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Taxpayer's Betrayal of Friend Leads to $7.8 Million Tax Bill.

(Parker Tax Publishing April 9, 2015)

A taxpayer was required to recognize taxable income when he misappropriated funds entrusted to him for investment purposes by an overseas friend. Minchem Int'l, Inc. v. Comm'r, T.C. Memo. 2015-56.

Background

Jerry Sun came to the United States in 1986 for a position with an international mineral trading company and in 1993, he organized Minchem International, Inc. (Minchem), a C corporation, to import and distribute industrial minerals from China. That same year, Sun met Bill Cheung, a resident of Hong Kong and an owner of several shipping companies. The two men became friends, frequently discussing American investment opportunities.

In 2006, the two verbally agreed on an investment strategy for Cheung after discussing potential opportunities in the United States: Cheung would transfer funds through his shipping companies' bank accounts to Sun, who would then invest the money in the United States and send portions of the returns back to Cheung.

Minchem opened a loan account for funds Cheung sent to Sun for investment. The loan account would be debited and the balance would be increased when funds were drawn by, or paid for the benefit of, Sun. Conversely, the account would be credited and the balance would decrease when funds were paid to Minchem. Minchem did not sign any contracts with Sun regarding the loan account, and he was not required to pay interest on any loans from Minchem, nor was Minchem was required to pay interest on any loans from Sun.

By the beginning of 2008, Sun began using the loan account as a slush fund for his personal expenses. He would either pay his personal expenses directly from the loan account or he would withdraw cash and use it at his discretion. For example, in 2008 Minchem paid $135,874 for home automation, $158,517 for a new car, and $49,598 for personal real estate tax, all for his own benefit. Large amounts of the personal expenditures also included gambling expenses, and over the course of 2008 and 2009, Sun lost $2,105,550 gambling with funds from the officer loan account.

Sun did use some of Cheung's funds for investment, directing transfers of $304,411 to his investment corporation (Sun Investment) and $2,900,000 to his personal online stock brokerage service account. However, Sun failed to distinguish whether the money was his or Cheung's.

Neither Minchem nor Sun reported money received from Cheung as income for 2008 or 2009, and the IRS sent deficiency notices to both. The IRS determined that the money from Cheung's foreign companies was either gross receipts to Minchem, which then made a distribution to Sun or, alternatively, represented direct income to Sun.

Analysis

Income is taxable to the person who earns it (Lucas v. Earl, 281 U.S. 111 (1930)). The "true earner" of income is the person or entity who controls the earning of such income, not necessarily the recipient of the income, and the crucial question is whether the person retains sufficient dominion and control over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes (Barmes v. Comm'r, T.C. Memo. 2001-155).

The Tax Court determined that Minchem did not retain sufficient dominion and control over the funds transferred by Cheung to make it the recipient of the income for tax purposes. Instead, the court found Minchem acted as a conduit for the money, and noted that taxpayers acting merely as a conduit do not receive taxable income.

However, the court did not believe the transfers from Minchem to Sun alone indicated the funds were income to Sun. Instead, the court found that Cheung entrusted the money to Sun for the specific purpose of having him invest the funds. The court noted a transferee does not receive income when he and the transferor agree that money received is held in trust for the benefit of others (Seven-Up Co. v. Comm'r, 14 T.C. 965 (1950)), and that under the relevant state law, a trust may arise at the implication of an intention to create a trust (Mills v. Gray, 210 S.W.2d 985 (Tex. 1948)). The court found that Sun and Cheung's conduct created an implied trust, with Sun acting as the trustee of Cheung's funds.

Although trustees generally do not include the funds in their control in income, those funds become taxable income if the trustee misappropriates the money. A trustee misappropriates funds when money has been entrusted for the sole purpose of investing and is instead used for personal activities (DeGoff v. Comm'r, T.C. Memo. 1966-89). The court found that Sun used the money held for Cheung's benefit for his own personal gain, pointing to Sun's use of the funds in his gambling activities, his purchase of a luxury car, and his use of the funds to pay personal tax liabilities. The court further noted that rather than pursuing investment opportunities, Sun left what money he didn't use for personal expenses sit idle. That deviation from the agreed-upon investment strategy, the court stated, amounted to a misappropriation.

Sun argued that he did invest some of the money Cheng sent to him, but the court noted that only a fraction of the funds were invested, and all of it was comingled with Sun's personal money, further evidencing misappropriation.

Because Sun clearly misappropriated the funds for personal use and did not invest the money in accordance with the agreed-upon strategy, the Tax Court held that all the money transferred to Minchem's officer loan account from Cheung constituted taxable income to Sun.

Despite the large understatement of tax Sun incurred by not reporting the funds received from Cheung as income, the Tax Court declined to impose a fraud penalty, finding Sun did not display the requisite "badges of fraud" under Spies v. U.S., 317 U.S. 492 (1943). The court did, however, impose the 20 percent accuracy related penalty under Code Sec. 6662(a). (Staff Editor Parker Tax Publishing)

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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