(Getty/Andrew Caballero-Reynolds)

The IRS ignores another whistleblower complaint

Part 3: How Koch’s company paid him millions of tax-free dollars while showing no profits


David Cay Johnston
June 15, 2019 1:29PM (UTC)
Read more articles from the DCReport here.
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Two years after a whistleblower first alerted the IRS to William Ingraham Koch’s dodgy tax behavior, the same insider told the IRS about even more efforts by the billionaire to skirt America’s tax laws.

In the first and second installments in this series, we looked at some the tax practices detailed in The Koch Papers, nearly a thousand pages of documents provided to the IRS Whistleblower Office by Charles Middleton, the former chief tax executive at Koch’s Oxbow carbon companies, and obtained by DCReport.

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Here in Part 3, we will look at how Bill Koch was able to collect almost $1 billion of income over nine years without owing income taxes.

Thanks to the generosity that our Congress shows to very rich business owners, living tax-free can be perfectly legal provided it is done precisely under the rules in our tax code.

The Koch Papers show that Bill Koch has created a way to perpetually collect tax-free profits by reporting profits earned in America, where he employs about 300 people, as profits earned in the Bahamas, where his companies employ three to five people. The Bahamas does not have an income tax. The whistleblower maintains that the transfer of profits to the Bahamas is a fraud and that documents revealing that were hidden from IRS auditors.

The Koch Papers also show that $6 million of executive bonuses that Oxbow America paid in 2011 were deducted that year and again 2012, generating tax deduction worth $4.6 million instead of half that amount.

"Fake loans"

From 2005 through 2013 Koch withdrew an average of $106 million each year from his Oxbow companies, The Koch Papers show. Some of that money involved what the whistleblower called “fake loans” used to manipulate the rules on tax-free income for rich business owners.

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Bill Koch is the Palm Beach, Fla., neighbor and supporter of Donald Trump. Koch was under IRS criminal investigation for tax fraud involving Oxbow until five months after Trump took office.

One year after the IRS stopped communicating with Middleton and his lawyers, he filed another whistleblower complaint about Koch and his Oxbow carbon fuels empire.

Middleton, who had been Koch’s top tax executive until he discovered company documents had been withheld from the IRS in an audit, told the IRS in 2016 about what he described in detail as massive calculated tax fraud at Oxbow. Middleton also detailed what he said were other calculated tax frauds in the nearly 1,000 pages of documents he gave the IRS, most of which DCReport has obtained, that we call The Koch Papers.

Bill Koch and the Oxbow company said in a statement that Middleton was fired for cause—a legal term that generally means a terminated employee made a severe error in action or judgment.

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Tax-free income

To legally enjoy almost $1 billion of tax-free income Bill Koch had to declare that his Oxbow carbon business was an S corporation, named for a tax code provision.

S corps, as they are called, are such a dandy device for escaping taxes that America has almost four million of them. S corps must have 100 or fewer owners (the Oxbow parent company has 27) who must be Americans.  There is no limit on how much revenue or profit the company make.

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As an S corp owner, Koch could withdraw money company each year without paying income taxes so long as he was merely taking back money he had already invested in the S corp. Doing this requires complying with two  rules:

  • Koch had to have at least one dollar still invested in the company after he took cash out.
  • Koch had to pay himself at the same rate as the 26 minority owners of Oxbow, all of them relatives, trusts for relatives or company executives.

Violate these rules, however, and the joy of tax-free riches can become an economic nightmare. The IRS can assess a 75% fraud penalty for violations. It routinely charges interest, too. And in extreme cases can ask the Justice Department to prosecute, as Middleton urged in his complaints.

But none of these awful results could occur unless the IRS discovers rules violations through audits, the focus of the second installment in our series, or by acting on a whistleblower complaint.

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"Audit roulette"

A tax return, if not audited and challenged by the IRS, is legally accepted as proper. Violating any tax rule, and taking the risk the tax return involved will not be audited or the impropriety will not be detected is known in tax world as “audit roulette.” The odds of winning are much better than picking numbers at an actual roulette wheel.

The chances of the IRS detecting any error in the tax returns of any S corporation and its wealthy owners is tiny—and shrinking.

Way back in 2000, I reported that the working poor were more likely to be audited than the affluent. The IRS shift away from auditing the richest among us and targeting the working poor has increased in recent years.

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The IRS devoted 36% of its shrinking audit resources to the working poor last year, ProPublica recently reported.

The IRS audit rate for the working poor is now higher than for millionaires. That means the super rich have little to fear from violating the rules, especially if they hide documents when auditors come calling, as Middleton says happened in the audits of Oxbow’s 2011 and 2012 tax returns.

Koch and his company, in a written statement, said that the IRS made no changes after auditing his personal tax returns and those of his Oxbow companies for 2011 and 2012.  The statement also said that neither Bill Koch or his company was aware of any whistleblower complaints to the IRS, and that Bill Koch had never discussed his tax issues with Donald Trump.

Middleton’s latest whistleblower complaint asserts that Bill Koch violated the rules governing tax-free withdrawal rules in 2014 and 2015, years the IRS has not audited.

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In his May 2018 complaint, Middleton estimated Koch owes more than $100 million in income taxes for violating the S corporation rules set by Congress. Koch’s minority partners may also owe more taxes. And all of them may lose the tax benefits of the S corp structure for violating the rules if the IRS acts.

If the IRS collects any money, Middleton is eligible to receive up to 30% of it as a whistleblower reward. However, Middleton is probably not eligible to collect any reward because of the terms of his departure from Oxbow, according to his principal lawyer, William Cohan of Rancho Santa Fe, Calif.

A special tax class

President Dwight D. Eisenhower signed the 1958 law that allowed S corporations as an alternative to the traditional C corporation. Most big U.S companies, like Microsoft and General Motors, are C corps.

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Investors in both S and C corps enjoy limits on their liability. If the company fails, all they can lose is the money they invested. Their savings, homes and other assets are shielded from creditors.

When it comes to taxes, however, the rules are very different.

C corporation pays taxes on their profits, recently reduced by Trump and Republicans in Congress to 21% of profits, down from 35%.

Shareholders also must pay taxes on any dividends, which C corporations pay out of their after-tax profits. That means such profits get taxed twice, one at the C corp level and once at the individual level.

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S corporation profits are only taxed when individuals get paid out. But there is also an extra and very valuable exception.

Any money invested in the company can be withdrawn without owing income tax. The law is based on the assumption that profits earned by the enterprise will be taxed, but only once and that is when they are withdrawn by owners, who will report the profits on their personal income tax returns.

Middleton contends that Bill Koch’s advisers devised a plan to earn profits in America, send them untaxed to the Bahamas and then withdraw the money without paying any income tax at any stage of the process.

It was, Middleton’s whistleblower complaints assert, effectively a perpetual tax-free profits machine. He called it a fraud. The IRS Whistleblower Office initially thought the evidence warranted sending the case to the IRS Criminal Investigation Division, which started an inquiry and then appears to have dropped it after Trump took office.

The Koch Papers show that Oxbow America reported a $229 million profit in 2009, the last year before Oxbow Bahamas began operating. By 2015 Oxbow America reported a tax loss, while Oxbow Bahamas was reporting huge tax-free profits.

By 2013 Koch had withdrawn all of the money had invested in Oxbow America. A spreadsheet prepared for him showed a deficit of $12.2 million in his S corp. That meant any withdrawals would result in American income taxes. In 2014 the red ink glowed brightly with a deficit of $42.2 million.

Middleton gave the IRS internal documents showing how Koch tried to make it appear that he had money in his S corp and could make tax-free withdrawals.  Koch made short-term loans to the S corp to create the appearance of having money in the firm. Koch did this by making the loans just before Dec. 31 of 2013 and 2014.

Basically, Koch was moving money from one pocket to another and creating tax savings in the process.  Middleton called these “fake loans” to enable what he asserts is tax fraud.

“The fake loans were a way to get cash to untaxed cash to Mr. Koch,” Middleton wrote to Teresa Homola of the IRS Whistleblower Office in May 2018.

Middleton told the IRS the cash Koch withdrew should be treated as fully taxable dividends. That, he said, would create a second problem.

Whistleblower Middleton, in some detail, contends the loans were shams.

Congress requires that S corps make payouts to owners in proportion to their share of ownership. Koch was entitled to 75% of payouts, the 26 other owners to the rest.

Payments made only to Koch, or at a different rate than the others, effectively created two tiers of ownership, which is barred for S corporations.

It is common for C corporations with publicly traded shares to issue two classes of stock. The New York Times Company, for example, has Class A shares owned by the controlling Sulzberger family that come with 10 times the votes per share of Class B shares that anyone can buy.

Since S corporations can have only one class of shares, Middleton said, payouts to Koch that were not accompanied by proportional payouts to the 26 other owners would be illegal. He also said that the IRS should treat Oxbow as a C corporation. That would mean the withdrawals would be taxed twice, first as corporate profits and then as individual dividends.

Owners loaning money to their S corp is common, said Professor Douglas A. Kahn, who teaches business tax planning at the University of Michigan Law School.

“The intention of Congress was to create one level of tax, but not to let you avoid tax that you would owe” on business profits, Kahn said.

Paying out to one owner and not others is a trickier issue, he said, because “the courts have been very liberal about hybrid stock issues and have been inclined to not” enforce the ban on S corps having more than one class of stock.

Deducting Bonuses Twice

Middleton said the IRS should also look into $6 million of executive bonuses the company paid. He said they were deducted twice, in 2011 and again in 2012. How IRS auditors could miss deducting the same bonuses one year and again the next raises questions about how diligent the IRS auditors were and whether they were given inadequate time to do their work.

Documents Middleton gave the IRS show that deducting the same bonuses twice was worth $2.3 million of tax savings.

During decades of writing about taxes, I’ve heard from other tax professionals at companies and inside the IRS about deductions being taken twice, though none would supply me with the kind of written evidence that Middleton gave the IRS.

Donald Trump engaged in a similar tactic when he deducted on his tax returns more than $900 million of losses taken by banks which he failed to pay back in 1990. The money Trump did not pay back should have been treated as taxable income to him. Instead, it allowed him to live tax-free for years.

Since the IRS has inexplicably dropped its criminal investigation of Koch and his Oxbow carbon businesses, Congress has a duty to investigate. It has the authority to see all of the tax returns, the audit papers and to subpoena witnesses.

It should do so with an eye not just to making sure that Koch and his team are held accountable, but also for reforming our tax laws so that no one can enjoy a lavish lifestyle because they can collect unlimited amounts of untaxed income.

In Part 4 of The Koch Papers, we will look at a Massachusetts vacation home Bill Koch owns, the place where he hosted a fundraiser for candidate Trump, and how he arranged to take a $20 million tax deduction that the whistleblower says was illegal.


David Cay Johnston

MORE FROM David Cay Johnston

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