Payment of taxes is absolutely a very lackluster affair that nobody enjoys fulfilling, even though it is a constitutional obligation of any citizen besides being a patriotic act. It was even said, ‘as sure as death and taxes’. People would want to reduce the amount of taxes that they pay, and if possible, to zero. However, this is not easy because refusal to pay taxes is playing dice with the Internal Revenue Service, the jail at times, and even dire financial consequences, which might take years to get clearance. As a tax advisor, it is therefore paramount to show clients how to reduce their tax bills and while at it, be within the precincts of the law. This paper aims at differentiating between tax avoidance and tax evasion using legal cases that have been decided in the U.S. to source for perspectives.
Differences between Tax Avoidance and Tax Evasion
Tax avoidance is the legitimate reduction of tax liability. To achieve this, taxpayers will capitalize on shortcomings that are within the law and the end goal is reducing the total tax payable. People will use different methods to avoid taxes, such as claiming exemptions. To demonstrate tax avoidance, this paper will consider the cases of Newman v. C.I.R and Caruth v. the United States.
Newman v. C.I.R. In Newman v. C.I.R, the appellants, Newman, appealed for a decision that was made in a lower court. Newman claimed an investment tax credit (ITC) from his purchase of a tractor-trailer. The Commissioner of IRS disallowed the credit and the Tax Court upheld the Commissioner’s determination since it was observed that the truck was leased to a third party after purchase and as such, was not entitled to a claim – the ITC. To appeal, Newman claimed that the agreement in consideration was not a lease agreement but rather an employment agreement between Newman as the employer, and the lessor, Schultz Transit who was the independent contractor. In this particular case, Schultz Transit was neither leasing nor purchasing trucks to exonerate itself from the risks. As such, it was only operating the trucks on behalf of the investors such as Newman. In this agreement, Schultz Transit would collect the gross revenues for operating the trucks and deduct 21% of such revenues as compensation.
An attorney who was advising the transaction advised that the owner of the truck would qualify for an ITC. Newman financed the transaction to a tune of $80,000 from a financier. In the agreement, the parties were referred to as lessor and lessee and the agreement as a lease. It was agreed that Newman was at liberty to cancel the deal with Schultz Transit, should the transaction not yield at least $5,037 as profits in any three consecutive months. The agreement did not yield the agreed profits, and Newman chose not to terminate the agreement until a deficit of $7,500 was accrued and at that point, he terminated. The agreement was then converted into a traditional lease and the debt owed by Newman to Schultz was satisfied out of the lease fees. Newman claimed ITC on the truck using the earlier agreement with Schultz Transit in the 1982 tax return to a tune of $5,556. The Commissioner characterized the operating agreement as a lease, a position that was upheld by the Tax Court.
In the appeal, it was determined that the Tax Court was correct in its holding that the operating agreement was a contract between Newman and Schultz and as such, it was a lease. To arrive at this conclusion, it was found that the Tax Court relied on the findings that Schultz Transit was in the day-to-day control of the truck. During the appeal, it was noted that when a taxpayer chose to conduct his business in a certain form, the tax collector should not deprive him the tax benefits of following such a decision unless it is fiction or a sham. In so doing, the court should not exalt the substance over the form and it was found out that the decision had economic substance and it was formed for other reasons, not merely tax avoidance. The decision to alter the business arrangement was influenced by factors beyond tax avoidance.
In the appeal, it was found out that the Tax Court was erroneous in its arrival to the legal conclusion. It was held that if the agreement was executed as a lease, the ITC belonged to Schultz Transit, and if it was an employer arrangement, it belonged to Newman but Newman bargained for the right to the ITC by accepting the risk of operating losses. As such, the Court of Appeal vacated the decision by the Tax Court and awarded Newman ITC.
Caruth v. the United States. In Caruth v. the United States, Caruth owned stocks at North Park Inn, Inc. in Texas to a tune of 75% of the total shares in both class A and B shares. The rest of the shares were owned by Caruth’s nephews. In 1978, Caruth also owned 100% of the shares in Caruth Corporation, which was active for 40 years. In 1978, Caruth was contemplating having North Park declare dividends and wind down the company and in the process get money out of the company. Caruth had failed to convince his nephews to sell their shares to him. Since North Park was winding down, it did not need cash reserves and as such, he wanted the company to make capital contributions to Caruth Corporation, as well as, have North Park declare a dividend.
To execute his strategy, Caruth transferred his 337.5 shares of North Park class B common stock to the Caruth Corporation. Three days later, North Park declared a dividend of $1,500 per share. A day later, he donated his 1000 preference shares of North Park to the Community Chest. On the dividend payment date, North Park paid the dividends as declared and the Community Chest got $1.5 million, Caruth Corporation goy $506,250 and Caruth received $56,250. Two months later, Community Chest sent a letter to Caruth to ask if there was anybody who would buy the shares at a call price of $100 per share. It is important to note that Caruth had not made any agreements to buy back the shares. Nine months after the inquiry by Community Chest, Caruth wrote back to acknowledge that he did not know anyone who would repurchase the stock but he would repurchase the stock for $100 something that was agreed upon and the shares were transferred back to Caruth. In 1978, IRS objected that the 1000 Community Chest shares were valued at $1.6 million by claiming that the dividend income from the stock should not be attributed to Caruth due to the ‘assignment of income’ doctrine. Further, the IRS claimed that the 337.5 shares transferred to the Caruth Corporation should be attributed to Caruth as an individual, and not the corporation. Caruth, in 1981 paid all the shortages as assessed by IRS for the 1977 and 1978 tax years to a tune of $723,790 in taxes and $177,392.45 as interest. The payments were denied and in 1984, Caruth filed a suit to have the taxes paid under protest refunded.
The court ruled that Caruth had a business case in his transfers. As such he was not required to pay income tax on the $1.5 million in dividends for 1000 shares of North Park, which was donated to Community Chest. The second aspect is that the court ruled that Caruth was not required to pay income tax on the $506,250 in dividends for the shares he transferred to Caruth Corporation.
Tax evasion is a deliberate and intentional act of either failing to pay for tax liabilities or failing to file tax returns or both. Further, falsifying income records or using underhanded methods to avoid taxes is also tax evasion. In the U.S., tax evasion is a serious crime that attracts significant fines and jail terms, which can extend to several years. To demonstrate the seriousness of this illegality, we shall consider Niles v. Milbourne and Commissioner of Internal Revenue v. Dyer.
Niles v. Milbourne. Niles v. Milbourne was an appeal from a judgment that was entered in the District Court for the District of Maryland. The case was necessitated by the plaintiff who wanted to recover income taxes that were paid under protest. Andrews who died on the November of 1933 and his wife who had died shortly before, had filed a joint income tax return of 1932, for himself and his wife. Their tax records indicated that they had a net income of $6,508.38. No tax was due from them since they had two infants and dividends. They also made a loss in their real estate investment sales, which were made by Andrews himself, through a local brokerage firm. On the same day of making the sales, the wife to Andrews made purchases and payments made the next day.
A claim for refund was filed and rejected after the husband made payments and the wife made purchases. The net effect of the two transactions was a loss and the question was whether the loss after the transaction was tax deductible. The Commissioner of Internal Revenue rejected the loss. In the Court of Appeal, it was determined that the transactions were circuitous and were employed to effectuated as gifts and not sales. As such, the plaintiff was dealing with himself and as such, there was no deductible loss.
Commissioner of Internal Revenue v. Dyer. In this case, Mr. Dyer and six others were all stockholders and directors at a company, Lamborn & Co., which owned all the capital stock of Elanco Realty Corporation. On 30 November 1927, seven shareholders of Lamborn & Co; Mr. Dyer contributed 1,005 shares of the 6,700 sold. The directors of Elanco authorized the purchase of 6,700 shares of Lamborn & Co. stock at $59.42 per share and 4.5% per annum interest. The transfer was recorded in the books of Elanco with all statutory payments paid. The directors of Elanco authorized the sale of 6,700 shares of preferred stock of Lamborn & Co. at the actual value and each seller repurchased from Elanco the same number of shares as previously sold but at an advance of 20 cents per share. A profit of $1,340 was included in Elanco’s income tax return of 1928. Mr. Dyer claimed the right to deduct from his income for 1927 the loss realized after the sale on November 30, which amounted to $37,172.92. The motive in the sale of shares by Mr. Dyer was determined to reduce taxes by claiming losses on the sales. The court determined that there were an actual transaction and delivery of stocks to Elanco, but the loss was not realized out of this transaction. The transfer was motivated by tax reduction motives but not commercial reasons. As such, Mr. Dyer was found to be guilty of tax evasion.
Tax Liability Minimization: Is it Tax Avoidance or Tax Evasion?
People are not fond of paying taxes. Furthermore, taxpayers are not responsible for paying more than they should, and as such, taxpayers can organize themselves in such a manner that will let them have a reduced tax burden. However, the same should be within the parameters set by law. In this paper, I, therefore, come to the conclusion that tax liability minimization is tax avoidance. If the same is within the law, it is avoidance, if it goes outside the legal parameters, it becomes tax evasion as expressed in the cases evaluated below.
In Coca Cola v. the United States, the case involved repatriation of assets from a foreign subsidiary to a local subsidiary and the implications of the same. Dividends from a foreign subsidiary, as it was argued by the defendant, should be taxable as expressed in the Revenue Act of 1928. The court found out that a reorganization involving the transfer of assets from one subsidiary to the other is non-taxable. As such, companies, which are changing the ownership of assets, are at liberty to involve their subsidiaries to reduce their tax burden.
In Lewis v. Commissioner of Internal Revenue, it was heard that the petitioners sought the court to invoke the doctrine of Gregory v. Helvering. This ending would lead the petitioners from avoiding tax consequences of a transaction that falls within the legal definition of‘reorganization’. In the case, the tax court found that there was no interruption of the business or any aspects of its operations. In so doing, the court found a commercial reason in the transaction and thus, termed the reorganization, genuine. As such, the dividends arising from such a transaction was taxable and the commissioner won the case. In this case, it is demonstrated that commercial transactions need to be well captured and with the right motive. Gains on such transactions should be reported and due taxes paid on them.
The continuity of a business is dependent on many factors, the major one being compliance with the tax system. As such, it is important to conduct business within the law to avoid litigation by tax authorities. Tax liabilities should be reduced to the bare minimum but the same should be conducted within legal parameters.
Caruth v. the United States, 566 F.2d 901 (5th Cir. 1978). Retrieved from https://www.leagle.com/decision/19871817688fsupp112911653
Commissioner of Internal Revenue v. Dyer, 74 F.2d 685 (2d Cir. 1935). Retrieved from https://www.leagle.com/decision/193575974f2d6852541
Gregory v. Helvering, 293 U.S. 465, 55 S. Ct. 266, 79 L. Ed. 596 (1935). Retrieved from https://www.leagle.com/decision/1935758293us4651704
Lewis v. Commissioner of Internal Revenue, 176 F.2d 646 (1st Cir. 1949). Retrieved from https://www.leagle.com/decision/1949822176f2d6461650
Newman v. CIR, 902 F.2d 159 (2d Cir. 1990). Retrieved from https://www.leagle.com/decision/19901061902f2d15911023
Niles v. Milbourne, 100 F.2d 723 (4th Cir. 1939). Retrieved from https://www.leagle.com/decision/1939823100f2d7231609United States v. Coca Cola Co. 241 U.S. 265, 36 S. Ct. 573, 60 L. Ed. 995 (1942). Retrieved from https://www.leagle.com/decision/194215647fsupp1091125
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