On July 14, 2021, the Tax Court issued a Memorandum Opinion in the case of Ryder & Associates Inc. v. Commissioner (T.C. Memo. 2021-88). The primary issues presented in Ryder & Associates Inc. v. Commissioner were whether the petitioners received unreported gross receipts from their company, and whether the petitioners had significant unreported dividend income.

Author’s Note on Ryder & Associates v. Commissioner

As I mentioned earlier this year, I have never seen it bode well for a petitioner to whom the Tax Court describes first in the background of the case as a tax attorney.  Not only was Mr. Ryder a tax attorney, but he also held his LLM in taxation from NYU.

Not only was Mr. Ryder a tax attorney, but he specialized in ERISA and qualified retirement plans. Not only did he specialize in ERISA and qualified retirement plans, but the IRS also determined that he had bamboozled the United States out of millions using a complex scheme of said plans to funnel money into his and his wife’s pockets.

Judge Holmes Encapsulation

Ryder & Associates, Inc., APLC, marketed six tax-reduction strategies that produced over $31 million in revenue between 2003 and 2011. The firm’s fixed costs were low, and its out-of-pocket expenses not very large. Yet year after year it paid zero income tax.

Its revenue flowed instead into 560 accounts and into Ryder Law Corporation, a related S corporation. It flowed into more than 1,100 ESOPs, S corporations, LLCs, and other passthroughs. It flowed into ranches in Arizona, and it flowed into other ranches in New Mexico. And then it mostly seemed to pool in places where it would benefit Ernest S. Ryder and his wife Patricia, who received more than $15 million in distributions between 2002 and 2011 but paid only $31,000 in income tax during the years at issue.

Background to Ryder & Associates Inc. v. Commissioner

Ernest Ryder, as mentioned, was a tax attorney. He began his career just before ERISA was enacted in 1974, and he quickly became an expert in the area of qualified retirement plans. Over time, he developed many of the aggressive tax-reduction strategies that led to the present consolidated cases. Patricia never graduated college, but she stated that she had “a better understanding of tax then [sic] most people walking around on the street.”[1]

She worked in jewelry and clothing stores and owned her own businesses including a bridal salon and cookie stores.  She also claimed to work on a number of the ranches that she owned with Ernest, though her involvement seems to be limited to counting cows.[2]

Note: Though it bears absolutely no importance to the case, at some point during Mr. Ryder’s legal career, he entered into a partnership with one Mr. Ruff, Mr. Harrigan, and Mr. Sbardellati. The name, which was adopted for the firm, as you may have guessed, was Ruff Ryder. This, Judge Holmes acknowledges in a footnote, pays dutiful homage to California’s cowboy past.

The aggressiveness of Ryder’s tax-reduction strategies seems to have caused some tension with his partners at Ruff Ryder, and he was asked to leave the firm sometime in 1995. He started his own practice in 1996 with a much more pedestrian name of Ryder & Associates (R&A), a professional law corporation (taxed as a C corporation).

Ryder owned 100% of the firm and acted as its president since its creation. He also provided 100% of his legal services to clients through R&A at all relevant times. Despite its success and longevity, R&A reported zero taxable income from 2002 through 2011. The Ryders also reported minimal taxable income on their individual returns for those years.

R&A pitched its tax-saving products as “next generation tax management services” to prosperous professionals and entrepreneurs who wanted to save for retirement using “unique” plans that would “defer a much greater portion of their income than they ever dreamed possible, and, as a result, substantially reduce their tax liability.”  Judge Holmes, as he is wont to do, then gives us the subtlest of metaphors, when he observed that “many took the bait, and R&A began reeling in the clients.”

R&A set up the necessary entities, handled all filings with the IRS and any state agencies, created retirement plans, drafted agreements to link its clients to the companies that held the retirement accounts, helped clients move money from one account to another as needed, and reviewed tax returns to make everything look as proper as could be.

At this point, Judge Holmes dedicates a significant amount of time to the six “clades” of tax schemes that R&A peddled. While creative, they are not technically “legal” under the Code, which turns out to be a bit of an issue for the Ryders.

The Audit

The IRS began an IRC § 6700 (abusive tax shelters) investigation into R&A’s use of ESOPs on August 26, 2003, after someone noticed that the firm had applied to have more than 800 ESOPs qualified at the same time. Then, “like antibodies swarming to an infection,” two more investigations latched onto the promotional activities of former R&A employees, whom Ryder had used to “manage” many of the different entities.

These converged into a full-blown audit of the Ryders and his law firm. This überaudit (I cannot take credit for this phenomenal word, as it is one of Judge Holmes’ classic turns of phrases—complete with the umlaut) spanned nearly a decade and expanded backward and forward to the Ryders’ 2002-11 and R&A’s 2005-09 tax years.

When questioned by IRS agents, Ryder pleaded the Fifth and refused to answer any questions regarding the tax structures sold by his law firm. The Tax Court observes that Ryder’s silence left the IRS with no choice but to use subpoenas and third-party interviews.

At this point, “more investigations broke out.” Eventually, the IRS found a tangle of 560 financial accounts used by hundreds of entities created by Ryder through R&A.

Ryder himself had signature authority over approximately two-thirds of these accounts; the fraction rises to nearly 95% if one includes accounts where Ryder’s employees had signature authority. The IRS completed a bank-deposit analysis to identify R&A’s gross receipts, and then the IRS determined that the Ryders were taking funds out of these accounts to pay personal expenses and linked these funds to R&A’s gross receipts.

The Trial

The trial lasted over two Tax Court sessions and over two months.  The record “sprawled over 8 million pages.”  The IRS introduced to bank deposit analyses, and although the parties conceded a number of issues to large adjustments remained: unreported gross receipts from R&A and unreported dividend income to the Ryders.

Burden of Proof

The Tax Court notes that the parties bickered about the burden of proof. However, with more than 8 million pages of evidence and 2,300 pages of transcript, Judge Holmes determined that the Tax Court could “decide almost all the issues on the preponderance of the evidence, with the limited exception of fraud, which IRC § 7454 and Rule 142(b) require the IRS to prove fraud by clear and convincing evidence.

The Unreported Income

The IRS alleges that R&A “massively underreported” it’s income during the periods at issue by assigning income to other entities and taking “very large and unsupportable deductions” from what income it did report. In total, the IRS determined that R&A underreported approximately $11.6 million.

Assignment of Income

The first question that the Tax Court addresses is whether R&A should be taxed on the money that went into the various and sundry accounts that it had set up.

Judge Holmes quotes the Seminole Supreme Court case of Lucas v. Earl, 281 U.S. 111, 114-15 (1930), for the proposition that “tax [cannot] be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it.”

Stated differently fruits may not be “attributed to a different tree from that on which they grew.” Judge Holmes observes that Justice Holmes “trees and fruits” metaphor has “long since ripened into cliche,” but it is still generally thought to be an accurate statement of the law.

Income should be taxed to him who earns it, see Commissioner v. Banks, 543 U.S. 426, 433 (2005), and one can’t escape tax by assigning income to another in advance, see id.; see also United States v. Basye, 410 U.S. 441, 449-52 (1973) (partnership members cannot avoid taxation by diverting income to retirement trust fund); Commissioner v. Sunnen, 333 U.S. 591, 604 (1948).

Indeed, “it has long been held that a taxpayer may not avoid his tax liability on income which he has earned by the simple expedient of drawing up legal papers and assigning that income to others.” Trousdale v. Commissioner, 16 T.C. 1056, 1065 (1951), aff’d, 219 F.2d 563 (9th Cir. 1955).

Although Mr. Ryder agreed with this general statement of law, he argued that he carefully planted “a great many trees in his orchard and that fruit actually grew on them.” Or to dispense with the metaphor, that the Tax Court should find that the many, many separate entities he created earned that income themselves.

Pursuant to IRC § 482, in the case of two or more businesses owned or controlled by the same interests, the IRS “may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such…businesses” to avoid tax evasion.

The common-law assignment-of-income doctrine and IRC § 482 overlap considerably. Nonetheless, the IRS “left IRC §482 in the shed” by failing to mention it in any pretrial documents, pleadings, memoranda, or briefs.”

Judge Holmes observes that, stretching the metaphor a bit further, R&A was “less like the orchardist who plants the seeds of trees and then steps back to watch them grow than it was like a set designer who built a papier-mâché forest and painted it to look like real trees.” This is so because R&A never stopped tinkering with these entities. At the end of the day, the Tax Court held that, due to this consistent practice, R&A was selling retirement-planning services and was the entity that was actually providing the services.

Constructive Dividends

The other major issue is whether Ryder received constructive dividends from R&A. A “constructive” dividend occurs when a corporation confers an economic benefit on a shareholder without the expectation of repayment. Magnon v. Commissioner, 73 T.C. 980, 993-94 (1980); see also Noble v. Commissioner, 368 F.2d 439, 443 (9th Cir. 1966). The Tax Court looks for the objective facts to figure out whether a benefit is a constructive benefit; what the parties might subjectively have intended doesn’t control. See Noble, 368 F.2d at 443; Clark v. Commissioner, 266 F.2d 698, 710-11 (9th Cir. 1959). There is a two-part test.

First, the expense must be nondeductible to the corporation. Meridian Wood Prods. Co., Inc. v. United States, 725 F.2d 1183, 1191 (9th Cir. 1984) (citing Palo Alto Town & Country Village, Inc. v. Commissioner, 565 F.2d 1388, 1391 (9th Cir. 1977)). Second, it must be an economic gain or benefit to the shareholder. Id. Taxpayers who control their own corporations do fairly often receive constructive dividends if they are not careful in keeping corporate assets separate from their own.

A common situation occurs when a corporation pays to construct or otherwise improve its shareholder’s real property without the corporation’s expecting ever to be repaid. See, e.g., Magnon, 73 T.C. at 994; Estate of Clarke v. Commissioner, 54 T.C. 1149, 1161 (1970); Asher v. Commissioner, T.C. Memo. 1998-219, *6. The Tax Court also routinely finds constructive dividends when a shareholder’s corporation pays his personal expenses. See, e.g., Dobbe v. Commissioner, 61 F. App’x 348 (9th Cir. 2003), aff’g T.C. Memo. 2000-330.

Dividends must come from a corporation’s earnings and profits. If a corporation doesn’t have enough earnings and profits, then these nondeductible uncompensated payments are a nontaxable return of capital to the extent of the shareholder’s basis under IRC § 301(c) and IRC § 316(a). Goyak v. Commissioner, T.C. Memo. 2012-13, *14.

However, if a taxpayer takes so much money from his corporation as to use up both all the earnings and profits, and all of his accumulated basis in his shares, that money can again become taxable as a capital gain. Truesdell, 89 T.C. at 1294-95. The Tax Court held that it was more likely than not that R&A’s accumulated earnings and profits were sufficient to support all of the distributions that the IRS alleges for each year at issue.

Paper Promises and Basis

Ryder claims that he had sufficient outside basis to make the distributions he took from one of the entities a tax-free return of capital.  This basis, however, arose only from promissory notes that Ryder signed and made payable to the entity for its stock. As the Tax Court observes, “[t]he problem for Ryder is that paper promises not backed by cash don’t create basis.”

Basis is the cost of property, IRC § 1012, and a shareholder gets basis in his shares in a corporation when he purchases those shares or contributes capital to that corporation, IRC § 351(a), IRC § 358(a)(1); see also Maguire v. Commissioner, T.C. Memo. 2012-160, *4. For a shareholder in an S corporation to increase his basis, he must make an actual economic outlay. Oren v. Commissioner, T.C. Memo. 2002-172, *8, aff’d, 357 F.3d 854 (8th Cir. 2004).

A shareholder makes an “economic outlay” when he incurs a cost or contributes money or property or is otherwise left poorer in a material sense after his contribution. See Putnam v. Commissioner, 352 U.S. 82, 85 (1956); Ruckriegel v. Commissioner, T.C. Memo. 2006-78, *7.

Ryder relies on Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998), for his argument that he had sufficient basis in the entity. Peracchi did hold that a C corporation’s shareholder can get basis in his shares with the contribution of a note, but it also made clear that this holding does not apply to S corporations. Id. at 494 n.16.

Indeed, the Tax Court itself has made “completely clear” that a shareholder doesn’t get basis in his S corporation’s stock by giving it a note—until and unless he advances funds on the note. See Perry v. Commissioner, 54 T.C. 1293, 1295-96 (1970), aff’d without published opinion, 27 A.F.T.R.2d 71-1464 (8th Cir. 1971); see also Underwood v. Commissioner, 63 T.C. 468, 477 (1975), aff’d, 535 F.2d 309 (5th Cir. 1976); Oren, T.C. Memo. 2002-172. In the present case, there is no additional basis. Instead, Ryder was simply moving unfunded promissory notes and subscription agreements around and around through offsetting book entries, illusory agreements, and the loan “repayments” to RLC that matched distributions from it.

In Sum

The Tax Court found ultimately that the IRS accurately traced funds through Ryder’s numerous accounts and avoided double-counting the different categories of constructive dividends that Ryder received.

The Tax Court noted especially that the IRS’s analyses eliminated the circular flow of funds that Ryder set in motion to create the appearance that he was boosting his basis in the entity discussed above by contributing capital to it.

Ryder’s argument that the Tax Court must treat each of the many entities he breathed into life as what Ryder, himself, labeled them and not as what they really were was unpersuasive to the Tax Court.  Ultimately, the Tax Court found that the Ryders were liable for just a skosh under $16 million in tax on the unreported dividend income received during tax years 2003 through 2011.

A Post-Script on Penalties

After much back and forth, and numerous concessions, the only penalties left at issue as asserted against R&A are the fraudulent failure to file penalties asserted under IRC § 6651(f) for the tax years 2005 and 2007 through 2009, and the only penalty left at issue against the Ryders is the fraud penalty under IRC § 6651(f) for the tax year 2009.

When the Tax Court analyzes whether a taxpayer fraudulently failed to file a tax return under IRC § 6651(f), it focuses on his “decision not to file [his] return when due. If that decision was made with the intent to evade tax, then the addition to tax under IRC § 6651(f) may properly be imposed.” Enayat v. Commissioner, T.C. Memo. 2009-257, *24.

Over the years the Tax Court has developed, what Judge Holmes denominates as a “precinctful” of “badges” of fraud, which include the following:[3]

• • understating income;
  • maintaining inadequate records;
  • failing to file tax returns;
  • giving implausible or inconsistent explanations of behavior;
  • concealing assets;
  • failing to cooperate with tax authorities;
  • engaging in illegal activities;
  • attempting to conceal illegal activities;
  • education and experience;
  • willful blindness;
  • dealing in cash;
  • failing to make estimated tax payments; and
  • filing false documents.

With respect to Mrs. Ryder, the Tax Court was not persuaded that the evidence on the record shows clear and convincing evidence that Mrs. Ryder was in on her husband’s tax-avoidance schemes or was willfully blind to them. While Mrs. Ryder does have experience as a cookie-selling, salon-owning businesswoman, “she has nowhere near the tax expertise of her husband.”

This does not bode well for Mr. Ryder…

“As to Mr. Ryder himself,” who I might remind you is an NYU LLM-holding tax attorney, “things are rather different.” Ruh roh.

Ryder is about as well-educated as one can be in tax law. It was his tax expertise that brought clients into R&A, and it was his use of that expertise that made the money that we’ve found taxable, first to R&A and then to him. We acknowledge his position that he did not intend to evade tax, but only to seek shelter in the gray areas in the Code.

We agree that there are gray areas in tax law. But one area that no one should consider gray is misrepresenting facts. Especially material facts.

As for material facts, the Tax Court lists seven, but the Tax Court observes that these are just “examples” of Ryder’s misrepresentations. These specific examples of Ryder and R&A’s material misrepresentations of fact establish a pattern of conduct that Ryder and R&A continued during the years at issue.

For that matter, Ryder also mischaracterized sources of income by ignoring well-established law about the assignment of income. Further, Ryder understood that at least one of his products had been condemned by the Tax Court in 2000, yet he continued to promote and sell the product for two years afterward. As the Tax Court notes, this “hardly exhibits good faith belief that these tax products were valid under the Code.”

Consistently understating income is strong evidence of fraud, especially when there are other circumstances showing an intent to conceal income. See Branson v. Commissioner, T.C. Memo. 2012-124, 2012 WL 1448473, at *8; see also Parks v. Commissioner, 94 T.C. 654, 664 (1990). R&A paid no corporate income tax for a decade. And the Ryders paid a grand total of $31,143 in individual income tax over that same ten-year period–despite the tens of millions R&A brought in and passed on to them.

According to the Ninth Circuit–where these cases are appealable–“repeated understatements in successive years when coupled with other circumstances showing an intent to conceal or misstate taxable income present a basis on which the Tax Court may properly infer fraud.” Furnish v. Commissioner, 262 F.2d 727, 728-29 (9th Cir. 1958), aff’g in part, remanding in part Funk v. Commissioner, 29 T.C. 279 (1957).

Ryder argues that his promotion of tax-avoidance schemes does not support an inference of an intent to mislead. Ryder cites Kernan v. Commissioner, T.C. Memo. 2014-228, aff’d, 670 F. App’x 944 (9th Cir. 2016), to support his contention. In Kernan, however, we stated that promoting tax-avoidance products is not evidence of illegal activity, a completely different badge of fraud. Id. at *26.

The Tax Court has inferred an intent to mislead from the promotion of tax-avoidance schemes. See Child v. Commissioner, T.C. Memo. 2010-58, *9. In short, R&A’s and Ryder’s creation of and participation in these schemes, coupled with the actions taken to execute them, is clear and convincing evidence of an intent to mislead.

R&A failed to file its corporate tax returns for the 2007, 2008, and 2009 tax years, and the Ryders failed to file their individual tax return for the 2009 tax year. The record in these cases includes filed tax returns of R&A for the 2005 and 2006 tax years, as well as filed tax returns of the Ryders for the 2002 through 2008 and 2010 through 2011 tax years. Nonfiling by taxpayers can weigh heavily against them when their filing history shows awareness of the requirement to file. See Castillo v. Commissioner, 84 T.C. 405, 409 (1985).

Nonetheless, the decision of the taxpayers not to file must be made with the intent to evade tax. If a taxpayer can establish that his failure to file was due to reasonable cause and not willful neglect, then he does not owe an IRC § 6651(f) penalty. Mohamed, T.C. Memo. 2013-255 at *22.

This is not, however, the case with R&A or Mr. Ryder. Not only did Ryder fail to show reasonable cause; he testified that he made the choice not to file.

I leave you with a quote from the case.  Paraphrasing it does not do it justice.  Also, kudos to NYU’s LLM program for providing such quality advice to an aspiring tax attorney…[4]

Ryder claims that he learned during his time in NYU’s LL.M. program that “where you’re uncertain as to how you should respond or report, you’re better  off not filing than filing at all.” And when discussing why he had filed other returns late in the past, Ryder stated: “[I]t’s better to have a misdemeanor than a felony.”

It’s hard to believe that Ryder’s decision not to file was done with any other purpose than to evade tax. [In short], the IRS wins on this one.

The moral of the story is that, whether a tax attorney or not, bad tax deeds, in the end, will turn right back on you and sting like hell…somewhat akin to a watermelon to the face.

(T.C. Memo. 2021-88) Ryder v. Commissioner

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Footnotes

[1] She may be well versed in tax law, but in grammar, not so much.

[2] “She claims to work at the many different ranches she owns with her husband, where she says her tasks include ‘tak[ing] inventory…of the animals’ and being ‘involved in their health.’”

[3] See Bradford v. Commissioner, 796 F.2d 303, 307-08 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Mohamed v. Commissioner, T.C. Memo. 2013-255, *32-*33; Fiore v. Commissioner, T.C. Memo. 2013-21, *21.

[4] In candor, I earned my LLM at the University of Florida, and I have an inveterate distrust of New Yorkers…having dated a crazy one and being a life-long Red Sox fan.

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