Piercing the Corporate Veil, Part I

Limited liability for shareholders is the norm for businesses; it is now specifically included as a part of the model business corporation act (section 6.22). There are numerous policy reasons for this, but the most compelling is it encourages risk taking. If it was possible for a shareholder to be personally liable for all corporate debts, risk raking would diminish, hurting overall economic growth. Limited liability also helps to increase liquidity for shares, as people purchasing stock in a corporation know their maximum loss will be the amount of capital they expend for the purchase.

But this was not always the norm. In fact, in the early 1800s several states imposed complete liability on shareholders. These states revised their laws as they saw investment capital leave for states where limited liability was the norm. By the mid-1850s, limited liability was the national norm.

However, there are times when a court will -- and should -- ignore this legal protection and "pierce the corporate veil" of limited liability. While law school corporate courses teach that this doctrine is well-defined, the reality is this legal field is very messy. One of the earliest attempts to explain the veil piercing doctrine was written by Maurice Wormser, in a law review article titled, "Piercing the Veil of Corporate Entity" which was published in the Columbia Law Review in 1912. It outlined several then standard veil piercing situations.

1.) Preventing fraud. Several cases were cited where shareholders of a debtor transferred assets to a newly formed corporation, essentially bleeding off assets from the company to prevent it from paying all its debts. This fact pattern would also run afoul of fraudulent transfer law.

2.) Alter Ego occurs when a corporation is a "mere instrumentality" of the shareholders. For example, suppose an individual drained his physical assets into a corporation, but failed to inform debtors of this fact, while at the same time, using the assets in the new corporation to live the high life. In this situation, the corporation would be an "alter ego" of the shareholder, because the shareholder was using the corporation to further his own lifestyle and not the corporation. There is also a certain amount of fraud in this argument for piercing.

3.) Evading a statute. The law review article cited several cases where companies had formed new companies to evade a specific law.

What Does a "Real" Transaction Look Like?

In my last post, I noted there is a difference between "real" and "tax shelter" transactions, with the former being legitimate and the latter being suspect in the eyes of the IRS and possibly the DOJ. That leads to the following question: what do we, as planners, need to demonstrate or prove in order for a transaction to be recognized as legitimate in the eyes of the taxing and enforcement authorities?

Unfortunately, most anti-avoidance cases express this in the negative -- you can't do this or that. However, the Frank Lyon case (435 U.S. 561 (1978)) provides us with a positive example by providing a list of factors to comply with. Here is the court's syllabus of the facts:

A state bank, which was a member of the Federal Reserve System, upon realizing that it was not feasible, because of various state and federal regulations, for it to finance by conventional mortgage and other financing a building under construction for its headquarters and principal banking facility, entered into sale-and-leaseback agreements by which petitioner took title to the building and leased it back to the bank for long-term use, petitioner obtaining both a construction loan and permanent mortgage financing. The bank is obligated to pay rent equal to the principal and interest payments on petitioner's mortgage and has an option to repurchase the building at various times at prices equal to the then unpaid balance of petitioner's mortgage and initial $500,000 investment. On its federal income tax return for the year in which the building was completed and the bank took possession, petitioner accrued rent from the bank and claimed as deductions depreciation on the building, interest on its construction loan and mortgage, and other expenses related to the sale-and-leaseback transaction.

Central to this case was the fact the regulatory issues prevented the bank from owning the mortgage on its books, forcing the bank to enlist the help of other parties in the transaction. That was a :business or regulatory reality" that made this multiple party transaction "real" from a tax planning perspective.

Here are the factors the court gives us:

-- there is a genuine multiple-party transaction
-- with economic substance that is
-- compelled or encouraged by business or regulatory realities,
-- that is imbued with tax-independent considerations, and
-- that is not shaped solely by tax-avoidance features to which meaningless labels are attached.

When putting together a transaction, planners need to ask the bigger questions beyond mere technical compliance with the law. Donald Korb of the IRS gave a speech in 2005 on the economic substance doctrine that provides a list of questions to ask regarding any transaction:

-- Is there a non-tax business reason to perform the transaction? In the Frank Lyon case, the taxpayer could point to the regulatory realities of the situation as the primary driver.
-- Did the taxpayer and their advisers actually investigate the transaction? Ask yourself -- did they really comply with the "duty of care" imposed on corporate directors? Did the advisers really comply with their fiduciary duties?
-- Is the taxpayer going to really commit money to the transaction? For example, does the taxpayer get an immediate loan back from a party that comprises most of the money he is committing?
-- Are all the parties involved real and separate from the taxpayer? A big giveaway in many tax shelter transactions are partnerships that disappear after being in existence for less than a year, or that only hold a single investment.
-- Were all steps and transactions engaged in an arms length manner?
-- How was the transaction marketed? This is a big giveaway in many tax shelter cases. If the sales literature or the advisers recommending the transaction talk about taxes and spend little time on substance, there's a big problem.

As advisers, we need to move beyond mere compliance with legal technicalities and instead move to the bigger questions underlying the transaction. In the long run, this will make us far more valuable to our clients as our advice not only encompasses the law but other components of our clients' business.

What's the Difference Between A Real and A Tax Shelter Transaction?

What follows is from "A Practitioner's Perspective on Substance, Form and Business Purpose in Structuring Business Transactions and Tax Shelters." by Peter C. Canellos. It was published in the SMU Law Review in the Winter of 2001. This is one of my favorite legal passages because it really gets to the heart of the difference between a "real" tax planner, and the marketed tax shelter business.

Real transactions, most obviously, have as their origins and purpose making money in the short-run or the long-run by increasing revenues or reducing (non-tax) expenses. As a subset, business-based financings attempt to raise capital for the company's business. Taxes of course play a role in analyzing financings and other business transactions, but they do not provide the primary motivation for undertaking the transaction. Tax shelters by contrast exist principally to reduce taxes by generating tax benefits usually derived from losses or credits that reflect outlays, expenses, and negative economic items. The equity investment in a real *53 transaction is aimed at generating a sufficient economic return to exceed, on a risk-adjusted basis, the entity's cost of capital. The investment in a tax shelter is a fee paid for tax benefits. The investor either expects to lose it or expects a return with an economic yield that is below market on a risk-adjusted basis. The economic return, if present, is often a carefully calibrated item designed to satisfy a perceived talismanic business purpose standard. The economic risk is likewise circumscribed so that, while predictable small losses may exist, large unpredictable losses do not.

Real transactions generally arise from commercial contacts, in-house corporate development and similar departments, business brokers and outside investment advisers. If not originated in-house, they are generally marketed to the sectors of corporate management dealing with acquisitions, divestitures, finance, corporate development, etc. They usually reflect a business or financing idea, not a tax-savings idea. Tax shelters are generally created by specialized tax professionals, usually but not always independent of the corporation in question. If developed outside the corporation they are generally marketed to the tax or finance department of the corporation, although in some high profile, large dollar cases the pitch is made to the highest management levels.

Real transactions generally involve real parties in interest (e.g. buyer and seller) with financing parties supplying capital at market rates of return. Tax shelters often, probably most of the time, involve accommodation parties that are not U.S. taxpayers (e.g. foreign entities, tax-exempts, loss corporations) to whom income is deflected, often through a partnership or other non-taxed entity.

Real transactions, other than financings, are generally open-ended with undefined outcomes. Corporations expect them to generate returns that exceed the corporation's cost of capital but also expect a corresponding risk of loss. (Financings generally involve predictable outlays but generate proceeds whose investment is expected to generate open-ended returns, or at least returns that exceed (pre-tax) financing costs.) In contrast, tax shelters usually involve largely predictable outcomes in order to assure that the expected tax benefit will be available to offset a particular gain or income item. To achieve the predictable result, carefully scripted scenarios are usually followed. Indeed, it is the choreographed series of steps--typically foreign to the corporation's usual business, involving extraneous parties and often employed by other users of the same shelter type--that courts often seize upon in branding a transaction as a shelter.

Although in theory the line between a tax shelter and an aggressively structured real transaction may appear difficult to draw, in actuality the *54 distinction is generally rather easy to establish when the transaction involves most of the tax shelter elements described above. That is why it may be hard to define shelters legislatively (and the difficulty is compounded if the stakes are substantive disallowance as opposed to disclosures and penalties) but so easy for courts to determine whether an actual transaction is a shelter. Consider these variations on partnership transactions. In the first case, corporations A and B contribute businesses to a partnership, A receives 90% from the income from B's business, B 90% of A's, with the expectation of a redemption of A in year eight for B's business. In the second case, A contributes its business, B contributes cash, partnership borrows cash (recourse to A) and distributes it to A; expected redemption of A in year eight. The third case parallels case two but the redemption is for stock of a subsidiary holding high-basis investment assets. In the fourth, A and B contribute cash, assets are acquired and sold in a manner designed to generate an artificial tax gain which is allocated to B, a non-taxable entity; B is redeemed and A is left with an artificial loss. Most observers would treat the first and second as real business transactions, the third as an aggressive but real business transaction, and the fourth as a tax shelter.

The tax shelter stigma attaches most firmly and justifiably to transactions involving loss generation and/or tax-exempt accommodation parties to whom income is deflected or whose investment is used to generate a loss allocated to the shelter investor but without the tax consequences of debt incurrence. The ACM case, for example, drew precious few criticisms of the outcome, which seemed well deserved. As for step-down preferred, the severe I.R.S. reaction reflected both the abusive nature of the transaction (deflecting uneconomic amounts of income to tax-exempt holders with matching artificial deductions to taxpayers for the equivalent of principle amortization) and its massive revenue implications. This was in the context of a transaction that probably worked under then-existing rules but was too good to be true. The same could also be said of so-called liquidating REIT transactions.

Transactions involving income shifting within an affiliated group, unwarranted interest deductions on corporate-owned life insurance or foreign tax-credits on dividend-stripping transactions exist in the hinterland between merely aggressive transactions and tax shelters, the border crossed as artificiality increases and tax benefits become more unreasonable. Cottage Savings-type transactions, resulting in recognition of true economic losses, have been sustained by the courts and would not generally be regarded as true tax shelters by practitioners.