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Sun v. Commissioner of Internal Revenue

United States Court of Appeals, Fifth Circuit

January 18, 2018

JERRY J. SUN; SUN NAM SUN, Petitioners - Appellants
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent - Appellee

          Appeal from the Decision of the United States Tax Court

          Before DAVIS, CLEMENT, and COSTA, Circuit Judges.

          GREGG COSTA, Circuit Judge:

         A friend from overseas sent Jerry Sun and a company Sun controlled about $19 million to invest. Sun used almost $6 million for personal expenses. Another $4 million was kept in the accounts of Sun's company. The remaining $9 million or so was invested, but it was held in brokerage accounts in Sun's name, mingled with his other funds, and the gains or losses were reported on Sun's taxes. The tax court held a trial to determine the appropriate tax treatment of the $19 million. It considered various theories. Sun argued the money was a loan, which would mean he did not owe taxes on it. The IRS argued he did owe taxes upon receipt of the money as income from a foreign company or, for the money that passed through Sun's company, as qualified dividends. The court also considered whether the transfer was a gift. In the end, it did not agree with any of these theories. The tax court concluded that the money was not a tax-free loan. It also found that it was not income to Sun when he received it because it was being entrusted to Sun to invest on his friend's behalf. But the court concluded that Sun diverted the funds for his personal benefit, at which time the money became taxable. Whether this misappropriation finding was a correct characterization is the primary issue we consider.

         I.

         Sun, an American citizen, is the sole shareholder and chief executive officer of Minchem International, Inc., a Texas corporation that imports minerals from China. Sometime before 2008, he and his good friend Bill Cheung, a Chinese citizen, agreed that Cheung would entrust funds to Sun to invest in the United States.

         The arrangement was oral. Both Sun and Cheung testified that Sun had broad discretion regarding how to invest the funds and that the funds were for investment purposes. But they differed on many details. Sun testified that he was to invest the money for at least five years, whereas Cheung maintained it was for seven or ten years. As to Cheung's return on investment, Sun said he and Cheung agreed to split any profits beyond a ten percent return. Cheung, on the other hand, asserted that Sun was obligated to pay him a ten to fifteen percent annual return.

         Of the $19 million Cheung sent between 2008 and 2009, almost $15 million was sent to Minchem's officer loan account. This account was listed on the company's general ledger but was solely for Sun's benefit. The remaining $4 million was sent to Sun's personal brokerage accounts or Sun Investment, LLC, a partnership in which Sun owns a 99-percent interest.

          As noted, Sun ended up using millions of Cheung's money for personal expenses. This included the purchase of a luxury car, payment of the mortgage and real estate taxes on his home, and-the biggest category-over $5 million for gambling which resulted in losses of about $2.1 million. The $4 million that remained in Minchem's officer loan account increased Minchem's working capital, which bolstered its creditworthiness when the company sought a line of credit. The remaining $9 million of Cheung's money was invested through either Sun's brokerage accounts or Sun Investment. This money was mixed with Sun's personal fund, there was no separate accounting of Cheung's performance, and Sun reported the gains, losses, and dividends from the accounts on his own taxes.

         Cheung testified, somewhat cryptically, that he may have been aware Sun was using some of his money for personal purposes. When first asked whether he knew this was the case, Cheung replied, "I do know." He then said, "Well, whether he used this amount of money - let me put it this way. I know he was gambling. Is that what your question is?" Unsatisfied with Cheung's response, counsel repeated the question. Cheung replied, "How did I put this way? That when he lost money in Vegas he had telephoned me and told me that. That whether he lost my money or used my money and then he lost it or used his money, well, let me say that I did not know. I did not know how he divided or how he distribute his money to be put in."

         After examining Sun's and Minchem's 2008 and 2009 returns, the IRS issued a notice of deficiency. The notice set out alternative theories for the tax treatment of Cheung's transfers. According to the first, funds sent to Sun through Minchem were gross receipts to Minchem and then dividend distributions to Sun (meaning both Minchem and Sun owed taxes on this money); funds sent directly to Sun were taxable upon receipt as income from a foreign company. The second theory asserted that Minchem was merely a conduit and thus all funds should be included in Sun's gross income. The notice also assessed fraud penalties or, in the alternative, the less onerous accuracy-related penalties for Sun's failure to report Cheung's transfers as income.

         In addition to claiming that the money from Cheung was taxable, the notice also alleged that Sun underpaid taxes by (1) failing to report as income travel and entertainment expenses paid by Minchem, and (2) incorrectly claiming an investment interest deduction. The basis for the deduction was interest paid on a home equity loan obtained by Sun; the loan proceeds were deposited into Minchem's bank account. Minchem's ledger lists the transaction as a personal loan from Sun to Minchem. The IRS contended this did not constitute a legitimate investment. These other two tax issues are only relevant to this appeal because of the negligence penalties the court imposed that Sun challenges. He does not challenge the tax court's agreement with the IRS about the underlying tax treatment of these transactions.

         As it is in this appeal, the primary dispute in the tax court concerned the biggest dollar item: the $19 million Cheung sent Sun. Sun argued that the money was a loan because Sun was obligated to repay it. The tax court rejected this contention, noting there was not a loan agreement, a security interest, a fixed term for repayment, or agreed rate of interest. But the tax court also disagreed with the IRS's position that Cheung's transfer of funds to Sun was taxable upon receipt. This was because the tax court determined that Sun held the funds in trust to invest for Cheung's benefit. But the money later became taxable because Sun "misappropriated the funds for personal use, abandoned the intended purpose for which the money was entrusted, and he did not invest the money in accordance with the agreed-upon strategy." Such misappropriated funds are income. Although the court did not impose fraud penalties, it did find that negligence penalties were warranted for Sun's failure to report Cheung's funds as income and for the other alleged deficiencies.

          The tax court's misappropriation theory required a recalculation of the tax and penalties listed in the deficiency notice. Recall that the IRS's primary theory was that money sent directly to Sun was taxable as income but the money sent through Minchem was taxable only as dividends. Because dividends are subject to lower rate than income, the finding that all of the Cheung transfer was income would increase Sun's tax liability from $3.9 to $6.7 million (though Sun and Minchem combined would face less overall tax liability as the funds that passed through Minchem would not be subject to double taxation at both the corporate and individual level). As a result of the tax court's finding that all of the Cheung transfer was income to Sun, the IRS moved for leave to amend its answer to conform to the proof at trial and assert a greater deficiency ...


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