“It’s My Business”
The owner of a closely held business will often find it difficult to distinguish the business from their own person. That is certainly true for a sole proprietorship. In many cases, unfortunately, the owner’s perspective toward the business does not change appreciably when the business is owned and operated by a legal entity, such as a corporation or a limited liability company, the equity in which is owned by, well, the “owner.”
How the owner views their relationship with the business – stated differently, how they sometimes equate themselves with the business[i] – may be manifested in a variety of ways, many of which would make both the owner’s and the business’s legal advisers[ii] cringe. The payment of unreasonably generous compensation to the owner and members of their family, the employment of unqualified family members, the use of business property without the payment of adequate consideration (including, for example, below market loans), the payment by the business of the owner’s personal expenses and obligations, engaging in transactions with related businesses on other than an arm’s length basis, and a general disregard of “corporate” formalities, are just some of the activities in which an owner will cause their business entity to engage without giving any thought to the potential consequences.
Exposure to Liability
Among the consequences arising from an owner’s disregard of, or failure to respect, the separate legal status of one’s business entity may be the loss of the legal protection from creditors of the business that the legal entity otherwise affords its owner; in other words, the owner’s “personal” assets (those held outside the entity that owns and operates the business, even when they are nor used for the business) may become subject to the claims of the creditors of the business. Likewise, the assets of the business may become exposed to the personal liabilities of the owner where the owner treats those assets as their own.
One creditor that not infrequently succeeds in reaching the assets of a business to satisfy a personal tax liability of an owner, or the assets of an owner to satisfy an entity-level (i.e., corporate) tax liability, is the IRS. Indeed, the IRS has a number of tools at its disposal by which it may reach the assets, strictly speaking, of one other than the taxpayer. Thus, concepts such as transferee liability, fraudulent conveyance,[iii] and substance over form, as well as the alter ego doctrine, have been utilized by the IRS to collect the outstanding tax liability of a taxpayer from someone other than the taxpayer, including the owner or the entity, as the case may be.
In one recent decision, a Federal District Court considered the Government’s claim that a corporation’s assets be applied toward the satisfaction of an individual taxpayer’s income tax liability. In support of its position, the Government argued: (1) that Taxpayer fraudulently transferred Property to Corp, (2) that Corp was Taxpayer’s alter ego; and (3) that Corp was the Taxpayer’s nominee.[iv]
Alter Ego or Nominee
Taxpayer was engaged in the business of owning, operating, and managing real property, including Properties 1-8, which were owned a corporation and by a partnership. Taxpayer had a small equity interest in each of these business entities, with the vast majority of the equity being held by trusts for Taxpayer’s children; however, Taxpayer controlled a third business entity (“MGT”) that managed the properties.
Taxpayer had some difficulties with the IRS, but the agency was kind enough to pay for Taxpayer’s room and board at a Club Fed, which included a gym membership.
Years later, and after Taxpayer’s forced vacation had ended, Corp was formed to take over management of Properties 1-8 from MGT. The corporation’s shareholders consisted of Taxpayer’s son and a couple of unrelated individuals. This son, along with another of Taxpayer’s children, were officers of Corp, together with two unrelated individuals.
Taxpayer’s children subsequently formed Newco Inc. to hold their real property interests in the corporation and partnership previously organized by Taxpayer and owned primarily by the trusts for Taxpayer’s children. These properties (Properties 1-8) were managed by Corp.
Shortly thereafter, Newco purchased Corp.
It turned out the IRS was interested in Corp’s and Newco’s activities, at least insofar as Taxpayer may have been involved therein – it seemed that Taxpayer still owed the Government some money.
Taxpayer’s Role in Corp
Taxpayer was not involved in the formation of Newco, and never had an ownership or management interest in Newco. Corp did not assume MGT’s (i.e., Taxpayer’s) management agreements or leases; instead, Corp prepared and executed its own property management agreements and leases.
Corp’s offices were not the same as MGT’s offices, and Corp’s telephone number was different from that of MGT. Corp never collected any rents or other funds that should have been paid to MGT, and it never paid any of MGT’s bills.
Taxpayer worked at Corp as a bookkeeper, primarily managing accounts payable. One of Corp’s officers, who was not related to Taxpayer’s family, negotiated a reasonable salary with Taxpayer after investigating the cost to engage a bookkeeper. Taxpayer worked approximately 30 hours per week as Corp’s bookkeeper. Taxpayer was not involved with Corp’s negotiations of any leases and had no authority or control over such negotiations.
For a time, Taxpayer received monthly payments as a guarantor of one of Corp’s leases, an arrangement that was required by a landlord, which provided an economic benefit to Corp. When the lease ended, Taxpayer’s guarantor payments ended as well. Corp never paid Taxpayer more than the fair value of the “services” provided.[v]
When Corp was awarded damages in a lawsuit brought against a tenant, it applied the proceeds toward improving Properties 1-8. Taxpayer was not involved in any decisions regarding the lawsuit or Corp’s use of the proceeds.
At about the same time, Corp retained Taxpayer as a non-employee contractor – who has adept at such work – to maintain Corp’s security systems and perform electrical repairs in exchange for an arm’s length fee. Taxpayer’s services provided a substantial economic benefit to Corp.
For several years, Corp rented dedicated office and storage space from Taxpayer. The rent agreement was negotiated by one of Corp’s officers who was unrelated to Taxpayer and who investigated alternatives before determining that the negotiated rent payable to Taxpayer was fair and reasonable. According to their written agreement, Corp paid the Taxpayer’s landlord directly for the use of the space and Taxpayer reimbursed Corp each month. The balance was tracked by contemporaneous ledger entries. Renting the office and storage space from Taxpayer provided a substantial economic benefit to Corp.
Corp loaned money to Taxpayer (ironically, to pay income tax), and the loan was repaid. Other non-owner Corp employees also borrowed money from Corp.
Taxpayer was never listed on any of Corp’s bills or invoices, and Corp’s bills were never sent to Taxpayer’s home office. In fact, Taxpayer was not authorized to deal with Corp’s creditors or lenders and did not do so other than in a clerical role. Management duties were the responsibility of Taxpayer’s son and an unrelated individual who was an officer of Corp.
Taxpayer did not comingle personal finances with those of Corp and did not pay Corp’s expenses; Corp did not pay Taxpayer’s personal expenses. Taxpayer never had check-signing authority for Corp.
At times when Corp did not have sufficient income to pay its bills, Taxpayer was never involved in deciding which creditors would be paid on time and which would be paid later; that responsibility belonged to Taxpayer’s son and an unrelated individual who was an officer of Corp.
Corp’s Purchase of Prop
At some point, Corp decided to purchase a ninth Property. Although Taxpayer was not involved in Corp’s decision to purchase Property, Taxpayer actually held the initial purchaser’s interest in a purchase and sale agreement for Property with its prior owners (the sellers).
Taxpayer transferred this “initial purchaser’s interest” to Corp; meaning, Corp acquired the right to purchase Property from the sellers. Oddly, Taxpayer’s transfer, we are told, was not based on any agreement with Corp.
Corp acquired Property from the sellers pursuant to the purchase and sale agreement. Only Corp provided funds for the purchase of Property. As a result of its purchase by Corp, Property became encumbered by a promissory note and deed of trust in favor of the sellers.
Taxpayer never held title to or a possessory interest in Property. Corp purchased Property from its prior owners, paid full fair market value, and maintained continuous ownership of Property after its purchase. Taxpayer neither paid nor committed any funds to the purchase of Property; Taxpayer never contributed any money of work toward the subsequent repair of Property; Taxpayer was never held out as an owner of Property. The deed for Property was recorded naming Corp as its owner.
The Feds Step In
The Government brought an action against Taxpayer and Corp to reduce certain tax assessments against Taxpayer to judgment and to foreclose federal tax liens.
The Government claimed: (1) that Taxpayer fraudulently transferred Property to Corp to avoid the Government’s tax liens and thereby avoid paying a delinquent federal tax liability; (2) that Corp was Taxpayer’s alter ego, against which the Government could proceed for recovery of the transferred property; and (3) that Corp was Taxpayer’s nominee.[vi]
The Court explained that the following factors would be considered in determining whether either the alter ego or nominee doctrine applied:
- the nominee paid no or inadequate consideration for the property at issue;
- the property was placed in the name of the nominee in anticipation of litigation or liabilities;
- a close relationship existed between the transferor and the nominee;
- the parties to the transfer failed to record the conveyance;
- the transferor retained possession; and
- the transferor continued to enjoy the benefits of the transferred property.[vii]
The Court explained that the Government was obligated to prove its fraudulent transfer claim by “clear and satisfactory” evidence; specifically, it had to demonstrate that the transfer was made:
(a) With actual intent to hinder, delay, or defraud any creditor of the debtor; or
(b) Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor:
(i) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or
(ii) Intended to incur or believed or reasonably should have believed that the debtor would incur, debts beyond their ability to pay as they became due.
The Court Disagrees
Following a trial, the Court determined that the Government failed to prove its alter ego and nominee claims by a preponderance of the evidence; the Court also found that the Government failed to prove its fraudulent transfer claim by clear and satisfactory evidence.
The Court acknowledged that Taxpayer received considerable benefits from Taxpayer’s relationship with Corp. The Court also noted that Taxpayer had substantial influence over those who owned, managed, and directed Corp’s operations. Even so, the Court observed, these benefits – which were generally reasonable payments for the rental use of portions of Taxpayer’s property and for services performed by Taxpayer for Corp – and Taxpayer’s influence did not amount to the control and possession required to rise to a level that rendered Corp as Taxpayer’s alter ego or nominee.
Further, the Court continued, the “transfer of Property” to Corp was not fraudulent. Taxpayer did not have any interest of value in Property when Taxpayer assigned to Corp its purchaser’s interest in the purchase and sale agreement for Property.
In support of its position, the Court relied upon the facts set forth above: Taxpayer was never an owner of Corp and never served on its board or as an officers; Taxpayer never had or exercised control over Corp; Taxpayer never received personal benefits from Corp other than payments for the fair value of services provided; these services that were a substantial economic benefit to Corp; Corp was a separate legal entity, owned by Newco, and Newco was not owned or controlled by Taxpayer; Corp purchased Property from the sellers and paid full fair market value for it; Taxpayer never held an ownership or possessory interest in Property and the assignment by Taxpayer to Corp was an assignment without value; there was no credible evidence that the purpose of Taxpayer’s transfer of the right to purchase Property was in anticipation of litigation or liabilities, or with intent to hinder, delay, or defraud a creditor of Taxpayer.
After what must have been a bumpy ride, the stars aligned for Taxpayer. In short, the Court found that, beginning with the organization of Corp, the “parties” acted at arm’s length with one another in many different business-related transactions involving Taxpayer, which neutralized the Government’s argument that Corp was Taxpayer’s alter ego. The Court even found (relying upon certain post-transfer developments regarding Property’s condition) that there was no value in the right to purchase Property that Taxpayer transferred to Corp without any consideration. I think it’s safe to say that Taxpayer benefited from their otherwise arm’s length course of dealing with Corp.
It is likely that many other business owners will not be as fortunate – at least not until they stop treating their business as their alter ego.[viii] Although it may seem counterintuitive, at least on some visceral level, for an owner to treat with their business as if they were transacting with an unrelated party, it is certainly advisable that they do so from a tax perspective. Indeed, an owner’s guiding principle in evaluating any transaction in which they may engage with their business should be the following: would an unrelated third party have entered the transaction on comparable terms, and is the owner’s behavior consistent with what one would expect from a third-party? To the extent these questions are answered in the negative, can the owner distinguish or otherwise account for the difference on reasonable business-related grounds? If not, then the owner has to be prepared to have the transactions challenged and re-characterized by the IRS and to accept the tax consequences that may follow.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] The statement,“L’état, c’est moi,” is ascribed to Louis XIV.
[ii] Often – usually? – one and the same person.
[iii] In general, a transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the debtor made the transfer without receiving a reasonably equivalent value in exchange for the transfer, and the debtor was insolvent at that time, or the debtor became insolvent as a result of the transfer.
[iv] U.S. v. Weathers, Case No. 3:18-cv-5189-BHS, February 8, 2022.
[v] Query how the amount of this payment was determined?
We were recently involved in a matter in which the IRS claimed a parent’s guarantee of a loan to a business owned by their child was a taxable gift because no consideration was paid to the parent.
Corporations face a similar issue – in the form of a constructive dividend – when they guarantee the personal debt of a shareholder.
[vi] The Government argued, and the Court agreed, that in the context of federal tax liens, the nominee and alter ego doctrines are analyzed similarly.
[vii] Corp argued that the Government was obligated to prove its case by clear and convincing evidence, but the Government correctly countered that both nominee and alter ego claims were subject to the less demanding preponderance of evidence standard (more likely than not).
[viii] Personal goodwill does not entitle an owner to ignore the separateness of the business.