A sport coat from Saks Fifth Avenue. Twice-weekly massage sessions. A vacation to Disney World. None of these sound like business expenses — and that's exactly the problem that landed one company's owner a 75% civil fraud penalty, a criminal conviction, and 46 months in prison.
The case is Hee v. Commissioner, and while the dollar figures involved are eye-popping, the underlying mistake is one that small business owners make every single day, just at a much smaller scale: running personal expenses through the company checkbook and hoping nobody notices. The Tax Court noticed. So does the IRS, routinely, in audits of businesses far smaller than the one in this case.
Here's what happened, what the court ruled, and — more usefully — what it means for how you should be running your own books.
The Setup: A Family Business, a Corporate Credit Card, and No Guardrails
Albert Hee incorporated Waimana Enterprises in 1988 and ran it for decades as sole shareholder and president, with subsidiaries in telecommunications. On paper, it was a legitimate operating business. In practice, from 2003 to 2012, Hee treated the corporate credit card as an extension of his personal wallet.
His administrative assistant coded the charges as directed — no independent review, no policy check, just whatever categorization kept the story consistent. Over nearly a decade, this pattern generated more than $2 million in unreported income, according to the court's findings.
What got swept into "business expenses"? A sampling from the opinion:
- $6,000–$10,000 a year in massage therapy, later described to tax preparers as "consulting" fees
- $33,523 in tuition for his daughter's MIT enrollment
- Salaries paid to family members with little to no documented work performed
- A $21,872 family trip to France and Switzerland, a $10,919 Disney World stay, and a $2,878 trip to a presidential inauguration
- A $1,249,608 residence in Santa Clara where his children lived rent-free — with over $192,000 in foregone fair-market rent across the disputed years
- Routine Costco, Target, and Nordstrom purchases, including a $1,246 sport coat, booked as office expenses
Separately, the company had advanced Hee roughly $1.1 million with no promissory notes, no interest schedule, no repayment terms, and no collateral — the hallmarks of a genuine loan were simply absent.
Why the Court Called These "Constructive Dividends"
You don't need a formal declaration of a dividend for the IRS — or a court — to treat a payment as one. A constructive dividend arises whenever a corporation confers an economic benefit on a shareholder that isn't a legitimate, substantiated business expense and isn't expected to be repaid. Once a corporation has earnings and profits, any unsubstantiated payout to the owner is fair game to be recharacterized this way — with corporate tax deductions disallowed and the amount added back to the shareholder's personal income.
The court applied the well-established Welch factors to evaluate the supposed $1.1 million in shareholder loans, and found every one of them missing: no note, no interest actually accrued and paid, no fixed repayment schedule, no collateral. Partial repayments made years later ($298,856 in 2011 and $736,000 in 2012) didn't rescue the characterization — by then, the absence of formalities at the time the money moved had already sealed it.
The family salaries fared no better. Compensation to related parties gets heightened scrutiny precisely because there's no arm's-length bargaining to keep it honest — the court wants to see hours worked, tasks completed, and pay that's reasonable for the work actually performed. Vague assertions that a college-enrolled, out-of-state child was "an employee" didn't hold up.
The 75% Fraud Penalty — and Why "I Trusted My Accountant" Didn't Work
Disallowed deductions and reclassified income are expensive on their own. What turned this into a career-ending case was the civil fraud penalty under IRC Section 6663 — 75% of the underpayment attributable to fraud, on top of the tax itself.
The court built its fraud finding on six "badges of fraud" that will feel familiar to anyone who's read a tax fraud opinion:
- A sustained pattern of underreporting income exceeding $2 million over nearly a decade
- Threadbare or nonexistent records for personal expenses and travel
- Implausible explanations — a Disney World trip justified as "rapport building," a Tahiti visit as a "cable inspection"
- Incomplete or misleading information handed to the tax preparer (calling massages "consulting")
- Testimony the court found not credible
- A related criminal conviction for filing false returns, which carried over via collateral estoppel
That fourth point matters enormously for anyone tempted to lean on "my CPA signed off on it" as a defense. Good-faith reliance on a tax professional only protects you if you gave that professional complete and accurate information. Mischaracterizing a personal expense before it ever reaches your accountant's desk isn't a paperwork shortcut — courts treat it as affirmative evidence of intent to deceive.
Because the fraud was attributed to Hee personally as the sole shareholder and directing mind of the company, the penalties extended to the corporation too, and the statute of limitations was suspended indefinitely under Section 6501(c)(1) — fraud, unlike an honest mistake, never runs out the clock.
The Real Lesson: This Isn't Just a "Big Company" Problem
It's tempting to read a case with a seven-figure fraud finding and a criminal sentence and assume it's irrelevant to a two-person LLC or a solo consultancy. It isn't. The mechanics that sank Hee — vague expense categorization, no contemporaneous documentation, funds moving between "the business" and "me" without a paper trail — are the exact same mechanics behind the much smaller, much more common IRS adjustments that hit small businesses every year.
You don't need $2 million in disallowed expenses for an examiner to disallow your home office write-off, reclassify a "loan" from your S-corp as a distribution, or challenge a family member's paycheck as unreasonable compensation. The dollar amounts scale down; the analysis the IRS applies does not.
A few practical takeaways that apply at any size:
Separate the accounts, completely. One business checking account, one business card, used only for business. The moment personal and business transactions share a ledger line, you've created exactly the ambiguity the IRS is trained to exploit — and in worse cases, opened the door for a court to pierce your liability shield entirely.
Formalize related-party money movement — every time. If the business is genuinely lending you money, that means a signed note, a real interest rate, and an actual repayment schedule, documented before the money moves, not reconstructed after an audit notice arrives. If you're paying a family member, keep the same records you'd keep for an unrelated employee: hours, duties, and a rate that matches the work.
Never let ambiguous categorization sit in your books. "Consulting fees" that are actually massages, "office expenses" that are actually Nordstrom receipts — these aren't clever accounting, they're a paper trail pointing directly at intent. Categorize transactions accurately at the time they happen, not in a way that looks better later.
Give your tax preparer the real story. The incomplete-information defense collapses precisely because taxpayers hand preparers a sanitized version of events. Full, accurate information protects both you and the reasonable-reliance argument if a dispute ever arises.
Substantiation: The Rule That Doomed the "General Assertion" Defense
One of the more instructive parts of the opinion is what didn't save the taxpayer: a general claim that a trip or purchase served a business purpose. Under IRC Section 274(d), travel, meals, and entertainment expenses carry heightened substantiation requirements — you need contemporaneous records showing the amount, time, place, and business purpose of each expense. A memory of "it was probably for work" doesn't meet that bar, no matter how confidently it's asserted at trial.
Taxpayers sometimes point to the Cohan rule — the old doctrine allowing a court to estimate a reasonable deduction even without perfect records — as a fallback. It doesn't apply here. Cohan estimation has never extended to the categories Congress specifically carved out for strict substantiation, and the Tax Court has reaffirmed that limit in several recent decisions involving unsubstantiated travel and vehicle expenses. If you can't produce a receipt, a log, or a calendar entry showing why an expense was business-related at the time it happened, don't count on a judge estimating your way out of it later.
The practical fix is unglamorous but effective: log the business purpose when the expense happens, not months later when you're preparing for an audit. A one-line note on the transaction — who, what, why — is the difference between a defensible deduction and a badge of fraud.
Why Your Bookkeeping System Is Your First Line of Defense
Every one of the fatal flaws in this case traces back to the same root cause: a bookkeeping system with no built-in accountability. Charges got categorized however was convenient, with nothing enforcing consistency, no audit trail showing who changed what and when, and no structural separation between "money in the business" and "money for me."
This is precisely the gap that plain-text, version-controlled accounting closes. With Beancount.io, every transaction is recorded as an explicit, auditable entry — not a vague swipe on a shared card that gets recoded after the fact. Because the ledger is text and tracked in version control, you get a real history of exactly when an entry was made and how it was categorized, which is the opposite of the ad hoc, after-the-fact recharacterization that doomed the taxpayer in this case. Get started for free and build a bookkeeping habit that would hold up under exactly this kind of scrutiny — because eventually, it might have to.