How to establish truly "separate" corporations in all your transactions
By F Hale Stewart, JD, LLM, CAM, CWM, CTEP
The Law Office of Hale Stewart
There is no magical combination of factors for the court to use in arriving at its decision. Instead, they weigh various elements in relation to the facts. From a compliance perspective, avoidance of the previously listed factors would go a long way to proving the separate nature of the corporation.
There are two prevailing theories of the nature of the corporation: either it is a privilege granted by the state (a more traditional view derived from the historical development of the corporation) or a “nexus of contracts” between shareholders (which is derived from a law and economics analysis).
But devotees of both theories must still prove a corporation has substance — a word whose entomology contains the concept of “any kind of corporeal matter.” This historical root is fortuitous for law, as the purpose of establishing corporate substance is to demonstrate that a corporation — a purely legal construct with no physical existence — is in fact a viable entity that must be recognized as separate and distinct by the court.
Despite the obvious importance of this concept, its scholarship is remarkably undeveloped. A broad search done of the Westlaw law review database for the term “corporate substance” performed on July 3, 2013 returned a mere 31 hits, none of which were directly on point. And the guidance provided by case law is no clearer, with some cases ruling that minimal activity is all that is necessary while others (such as veil piercing law) demand the shareholder demonstrate the corporation is not the “alter ego” — literally, the “other self.”
Despite the seemingly unsettled or under-researched nature of this area of law, guidance does exist. Beginning with the Supreme Court’s Moline Properties decision in 1935, U.S. courts have held that a corporation should be recognized as a separate entity, even if the traditional methods of establishing some (such as keeping corporate records and following corporate formalities) are thinly developed. Additionally, two other areas of law provide further positive guidance. The factors courts use to determine whether or not to pierce the corporate veil also provide positive guidance on factors taxpayers must comply with in order to prove the existence of a separate and viable corporate entity.
And finally, the active income factors outlined in 26 USC 469, which were added to the code to prevent the abuses of the 1970s passive income tax shelters, and the accompanying Treasury regulations provide positive guidance for grouping together disparate activities in a manner the service will recognize as a single, cohesive economic unit.
Moline Properties’ facts are straightforward. An individual who owned commercial real estate placed a single building into a corporation and subsequently placed the corporate shares with a voting trustee for the benefit of the mortgagee. When the corporation sold the property three years later, the single shareholder attempted to claim the sale as individual income rather than corporate income. The court ruled against the taxpayer, writing this now famous conclusion:
The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity.
Until 1933 the business done by the corporation consisted of the assumption of a certain obligation of Thompson to the original creditor, the defense of certain condemnation proceedings and the institution of a suit to remove restrictions imposed on the property by a prior deed. The expenses of this suit were paid by Thompson. In 1934 a portion of the property was leased for use as a parking lot for a rental of $ 1,000. Petitioner has transacted no business since the sale of its last holdings in 1936 but has not been dissolved.
To this day, Moline Properties is cited as a primary authority for the proposition that courts must accept the separate nature of a properly incorporated entity. It has been cited approvingly in all but the 10th judicial circuit. More importantly, it has been cited approvingly by the U.S. Tax Court 30 times and 26 times by various IRS materials, including chief counsel memorandum, general counsel memos, letter rulings and field service advance memos. While none of the IRS materials cited are binding, they amply demonstrate the IRS’s knowledge of this well-settled legal doctrine.
This leads to a question of how to effectively develop corporate substance in a manner that prevents a successful IRS challenge. Enter the concept of "alter ego" from veil-piercing doctrine. According to Ballentine's Law Dictionary, an alter ego is literally "the other self." Instead of the company being a separate and distinct legal entity, it's actually an extension of an individual or another company who is using the limited liability shield not to protect their investment (a primary reason for the shield) but instead for other, non state-sanctioned purposes, such as fraud. When the personal and business substance are intertwined — or when a company is not "unique" but a mere extension of an individual — a court can "pierce the corporate veil," stripping the company of its limited liability shield and thereby making the individual shareholders personally responsible for the corporation's debt.
Depending on the jurisdiction, there are either two or three elements to veil piercing. The three prong test is usually worded thusly:
1. a single individual or small group of individuals is in complete control of the company,
2. they use the corporation to commit some type of tort or breach of contract and
3. the tort or breach is the proximate cause of the plaintiff's harm.
The courts will look at many factors to consider piercing the veil, such as, "(1) majority ownership and pervasive control of the affairs of the corporation; (2) thin capitalization; (3) nonobservance of corporate formalities or absence of corporate records; (4) no payment of dividends; (5) nonfunctioning of officers and directors; (6) insolvency of the corporation at the time of the litigated transaction; (7) siphoning of corporate funds or intermingling of corporate and personal funds by the dominant shareholder(s); (8) use of the corporation for transactions of the dominant shareholder(s); and (9) use of the corporation in promoting fraud." There is no magical combination of factors for the court to use in arriving at its decision. Instead, they weigh various elements in relation to the facts. From a compliance perspective, avoidance of the previously listed factors would go a long way to proving the separate nature of the corporation.
A second way to establish the separate nature of the corporation is to comply with the material participation rules of tax code section 26 USC 469 and the accompanying Treasury regulations. The material participation rules were added to the tax code in reaction to the tax shelter industry of the 1970s and 1980s, where promoters put together limited partnerships that primarily invested in assets with high interest deductions or depreciation expenses. A deeper examination of these deals usually revealed a remarkable lack of business substance and included things such as phantom loans, circular cash flows and massively overstated basis. These deals were sold to high-net-worth individuals who were looking for ways to obtain losses to offset income; they wouldn't "materially participate" in these deals, instead acting as the classic "silent partner" exemplified by their legal status as a limited partner.
As a result, Congress passed section 469 of the tax code, which divided income into passive and active income. "Usually, passive activity losses can be offset only against passive activity income." Hence, limited partners would now need to have passive gains against which to offset their passive losses, essentially shutting down this type of tax shelter. The Treasury regulations provide guidance on the application of the material participation rules and include a section that allows a taxpayer to group activities according to certain criteria, thereby claiming that are all active. The regulations include the following criteria — “not all of which are necessary” — to determine if the grouping of an activity will be recognized by the service as a viable grouping:
1. The extent of common control
2. The extent of common ownership and
3. The inter-dependencies between or among the activities.
In conclusion, we arrive at the following points. First, under Moline Properties, a court will recognize the separate nature of a corporation, even if the taxpayer has not followed all the required corporate formalities. However, to add a further layer of protection, the taxpayer should comply with various factors courts use to pierce the corporate veil to establish substance. In doing so, the taxpayer will show that the corporation isn’t an alter ego, but instead a separate corporate entity. And finally, under the active participation rules of established under the Treasury regulations for section 469, a taxpayer can group commonly owned and controlled activities — especially those that are inter-related — into one “economic unit.” As these rules were put in place to prevent tax evasion, they go a long way to demonstrating corporate substance.