company without any ownership interest.

In closing arguments to the Court, I stated that the decision should be based on whether there was a reasonable basis independent of tax considerations for the Company to deduct the settlement payment and for Peter to exclude it as compensation for personal injuries.  The fact that Peter was a controlling shareholder of the Corporation should not disqualify him from the reasonableness of receiving a tax free settlement under the law which allows for the Corporation to deduct such settlement payment.

During the final arguments of the case, the IRS attorney finished his closing remarks by stating that the whole transaction was just a manipulated tax saving scheme.  My retort was that the obvious inference of the IRS argument was that Peter intentionally stuck his arm in the machine and suffered the grievous injury on purpose.  I told the Judge that this would truly be “tax planning with a vengeance”.  The Judge acknowledged the absurdity of this notion with a smile.

In any event, the Judge ruled in our favor and Peter and his Company were able to receive a huge income tax benefit.  Of course, the moral of the story is that Peter and his Company had the proper tax and legal advice which included a very practical and well thought out plan:  1) the hiring of an independent personal injury lawyer for Peter; 2) the representation of the client by Peter’s personal injury lawyer which was backed up by medical reports; 3) the negotiation by the corporate attorney, reviewing the claim and the medical reports and 4) the action by the Board of Directors of the Company to give effect to the settlement proposal.

Of course, the preparation of a compelling brief to the Tax Court along with a winning trial presentation and closing argument were critical.  There is, obviously, no substitute for creative and well thought out tax strategy followed by the implementation of a very specific and practical plan.

If you would like to read more, the citation for the case is Maxwell v Commissioner, United States Tax Court, 9T.C.107 (1990).  As an aside, a few weeks after the issuance of the written of opinion by the Tax Court, Time Magazine ran a short article on the case with the implication that the taxpayer had really gotten away with an unbelievable tax dodge and huge tax benefits.  I wrote a letter to Editor in reply to the article, more or less, summarizing my closing arguments to the Judge and pointing out that if this really was a tax dodge, it carried a very high price of injury and disability to Peter (my letter was never published).  As another aside, the IRS counsel on the case, who is currently in private practice, refers me clients.

Contact us today for individualized planning strategies to meet your unique needs.

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