New Opinion Illustrates the Dangers of Going to Trial

Trials are unpredictable things. That's why most cases settle. A recent opinion from Austin Bankruptcy Judge Frank Monroe illustrates how a case can go astray. In MARTNKIM Dining, LLC vs. Chaney, Adv. No. 07-1082 (Bankr. W.D. Tex. 5/29/08), the defendants won the case but in the process exposed themselves to new and potentially greater legal problems.

The adversary proceeding involved a suit over sale of a restaurant. The debtor claimed that the sellers had committed fraud, including providing false financial statements. This required the court to examine the sellers'/defendants' unique accounting practices. According to the court, the sellers received 2/3 of their revenues from cash sales. These funds were deposited into the owners' personal bank account rather than the corporate account. They then "loaned" these funds back to the corporation as needed. At the end of the year, the sellers would add up the cash register tapes and report these items as income to the company's CPA. While the full amount of revenues were reported to the IRS on the company's form 1120, the cash receipts were not included on the company's sales tax return. The Court stated:

"There can be only one rational explanation for this procedure. The Chaneys did not want to, and did not, pay the sales taxes on the cash sales to the State of Texas. This is, most likely, a considerable sum of money."

Memorarndum Opinion, p. 7. The Court later estimated the amount of diverted sales taxes at approximately $100,000.

The Court also noted that the sellers paid some of their employees in cash and reported their income on form 1099 instead of paying payroll tax as required by law.

Ultimately, the Court found that the sellers/defendants had not defrauded the debtor/purchaser. The Court found that the financial statements provided were not inaccurate with regard to revenues and had not been relied upon for the expense side. As a result, the Court entered a take-nothing judgment for the defendants. However, the Court's written opinion shone an unwelcome light on the defendants' accounting practices prior to the sale. Thus, it can be said that both the plaintiff and the defendants lost.