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Oct 7Glen Katlein

What To Do When the Boss Is a Tax Evader

Oct 7Glen Katlein

Our CEO , Contributor to CFO.com

Most privately held U.S. companies are formed as pass-through entities, such asS Corporations, limited liability companies (LLCs), and partnerships etc. This means that the income from such entities is passed to the owners, who are taxed at personal income tax rates.

Effective personal income rates, including federal, state, local, county and other taxes, may exceed 50% in certain areas of the country. Those high tax rates cause some business owners to become aggressive in their attempt to reduce taxes. And some of those owners treat their companies as alter egos and bury personal and family expenses in their company’s income statements.

A delicate way to describe aggressive tax methods by business owners is to say they are “working in the gray area.” Tax evasion is the correct way, since such approaches amount to illegal attempts to lower or avoid taxes.

Regrettably, some of these employees don’t “blow the whistle” on these activities for a variety of reasons, including a fear of losing their jobs. In addition, the owner may disguise the tax-evasion transactions so that employees don’t know about them.The repercussions to business owners who are tax evaders are obvious and well-known. Unfortunately, the owner usually isn’t the only person that may be punished for tax evasion. Tax evasion by the owners of private companies can cause stress, unemployment and legal problems for CFOs, treasurers, controllers, chief accounting officers and people in similar positions.

Business owners can become very creative in burying personal items in their company’s income statements. Below are some examples that I have either personally seen or know about.

  • An owner used money borrowed from a bank to buy more than $1 million in personal jewelry, all of which was expensed on the company’s income statement. The news of the jewelry purchases was inadvertently made public, and the owner was murdered by someone who stole the gems.
  • An owner treated tuition for his children as a business expense.
  • A businessman wrote off almost $10,000 annually for work boots. He did in fact purchase the boots. But they tended to be made of exotic materials like ostrich and boa constrictor skin, and seldom did he wear them to work.
  • Although the 17-year-old son of an owner/manager did not produce anything of value for the company, he drew a salary of $100,000.

And here are some generic examples of personal expenditures that are sometimes buried in company income statements.

  • Repairs, remodeling, maintenance, insurance or other expenses for a personal residence.
  • Legal expense for a divorce, personal litigation or personal estate planning.
  • Personal hobbies, such as buying antique automobiles.
  • Inventory or scrap metal sold in cash and deposited in the owner’s personal bank accounts.
  • Alimony or child-support payments made by the company and treated as a company expense.

Obviously, not all business owners use aggressive tax-evasion tactics. There is a difference between tax evasion and tax avoidance. Business owners have a legal right to avoid taxes and should hire the most competent tax professionals possible for income tax avoidance.

What can CFOs, treasurers, controllers and chief accounting officers do themselves in a situation in which they see or uncover something that might look like tax evasion? They have options. Something may look like tax evasion but may be really tax avoidance.

Avoidance or Evasion?

Tax avoidance is the legal process of using the tax laws to one’s advantage to reduce the amount of tax payable by means that are within the tax law. Tax evasion, on the other hand, is the deliberate avoidance of taxes by illegal means. Tax evaders deliberately misrepresent or conceal the true state of their situations to the tax authorities for the purpose of reducing their tax liability.

For instance, a business owner may be remodeling the kitchen and bathrooms of his personal residence, which is not used for any business purpose, for $60,000. The disbursements for the remodeling of the personal residence are made by the owner’s business.

The owner instructs the accounting staff to treat these disbursements as an expense in the company’s repairs and maintenance account instead of treating the transaction as a loan and/or distribution to the owner. The company’s taxable income ends up being understated by $60,000. The owner has deliberately concealed the true state of both his company and his personal tax return and has committed tax evasion.

Another example might be a business owner who has an expensive hobby: buying and remodeling old automobiles. He uses his business to purchase and repair the autos. The repairs are often made by his employees, who also purchase repair materials in the company’s name. The purchase and repairs are expensed in various accounts on the company’s income statement, including miscellaneous expense, repairs and maintenance, insurance expense, and payroll.

The owner often sells the autos for cash and doesn’t report the sales proceeds in his company’s or his own personal tax returns. This owner has deliberately concealed the true state of both his company and his personal tax return and has committed tax evasion.

Watch What You Divulge

In light of the risks they face, employees should handle their discussions with their firm’s tax advisers carefully. They should, for instance, receive written permission from the officers and/or owners of the company before talking to the advisers.

Such precautions should be taken because employees of a privately-held company can be sued by the owner if they divulge company information without permission from the owner. The financial information of the company belongs to the company and its owners, not the employees. Owners can charge employees with such things as theft and breach of fiduciary duty if they take financial information outside of a company without the permission of the officers and/or owners of the company.

An employee sued in such a situation might eventually win the lawsuit. But he or she employee will most likely pay tens or hundreds of thousands of dollars in legal fees for the defense of his or her actions.

The employee should thus disclose to the officers and/or owners of the company any and all information that will be disclosed to a tax adviser and the nature of the questions to be asked of the adviser.

Employees who know or suspect that their employers are evading taxes should seek advice from a personal attorney. The employee should tell the entire story to the attorney without taking any physical evidence from the employer’s business.  The attorney should know the questions to be asked and work to help the employee from either being sued and/or being held accountable or complicit with the alleged tax evasion.

Under such circumstances, and after consulting with the personal attorney, an employee would do well to consider resigning from the company. That’s because the issue of tax evasion may not go away in the near future.

The higher the effective tax burden, the more is the temptation the for business owners to use aggressive methods to lower their tax payments. We need to keep our eyes and minds open. Our professional careers and personal livelihoods may be in jeopardy if we don’t use caution and wisdom about possible tax evasion by an employer.

Jerry L. Mills is founder of B2B CFO, a firm that provides finance advice to privately-held companies with annual sales of up to $75 million.

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