Using the Material Participation Rules to Establish Corporate Substance

As I have previously noted, the concept of corporate "substance" is a poorly developed area of law.  In this post, I wanted to expand the concept for the practitioner with the intent of borrowing from other legal areas in the hopes of providing further guidance.  I want to note upfront that the analysis I am about to offer has to my knowledge not been proposed or offered in any case law or law review article (if a reader knows of this, please post it in the comments); it's merely presented as a way to broaden the concept and provide high level guidance.

Establishing corporate substance is incredibly difficult for the small to medium size business owner for two reasons: (1) they typically work long hours building their business but (2) they have insufficient staff to document their actions in order to establish the requisite paper trail proving corporate substance.  Compare this to a larger company which either has in-house legal or an ongoing relationship with an outside firm that continually monitors and documents the company's legal developments in real time.  The former situation could leave a company vulnerable to a veil piercing claim in the event of lawsuit with the lack of a contemporaneously created record adding fuel to the fire.  But an alternative approach does exist which borrows from tax law, using the concept of material participation.

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." William Hoffman, Corporations, Partnerships, Estates and Trusts, page 10-35 (c) 2008, West.  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.

But just as important as passive activity is active activity, which is established by a person "materially participating" in the enterprise.  Under section 469, "[a] taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is—
 

(A) regular,
(B) continuous, and
(C) substantial. 

The regulations provide some guidance on the actual definition of these terms.  Here are three basic facts patterns from the accompanying Treasury Regulations that would apply to most individuals:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

Arguing material participation is prima facia evidence of corporate substance has one powerful benefit: counsel is not advancing a new, untested concept, but instead relying on a well-established and now well-developed area of law to prove his point.  

The three fact patterns would apply to a broad swath of entrepreneurial activities.  Assuming a 40 hour work week (which grossly understates the hours worked by most business owners), fact pattern 1 would account for 3 1/2 months of work.  Fact pattern two would be appropriate for any individual who is self-employed and has filed entity status (and when combined with fact pattern 1 would be extremely powerful) while fact pattern 3 would apply to most lightly staffed companies.  

More importantly, all three fact patterns should establish a sufficient amount of corporate substance as they indicate a fair amount of activity -- at least enough to give a potential veil piercing claim pause.

Veil Piercing and Corporate Substance

The idea of corporate substance is essential to corporate law.  Professors inform students in corporation class they must endeavor to give their corporate clients "substance" lest courts be given the opening to pierce the corporate veil.   Unfortunately there is a dearth of scholarship defining and developing this concept, despite its obvious importance.  While this post will hardly provide the depth needed for a true analysis, it will provide some insight on the exact nature of this idea.

Depending on your view, a corporation is either a privilege granted by the state (an older, more traditional view) or a nexus of contracts (from a law and economics analysis).  But regardless, it's an artificial construct with no physical existence.  At the same time, a corporation is allowed to perform many of the acts of an individual such as sign contracts, sue and be sued, hold property, transact business and the like. Del. Code Ann. tit. 8 Section 122.  This leads to the question of how exactly do we prove the corporation not only exists, but is in fact a unique entity with a separate existence? Or, to put it more existentially, how to we demonstrate it is "alive" or has "substance?" 

This is usually demonstrated by establishing a paper trail -- meeting minutes, a sales records, contracts and the like.  This leads to point number 1: the paper trail must exist and it must be documented.  Ideally, each fiscal year of a corporation's life can be placed into a folder (most likely electronic in nature) that includes contracts, payments, meeting minutes etc... outlining what exactly has occurred.  The folder should be readily available and easy to access. 

But there is an important corollary to rule number 1: the existence must demonstrate uniqueness, which is defined as, "existing as the only one or as the sole example; single; solitary in type or characteristics."  While this is easily accomplished with a larger publicly traded or private company it can run into trouble with smaller, closely held family businesses.  As an example, take the generic company Acme Corp.; Mr. Smith is the president, and Mrs. Smith is the treasurer.  The company has made two questionable purchases: high-end cars for its executives as a perk and property in a known vacation spot like Colorado in the name of "entertaining potential clients."  Has the company purchased these for legitimate corporate reasons or has the Smith family used the company to make personal purchases disguised as company purchases?

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 are 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 inter-mingling of personal and business substance is so inter-twined -- 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 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 two prong test is phrased thusly: there is such unity of the interests between the individual and the corporation that the separateness of the corporation is erased and holding the "alter ego" as the only liable party would lead to an injustice.  There is a fair amount of overlap between the two tests.  In addition, veil piercing is not the cause of action but the equitable remedy; the plaintiff must allege an additional cause of action such as fraud or breach of contract.

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."  Pointer (U.S.A.), Inc. v. H & D Foods Corp., 60 F. Supp. 2d 282, 287 (S.D.N.Y. 1999).  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.

And this returns us to the concept of "substance."  A company that exhibits some of the factors listed in the previous paragraph and also engages in questionable behavior does not demonstrate that it has sufficient substance to be recognized at law.  In the alternative, it is not a unique entity with its own demonstrable personality, but instead an abuse of the limited liability granted by law.  As there is insufficient substance, a court can hold individual shareholders personally liable for corporate debts and obligations.  

 

An Inquiry Into the Legitimacy of Offshore Planning: Establishing Business Purpose

I have previously referred to US anti-avoidance law as a "conceptual briar patch."  In learning about this law, the practitioner is first faced with a fundamental question of just how many US doctrines exist.   He could easily come to the conclusion there were five, which are

1. Substance over form
2. Sham Transaction
3. Business Purpose
4. Economic Substance 
5. Step Transaction Doctrine

At the same time, he could reasonably conclude the sham transaction and economic substance doctrine are the same concept (both have an objective and subjective component) with sham transaction terminology used from the late 1950s to the late 1970s/early 1980s and the economic substance doctrine used thereafter. Or he could conclude the sham transaction is used in simpler transactions (such as interest deduction manipulations) whereas economic substance is used in more complex transactions (such as the tax evasion plans promulgated during the 1990s).  And is the business purpose doctrine a separate doctrine or one of the factors of the shame transaction/economic substance doctrine?  A reading of the case law supports both views.  And just to make matters that much more confusing, aren't they all really just branches of the substance over form doctrine?  

The preceding discussion highlights the overall complexity of this area of US tax law.  I will admit to treating the business purpose doctrine as one of the factors of the economic substance doctrine for a number of years, largely based on the BNA Tax Portfolio asserting this argument. However, I have come to the conclusion that business purpose is a separate doctrine for two reasons.   The first is the Frank Lyon Supreme Court Decision Frank Lyon Co. v. United States, 435 U.S. 561 (1978).  Any doctrine outlined in a Supreme Court case should rise of the level of black letter law, largely based of the precedential weight afforded the deciding body.  But just as importantly, this case provides a positive set of factors with which the practitioner must comply.  This is in sharp contrast to the vast majority of anti-avoidance cases which contain only negative suggestions: most cases essentially state don't do this, but offer no affirmative guidance. 

The facts in the case are straightforward.  Worthen bank in Arkansas wanted to build a new headquarters.  However, "[a]s a bank chartered under Arkansas law, Worthen legally could not pay more interest on any debentures it might issue than that then specified by Arkansas law. But the proposed obligations would not be marketable at that rate."  To avoid this problem, the bank structured a sale-leaseback transaction, selling the building and underlying property to the Frank Lyon company (Frank Lyon sat on the bank's board), who in turn leased the building back to the bank.  New York Life also provided financing.  The service determined that for tax purposes Lyon did not own the building, so the deductions claimed as a result of property ownership were not allowed.  While the lower court sided with Lyon, the appellate court ruled for the service.

Sale-leaseback transactions are hardly a revolutionary concept.  In fact, I believe one could argue they are part and parcel of corporate transactional practice -- a reality recognized by the court:

The present case, in contrast, involves three parties, Worthen, Lyon, and the finance agency. The usual simple two-party arrangement was legally unavailable to Worthen. Independent investors were interested in participating in the alternative available to Worthen, and Lyon itself (also independent from Worthen) won the privilege. Despite Frank Lyon's presence on Worthen's board of directors, the transaction, as it ultimately developed, was not a familial one arranged by Worthen, but one compelled by the realities of the restrictions imposed upon the bank. Had Lyon not appeared, another interested investor would have been selected.  The ultimate solution would have been essentially the same. Thus, the presence of the third party, in our view, significantly distinguishes this case from Lazarus and removes the latter as controlling authority (Lyon at 576-576).

By noting the taxpayer had a legitimate business reason to structure the transaction in this manner, the court outlined several factors that must be present in all business transactions to demonstrate business purpose:

1. there is a genuine multiple-party transaction 
2. with economic substance that is 
3. compelled or encouraged by business or regulatory realities, 
4. that is imbued with tax-independent considerations, and 
5. that is not shaped solely by tax-avoidance features to which meaningless labels are attached.  (Lyon at 583-584)

Now that we've outlined business purpose factors, the question logically turns to proving a transaction complies with them.  As I've previously noted, one commentator has correctly observed that business transactions fall into three categories: increasing revenue, lowering expenses, raising financing or some combination of the three (Peter C. Canellos, Business Purpose, Economic Substance and Corporate Tax Shelters, 54 SMU L. Rev. 47, 52-53, (2001)).  I would add that lowering a risk profile is also a valid business purpose.  This is one of the fundamental reasons corporations divide themselves into divisions and a primary motivator for incorporation in the first place.  Successfully showing that a transaction falls into one or more of these categories would demonstrate substance.  The process of making this determination requires the lawyer to look at the transaction at the company level, making an exhaustive inquiry one that is similar to those engaged in by courts implementing an economic substance doctrine investigation.  Only after the practitioner develops the facts of the case should he begin developing a transactional strategy that incorporates various elements of law such as business entities, tax, securities and insurance.

An Inquiry Into The Legitimacy Of Offshore Tax Planning; Substance Over Form and World Wide Taxation

When planning and constructing a transaction, merely complying with the technical provisions of the code is insufficient.  For example, the tax code allows a specific deduction for interest (26. U.S.C. 163).   But the debt used in a transaction claiming the deduction must comply with certain factors in order for the transactional instrument to be recognized at law.  All tax code sections contain this added layer of depth with which each element of the transaction must comply.  This is the lesson learned from the myriad tax shelters promoted by large accounting firms in the 1990s that followed the letter of the law to a "T" but had no corporate substance (see this Senate report (from the 108th Congress) on the US tax shelter industry).  

All of the transactions listed in this report (BOSS, son of BOSS, OPIS, BLIPs and many others) began with an extremely technical analysis of a particular code provision -- or even a much smaller sub-section of the code.  A structure was then built around this particular analysis and sold to clients.  The inherent problem with this methodology is it completely ignores the particular client's situation and moreover assumes a uniformity of structure and need between potential clients that does not exist.  The proper way to construct a transaction is the exact opposite: begin with an analysis of a client's overall situation and stated goals then develop a solution which complements that situation.  While it sounds cliche' (and perhaps a bit like a legal inside joke) the individual facts and circumstances of each circumstance really are unique and should be considered in their respective entirely to craft a unique solution to each situation.

When looking at the legislative intent (or substance) of the tax code, one fact stands out very clearly, rising to the stature black letter law: the US' tax code intends to tax US citizens on their world wide income.  This is derived from two sources, the first of which is a plain reading of 26 U.S.C. 61 which states, "gross income means all income from whatever source derived, including (but not limited to) the following items."  The accompanying Treasury Regulations use the exact same phrase: "Gross income means all income from whatever source derived, unless excluded by law."  And finally, Treasury Regulation 1.1-1(b) states, "In general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States."

Regarding foreign earned business income, earnings from various foreign corporations is included in the income of certain US shareholders under the controlled foreign corporation statute (sections 951-965 of the tax code).  These rules were added to the tax code in the early 1960s as a way to prevent the then growing practice of forming a corporation offshore and then transferring family wealth to the newly formed foreign corporation.  The assumption in this section of the code is that certain offshore structures are prima facie evidence of tax evasion.  Offshore partnership income is assumed to flow through to US taxpayers via general partnership law tax principles and the code sections listed in the previous paragraph clearly and indisputably apply to personally earned income.  Certain income from offshore trusts are also included in US taxpayer's income under specific grantor trust rules.  Finally, the US tax code uses a foreign tax credit system, offsetting US taxes with foreign taxes paid.    

The legislative intent could not be clearer: the code defines income in the broadest terms possible, and then specifically excludes various categories of income, all contained in Chapter 1, Subchapter B of the tax code.  The locus of the earning activity is not relevant; it is included unless specifically excluded.  Put more directly, the substance of the tax code when read in its entirely is that all income earned by US citizens is taxable by the US.  Moving offshore for the sole purpose of avoiding US taxation runs counter to legislative intent and the substance of the tax code when read holistically.  And complying with the technical requirements of code -- especially in small section level pieces -- is insufficient legal grounds for a transaction to be recognized at law.