Gentlemen's Club Owner Liable for Penalties for Filing False Returns.
(Parker Tax Publishing February 2014)

An owner of a strip club who admittedly filed false corporate tax returns was liable for the 75 percent fraud penalty because his conduct of transferring large amounts of cash from the company to his personal bank account and maintaining two sets of sales ledgers to conceal the company's actual receipts established the requisite fraudulent intent. Potter v. Comm'r., T.C. Memo. 2014-18 (1/27/14).

John Potter owned and operated Potter's Pub, Inc. in Jackson, Michigan. Potter's Pub was a cash-based business that sold food and beverages, charged a cover charge, collected receipts from a juke box and from renting pool tables, and collected money from its dancers for the privilege of "dancing." As president, John signed and filed the company's Forms 1120, U.S. Corporation Income Tax Return. Those returns reported losses for years 2002 and 2003 and zero taxable income for 2004 and 2005. John filed individual tax returns, but his returns for 2002 and 2003 were untimely. John reported no wages, dividends, or other income from Potter's Pub for any of the years at issue.

In December 2006, undercover IRS agents posing as buyers interested in acquiring Potter's Pub met with John. John assured the agents that Potter's Pub was much more profitable than it appeared. He explained that he deposited in the corporate account only enough of the business revenues to cover the company's expenses and that he wired the balance of the revenue to his personal bank account in Florida. These wire transfers were structured in amounts less than $10,000 to avoid reporting obligations by the bank to the IRS. In reality, John told the agents, Potter's Pub grossed more than $1 million annually and he took home between $400,000 and $520,000 each year. John showed the agents clandestine sales ledgers for 2003 and 2004 that supported the gross receipts he claimed, acknowledging that it might have been unwise to maintain documentary evidence of his skimming. During a subsequent search of Potter's Pub, IRS agents seized upwards of $200,000 in cash and obtained the set of clandestine sales ledgers. The ledgers confirmed that Potter's Pub's annual receipts for 2002-05 were vastly in excess of the amounts that John had reported to the IRS. The difference between its actual gross receipts and the gross receipts reported on the company's Forms 1120 for those years exceeded $2 million. After the search of Potter's Pub, when he knew he was under criminal investigation, John provided his accountant with additional bank account information for the 2003-05 tax years. His accountant used this information to file amended federal income tax returns for those years, both for Potter's Pub and for John. The IRS determined that John was liable for the 75 percent fraud penalty and for additions to tax for failure to timely file returns.

John tried to avoid the fraud penalty by arguing that he lacked fraudulent intent because he was unsophisticated and needed to hire tax professionals to prepare and file his individual and corporate tax returns.

The Tax Court held that John's underpayments of tax were attributable to fraud and, thus, he was liable for the fraud penalty. The existence of fraudulent intent is a question of fact. The court noted that, in Spies v. U.S., 317 U.S. 492 (1943), the Supreme Court set forth the following circumstances that tend to indicate fraud: (1) understating income; (2) maintaining inadequate records; (3) concealing income or assets; (4) providing incomplete or misleading information; (5) filing false income tax returns; and (6) extensive dealings in cash. In this case, the court said, John admitted in his guilty plea that he intentionally underreported the company's income for multiple years to evade the corporate-level income tax. He maintained two sets of sales ledgers that were designed to conceal the cash he was transferring into his personal bank account, and he kept the transfers below $10,000 to avoid bank reporting to the IRS.

With respect to John's argument that he was unsophisticated and thus lacked fraudulent intent, the court noted that he was sophisticated enough to structure his wire transfers in amounts under $10,000 and preparing clandestine sales ledgers for tax professionals.

For a discussion of the fraud penalty on underpayments of tax, see Parker Tax ¶262,125. (Staff Contributor Parker Tax Publishing)

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