Let’s say you own a business. Putting aside flow-through entities (explained here, but don’t worry about it), the general rule is that any money you earn from your business is taxed twice. First, the business pays income tax on its earnings. Then, when the business pays you, you have to declare those earnings — whether the business is paying you a salary or issuing you a dividend — as income. And your income gets taxed. From the law’s perspective, the business and you, the individual, are two separate “people,” and each one can be taxed separately.
That may seem bad for business owners, and if we want to encourage people to start businesses, this double taxation is a bad idea. But that’s a topic for another newsletter, not a trivia one. Suffice it to say that if you’re a business owner who also takes a dividend from your company, you want to avoid this situation if at all possible. But the sad truth is that you can’t, at least not legally. If your business pays you in this manner, you’re going to be double taxed.
And that’s probably why, in the late 1970s or early 1980s, the IRS tried to fine a business owner named Peter E. Maxwell.
In the summer of 1976, Maxwell, with his wife, her sister, and his sister’s husband, formed a business that manufactured urethane foam carpet padding (this stuff) called Hi Life Products. The Maxwells owned 47.5% of the business each; the other two split the remaining 5%. According to a court decision, Mr. Maxwell was “responsible for sales, purchase of major materials, and engineering of plant equipment. Mrs. Maxwell was the executive vice president, secretary, and treasurer of Hi Life, and was responsible for all of Hi Life’s financial matters.” Mr. Maxwell earned $10,000 in salary in 1977, or the equivalent of about $50,000 in today’s dollars.
But on October 31, 1977, Hi Life paid Maxwell $72,500. And just a few weeks later, Maxwell’s company wrote him another check, this time in the amount of $50,000. When it came for the Maxwells to file their taxes, they didn’t declare the $122,500 as income. And even stranger, the company deducted that payment as a business expense, lowering their tax liability. Instead of the IRS getting double paid, the tax man actually was paid less. And you don’t need to know much about taxes to know that the IRS does not take kindly when people scam their way out of paying their taxes.
And it definitely looked like Maxwell was trying to pull a fast one. His story? He was hurt on the job — specifically, he was injured while running a mixing machine. Given that none of his duties required him to be on the factory floor, at least not while the machines were in operation, that seemed specious. But it turned out, that’s exactly what happened. Per the court, ” At the time of the injury, petitioner had been training plant personnel to operate the mixing machine. He failed to notice, however, that a bolt was protruding from the rotating cylinder in place of the flush setscrew. As [Maxwell] was attempting to turn off the machine, his sweater sleeve caught on the protruding bolt, and he was pulled into the mixing machine. As a result, [he] suffered serious injury including a fractured forearm, soft tissue lacerations, and second and third degree burns.” Ouch!
Maxwell probably only had himself to blame — he was, after all, in charge of engineering the plant equipment, and in that capacity, he should have noticed the protruding bolt. But in this case, financially, that worked in his favor. Again, legally speaking, the business that Maxwell co-owned was a distinct “person” from Maxwell himself. And the business, due to the negligence of its employee, was responsible for Maxwell’s injury. So Maxwell hired a lawyer and sued the company he owned. The company used a separate lawyer and the two sides settled, with the company’s board approving the settlement. (Maxwell, despite being a plurality shareholder, abstained from the board vote; his wife and brother-in-law each voted in favor.) Everything, it seemed, was on the up and up. But the IRS decided otherwise — they ruled that he owed $64,185 in taxes and the business owed $58,800.
Maxwell then filed another lawsuit — this time against the IRS. And it took a while but in 1990, he finally won. The court found that both he and his company were acting reasonably and within the letter of the law, and the IRS wasn’t entitled to any recovery.
From the Archives: The Driver Who Sued Herself (and Won): Again, it worked.