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Son Fraudulently Induced Parents to Sell Company at a Discount by Not Disclosing Nonpayment of Payroll Taxes

(Parker Tax Publishing May 2018)

The Fifth Circuit affirmed a district court's holding that an individual who managed a business owned by his parents fraudulently induced them to sell the company to him at a discount by not disclosing that the company had withheld but failed to deposit approximately $1 million in payroll taxes, a liability which was not transferred but remained with the parents after the sale. The court found that the omission constituted fraud because the son had a fiduciary duty to his parents to disclose the nonpayment, and the court rejected the son's argument that he was not aware of the nonpayment before the sale after finding that the son's awareness could be inferred from the evidence. Bailey v. Bailey, 2018 PTC 115 (5th Cir. 2018).

Shirley and Roger Bailey owned Rig-Up Electrical Services, Inc. (Electrical), an Arkansas corporation located in both Arkansas and Texas. Mrs. Bailey served as president, while her son, Jeffrey Bailey, was the executive vice president of the Texas location. In 2007, Mr. and Mrs. Bailey were considering retirement and left Jeffrey in charge of managing the company. Mrs. Bailey continued as president but assumed a smaller role.

Electrical's bookkeeper, Michelle Reed, was responsible for calculating the weekly payroll, tax deposits, and operating expenses. Once Jeffrey began managing the company, Mrs. Bailey's only remaining role was to make weekly draws on the company's line of credit at an Arkansas bank based on information provided by Reed for the amounts needed to cover expenses. Mrs. Bailey would transfer the funds from the Arkansas bank to a bank in Texas, and Reed would disburse funds from the Texas account.

Jeffrey started a new company in 2008 called Rig-Up Services, LLC (Services). He expressed interest in purchasing Electrical's assets. To help secure financing, Jeffrey hired Roy Johnson to serve as Electrical's chief financial officer. Jeffrey and Johnson then hired Harris Arthur, a CPA, to review Electrical's financial records and provide financial reports.

Electrical's payroll and tax deposits were computed on a weekly basis using accounting software. In April or May 2008, Arthur noticed that the software showed the payroll taxes as having been sent to the IRS while the bank records showed that they had not. Arthur tried to resolve the issue but was unsuccessful, so he sent a letter to Jeffrey asking for a power of attorney to request from the IRS information concerning Electrical's payroll tax payment history. Arthur confirmed a few days later that Electrical owed over $1 million in unpaid payroll taxes.

Meanwhile, Mr. and Mrs. Bailey began receiving letters from the IRS requesting Electrical's tax returns for unemployment and payroll taxes because they had not been timely filed. Mrs. Bailey faxed the second IRS notice to Jeffrey, who assured her that he had taken care of the problem.

In August 2008, Jeffrey and his parents executed an asset purchase agreement. Mrs. Bailey sold Electrical's assets to Jeffrey for $4 million when the market price was $12 million, resulting in an $8 million discount. She did so because of the family tie and her trust in him to run the business. Soon after the sale, Arthur sent a letter to Mrs. Bailey explaining that Electrical had been withholding funds from employees' paychecks but not transferring the money to the IRS. This information had been kept from Mrs. Bailey until after the deal closed. Six days before the closing, Johnson had instructed Arthur to focus on other issues and "leave the tax thing alone for now." Mrs. Bailey was thus surprised to learn of the tax liability, and a dispute arose as to who was responsible for it.

Jeffrey sued in a district court for a declaratory judgment that the obligation belonged to his parents and Electrical. Under the terms of the agreement, only certain preexisting liabilities of Electrical were transferred to Services, and those specified liabilities did not include payroll taxes. In an initial appeal, the Fifth Circuit held that Services and Jeffrey were not liable for the unpaid payroll taxes. The Fifth Circuit remanded for consideration of the parents' defense that they would not have sold the assets to Jeffrey at such a steep discount had they been told about the tax liability. On remand, the district court held that Jeffrey fraudulently induced the sale. The district court entered a judgment that Jeffrey and Services were responsible for Electrical's outstanding payroll taxes, plus interest and penalties.

Jeffrey appealed that decision to the Fifth Circuit. He argued that he did not have a duty to disclose Electrical's payroll tax liability before the execution of the agreement. He also argued that there was no evidence that he knew about the unpaid taxes before the sale. Jeffrey objected that Mrs. Bailey had an equal opportunity to learn of the nonpayment before the sale. Finally, Jeffrey argued that his parents had unclean hands because they increased Electrical's line of credit by approximately $500,000 days before the sale closed, and this liability did not transfer to Services.

The Fifth Circuit held that Jeffrey fraudulently induced the sale. It found that, as an officer of Electrical, Jeffrey had a fiduciary duty to disclose the tax liability to his parents as the owners of the company. Next, the court found that the evidence supported the conclusion that Jeffrey knew about the unpaid payroll taxes before the sale.

First, the court noted Arthur's testimony that before the sale, he twice discussed the problem with Jeffrey and Johnson and sent an email listing the unpaid amount. Although the email was not sent to Jeffrey, that fact did not undermine, in the court's view, Arthur's credible testimony that he discussed the problem (if not the exact amount) with Jeffrey before the sale.

The Fifth Circuit then laid out additional evidence that corroborated Arthur's testimony that he told Jeffrey about the tax problem. The court explained that Jeffrey knew the quarterly payroll tax returns had not been filed and told his mother he was taking care of it. Although a failure to file did not necessarily mean the payroll taxes had not been forwarded to the IRS, an inference could be drawn that there was also a problem with the payments themselves.

Arthur's request for a power of attorney also supported the conclusion that Jeffrey knew about the unpaid taxes. Arthur said he needed the power of attorney to determine all of the company's 2007 tax deposits. To the court, this suggested that Jeffrey knew not just about the failure to file but also that there was a problem with money being forwarded to the IRS, because there would be no reason to ask the IRS for payment information if Jeffrey believed that all 2007 tax deposits had been made. Moreover, it made little sense for Arthur to request the power of attorney but then hide from Jeffrey that the company had not paid the taxes it owed.

The court also found probative an email Johnson sent to Arthur, Reed and Jeffrey after the sale stating that the group needed to discuss how to handle the taxes owed from a financial reporting perspective. Although sent after the sale, the email's discussion of the $1 million owed and Jeffrey's inclusion on the distribution list supported the view that the group know about the liability before the sale. The court reasoned that nothing in the email suggested that Jeffrey was learning about the liability for the first time.

The Fifth Circuit found that Mrs. Bailey did not have an equal opportunity to learn of the nonpayment because it found that three days before the sale, Johnson directed Arthur not to tell her about the tax problem. The court also noted that Reed never advised Mrs. Bailey of the liability during their weekly phone calls.

Jeffrey's unclean hands argument was rejected because the transfer of funds was at issue in a separate lawsuit, and that case settled. In the settlement, the parties agreed to dismiss most of Jeffrey's claims against his mother in this case, including breach of contract, fraud and negligent misrepresentation. The Fifth Circuit reasoned that if Jeffrey achieved a settlement in the other lawsuit based on these same allegations arising out of the increased line of credit, it would be double dipping to use the same conduct as a defense in this case.

Finally, the Fifth Circuit discussed the consequence of Jeffrey's fraudulent inducement. The court found that the district court's remedy was effectively a reformation of the contract, and reformation is not a remedy for fraudulent inducement. The Fifth Circuit therefore remanded to allow Electrical and the Baileys to elect whether to rescind the contract or affirm it and recover damages.

For a discussion of the requirement to deposit employment taxes, see Parker Tax ¶217,000.

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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