In the movies, an American who is entrusted with millions from a Chinese shipping magnate, but blows it at casinos, would face unimaginably dire consequences. In real life, he faces the IRS.
That’s the story in a weird Tax Court case decided yesterday. The shipping magnate, a Mr Cheung, had fared poorly as an investor. He met a Mr. Sun from Texas and decided that he might be better at investing. He shipped the money to a C corporation and an e-Trade account owned by Mr. Sun, under a handshake deal with fuzzy terms. Judge Paris explains:
The only part of the arrangement that both Mr. Cheung and Mr. Sun consistently agreed on was the general structure of the investment. Mr. Cheung would transfer sums of money through his shipping companies’ bank accounts to Mr. Sun, who would then invest the money in the United States. Mr. Cheung would decide how much money he wished to send, and Mr. Sun had discretion on which investments to pursue with Mr. Cheung’s money.
The remaining terms of the verbal agreement were not memorialized and are unclear. Specifically, Mr. Sun and Mr. Cheung inconsistently described the investment term, the expected return, and enforcement provisions. Mr. Sun believed the term was a minimum of 5 years and did not give a maximum period, whereas Mr. Cheung believed the term was 7 to 10 years. The expected return is also unclear; Mr. Sun believed the return on investment would be a 50-50 split of the net profit with a minimum 10% gain annually, but the return might not be paid annually. Mr. Cheung believed the return would be 10% to 15%, but was uncertain whether that return was annual or total.
Not the sort of investment arrangement Suze Orman or Dave Ramsey would embrace. Nor would they embrace some of the “investments” described in the Tax Court case.
The funds sent to Mr. Sun’s C corporation went into an “officer loan account” for Mr. Sun. And then… well, again from Judge Paris (emphasis mine):
Mr. Sun would either pay his personal expenses directly from the officer loan account or he would remove money and use it at his discretion. For example, in 2008 Minchem paid $135,874.43 for home automation, $158,517.80 for a new Mercedes Benz, and $49,598.81 for personal real estate tax. In total, Minchem’s officer loan account was debited $4,116,414.43 in 2008 and $1,811,127.65 in 2009 for expenses that Mr. Sun identified as personal during his trial testimony.
Some of the personal expenditures included gambling expenses. In 2008 $4,800,100 was transferred to casinos from the officer loan account and $2,394,550 was returned. In 2009 $1 million was transferred to casinos and $1,300,000 was returned. Thus between 2008 and 2009 Mr. Sun transferred $5,800,100 from the officer loan account to casinos and received back $3,694,550; i.e., over the two years in issue Mr. Sun lost $2,105,550 from gambling from the officer loan account.
Judge Paris said that the funds never belonged to the C corporation because it was a mere conduit for the cash; that meant the corporation was not taxable on the amounts.
Mr. Sun didn’t get off so easy. Judge Paris said that the funds became income to Mr. Sun when he began spending them for his own purposes (citations omitted):
Whether funds have been misappropriated is a question of fact, but facts beyond “dominion and control” must be considered. More specifically, an individual misappropriates funds when money has been entrusted to the individual for the sole purpose of investing and the individual instead uses the money for personal activities.
Mr. Sun undisputedly treated as his own money held for Mr. Cheung’s benefit and specifically earmarked for investment purposes. For example, Mr. Sun used some of the funds to purchase a personal automobile and a home automation system. Perhaps the most obvious example of Mr. Sun’s misappropriation of the funds is his gambling activities.
The opinion dismissed the idea that the funds were loans because there was no documentation of any sort of loan agreement or terms. The court said that the amounts weren’t gifts because no Form 3520, where U.S. taxpayers report large foreign gifts, was filed, and because there was no evidence of an intent to make a gift.
While the Tax Court ruled that Mr. Sun misappropriated the money, it ruled that the IRS failed to prove fraud. That meant the penalties were only 25% of the roughly $4.7 million of additional tax, rather than the 75% under the civil fraud rules.
The Moral? Hard to say. Don’t squander millions of dollars entrusted to you for investment at casinos? You didn’t need the Tax Court to tell you that. Maybe it’s a handy reminder to file Form 3520 if you receive large foreign gifts, lest the IRS get the wrong idea (and lest they hit you with a $10,000 penalty for not filing it). And if you have had bad luck with your investments, maybe index funds are a better way to go than a handshake deal with some guy in Texas.
Cite: Minchem International, Inc., et. al., T.C. Memo 2015-56.
Kyle Pomerleau, U.S. Taxpayers Face the 6th Highest Top Marginal Capital Gains Tax Rate in the OECD (Tax Policy Blog):
The United States currently places a heavy tax burden on saving and investment with its capital gains tax. The U.S.’s top marginal tax rate on capital gains, combined with state rates, far exceeds the average rates faced throughout the industrialized world. Increasing taxes on capital income, as suggested in the president’s recent budget proposal, would further the bias against saving, leading to lower levels of investment and slower economic growth. Lowering taxes on capital gains would have the reverse effect, increasing investment and leading to greater economic growth.
But, but, the rich!
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Joni Larson, Proposal to Amend Section 7453 to Provide that the Tax Court Apply the Federal Rules of Evidence (Procedurally Taxing)
Tony Nitti, Ted Cruz To Run For President: Why His Plan For A Flat Tax May Doom His Candidacy:
Whether a move to a much more regressive system than the one currently in place is ultimately in the best interest of the economy and country is irrelevant; the Democrats will seize on the shift in the tax burden and continue to paint Republican candidates as seeking only to placate the rich.
I think Hillary Clinton, or whoever the nominee is, will do that to any Republican opponent, regardless of any actual policy positions. The question is whether they will be able to more successfully deal with the issue than Mr. Romney.
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