Moline Properties and The Separate Nature of the Corporation

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.2 When the corporation sold the property three years later, the single shareholder attempted to claim the sale as individual income rather than corporate income.3 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.4

The broad range of reasons given by the court to justify incorporation is striking. The incorporator can be “seeking to take advantage under the law,” the most obvious of which is the corporation’s limited liability shield. In addition, he can be seeking to comply with creditor demands as in this case or do so merely for his “convenience.” Regardless of the actual reason, it’s possible to read practically any legally cognizable justification into the above cited sentence.

But just as importantly, ample reasons existed for the court to not recognize the separate nature of the company. The taxpayer in Moline Properties was less than diligent in maintaining the required corporate formalities as the corporation kept no books or records.5 These are factors often cited as reasons for piercing the corporate veil (see discussion below), which the court could arguably have done in this case. Also note the corporation was hardly a hot bed of corporate activity:
 

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. 6
 

While the corporation was a petitioner in a lawsuit, it did not pay for its own legal expenses. This factor in combination with the lack of corporate formalities would give most courts ample reason for veil piercing or, at minimum, non-recognition of the corporate form. Yet the court chose not to do so, instead ruling sufficient substance existed for the separate nature of the corporation.
 

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 citing approvingly by the U.S. Tax Court 30 times and 26 times by various IRS materials, including Chief Counsel Memorandum,7 General Counsel Memos,8 Private

2 Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 437 (1943)
3 Id
4 Id at 438-439

5 Id at 437-438
6 Id
7 IRS CCA 201123027, 2011 IRS CCA LEXIS 119 (I.R.S. 2011)
8 Gen. Couns. Mem. 35481 (1973)
Letter Rulings,9 and Field Service Advance Memos.10 While none of the IRS materials cited are binding, they amply demonstrate the IRS’ knowledge of this well-settled legal doctrine.

Court Denies Motion for Summary Judgement in Bancroft Case

The following is the court's ruling on the motion for summary judgement in one of the Bancroft cases.  It proves that courts indeed have a sense of humor:

The Court has amply telegraphed its belief that Bancroft’s “Premium Lite” “insurance” program is, at best, a scheme, and at worst, a scam. This Court has on multiple occasions [Dkt. Nos. 76, 94, 140] dealt with the factual underpinnings of Plaintiff’s Motion for Partial Summary Judgment [Dkt. #160]. No matter how the parties reformulate the questions, the answer is the same: “That’ll be DENIED.” The Court does not believe the parties. The Court does not believe the lawyers. This matter will be resolved once and for all in the crucibles of trial. Credibility issues alone prevent summary adjudication of core issues in this case.

UK Doubles the Amount of Tax Evasion Cases

From the Financial Times:

The number of criminal prosecutions for tax evasion more than doubled last year, as the government stepped up its crackdown on individuals suspected of defrauding the Exchequer. 

Tax evasion prosecutions rose from 302 in 2011-12 to 617 in 2012-13, according to figures obtained by Pinsent Masons, an international law firm. The increase reflects the Treasury’s pledge in 2010 to quintuple the number of tax prosecutions in an effort to create a more robust deterrent against evasion.

Practically all tax systems are based on self-reporting -- meaning that each taxpayer reports his level of income to the appropriate governmental authority.  This of course encourages the non-reporting of income along with various practices which makes income untraceable.  

The threat of prosecution keeps most taxpayers this side of to the compliance line.  However, a dearth of prosecutions encourages taxpayers to play "audit roulette" -- not complying with the law in the hopes they won't get caught.  In a low prosecution environment, this is actually a well-reasoned strategy (although as an attorney I would advise against it). 

The US recently went through a period of heightened audits for high net worth individuals as well.  I would expect more of the same over the next few years.

Is A New Round Of International Tax Regulation Coming?

Over the last few years, large corporation's tax bills have come into more and more public focus.  Both Google and Apple have been called in front of Congress to explain their low rate and the overall tax plan of both corporations has become public knowledge.  These revelations are occurring at a time when the global tax base is being eroded as companies are shifting more and more of their income and assets to low-tax countries.  As a result, the OECD has issued a report titled, "Action Plan on Base Erosion and Profit Shifting." 

Let's first look at a brief history of the OECD-tax haven conflict to provide historical perspective, starting with this question: why are the tax rates in tax havens so low?  There are two inter-related answers: they have a tiny geography and small population.  The Cayman Islands is a mere 264 square km in size with a population of 53,737.  Looking at these two inter-related factors from a governing perspective, there is little need for a massive infrastructure system or social safety net programs and hence, little to no need to tax.  The exact opposite is true for OECD countries, who have large land masses and large populations.

Compounding this difference between large, populous countries and small less populated island nations is that businesses which require far more paper-work than physical product are easily moved to tax havens.  The first and most obvious example of this is financial services, an industry dominated by ledgers and accounts, not physical products.  The digital age has exacerbated this phenomena as web pages replace physical storefronts, thus enabling transactions to occur in cyberspace which can be located on a computer server rather than a bricks and mortar locale.  We can also place non-physical assets such as intellectual property into corporations located in these offshore jurisdictions and establish an intra-company payment system where a company will pay its offshore subdivision for usage of the company's intellectual property.  As a result of all these developments, more and more actual economic activity can be moved to these low-tax jurisdictions, thereby eroding the tax base of larger countries.

The OECD started to target offshore activity in the late 1990s with the issuance of the report "Harmful Tax Competition: An Emerging Global Issue."  In effect, the report argued the combination of banking secrecy and low taxes was eroding the OECD's tax base, leading the group to begin a lobbying campaign with these jurisdictions to both lift the secrecy veil and raise their taxes.  Little happened on this front until 9/11, which added further strength to the OECDs anti-secrecy arguments.  Now, more and more offshore jurisdiction are signing "mutual assistance" treaties which allow coordination of tax prosecutions with treaty signatories in certain situations.  From a macro perspective, these developments are leading to a slow end to the age of banking secrecy, which will probably disappear for the most part by the end of my lifetime.  

However, the issue of offshore tax arbitrage is still alive and well, hence the talk of a new global crackdown:

Finance ministers from the Group of 20 leading nations plan to launch a new phase of the international crackdown on corporate tax avoidance this week even as UK business leaders are warning their government to resist “radical new solutions” to profit shifting by multinationals.

Britain has taken a lead in pressing for reform of the international tax rules after a wave of public anger over the low tax bills paid by some large multinationals. An action plan on tackling base erosion and profit shifting is due to be presented to the G20 by the Paris-based Organisation for Economic Co-operation and Development on Friday.

We have no idea where this will end -- or if it will get anywhere in the first place.  However, I do think with the heightened spotlight on low multi-national  tax bills and increasing number of cross-border tax arrangements, this might have legs.

     

What Does a Tax Scam Look Like?

Planners have offered questionable ways to "minimize" tax since the implementation of the tax code.  Attesting to this are the first assignment of income cases which tested the validity and strength of the grantor trust rules when first established (see code sections 671-679).  In fact, a thorough reading of anti-avoidance case law shows there were several important periods in tax scams: the 1950s brought attempts to create phantom "interest" deductions, the 1970s and early 1980s brought limited partnership plans and the 1990s saw the creation of an entire industry encompassing the accounting, legal and financial professional industry.  

But while the long history of this industry could lead to the impression there is a vast difference regarding these plans, there is in fact a remarkable amount of similarity to the way they were structured.  What follows are some of the more common elements.

A hyper-technical reading of the tax code: this is probably one of the most common traits of tax shelters across the time periods listed above.  While the ability to comprehend particular sections of the tax code is obviously a prime requirement for a tax attorney, that knowledge has to be placed in the context of the legislative intent of the code in general.  For example, a common tax shelter in the 1990s involved the contingent liability section of the tax code, which would shift the gains of a transaction to a tax neutral participant (a party for whom income was immaterial) while it shifted the losses to a party that was trying to offset capital gains (usually a US taxpayer).  While these transactions complied with the technical aspects of the contingent liability section of the code, they had no substance, meaning there was no meaningful business purpose for the transaction, save sheltering taxable income.

Ground up tax planning: Most legitimate tax planning starts with a company approaching their attorney with one of four basic needs: the need to increase income (such as expanding into a new market), the need to lower expenses (combining subsidiaries; lowering taxes alone is not a legitimate reason), the need to raise capital or the need to lower risk.  But all four of these transactions starts at a high level and are motivated by a legitimate business need.  In contrast, most tax shelters are transactions in search of a client -- that is, a tax promoter will develop a transaction (usually involving a hyper-technical reading of the tax code) and then sell it to a client, one who is usually looking to offset income or capital gain.  When a transaction starts at a low level it has a difficult time establishing business purpose.  For a further explanation of this issue, see the Senate's Report on tax shelters.

Multiple, pre-planned steps: most transactions are actually very simple: company X buys company Y; company X forms an accounts receivable sub-division; company X divests itself of a subsidiary; company X issues stock, etc...   In contrast, most tax shelters use multiple, pre-planned steps to arrive at a particular destination.  For example, company X and company Y form an offshore partnership.  After 30 days, they purchase short-term notes.  After 35 days, they sell notes to received a contingent liability note.  After 12 months, company Y leaves the partnership ... you get the idea.  Pre-planned steps are a big warning sign that something is probably amiss.

Offshore: first of all, about 30% of my practice involves international tax planning, so I'm obviously not against the practice.  However, tax shelter promoters typically use an offshore jurisdiction for one reason: secrecy, a trait shared by many offshore jurisdictions (although this practice is changing).  This has obvious benefits if the participants are attempting to lower their tax burden in a questionable manner. 

Business Entities with a short life span: how long should a business enterprise exist?  Ideally in perpetuity -- which is one of the primary advantages of the corporate form.  And while businesses do go bankrupt or are sold, thereby ending their corporate life, most business owners want their business to exists for as long as possible as this indicates the company is a viable, ongoing concern.  In contrast, short duration corporations or partnerships are common in tax shelters, some of which contain entities with a life span of no more than 18 months.  While some could argue that joint ventures are an exception to the rule, most of these short-term combinations still have expected corporate an life expectancy of multiple years.

The above points cover most of the basic problems seen in tax shelters.  If you can think of others, please post them in the comments section.

  

How Reality Severely Limits My Vast Legal Super-Powers

The highly skilled lawyer who saves the protagonist from certain impending legal doom is one of the most iconic images in popular media.  Perry Mason of course stands out as one of the first characters that fit this bill, although others such as the cast of LA Law (a college favorite), The Practice and Law and Order stand out as well.  Real life examples include Clarence Darrow (who was portrayed wonderfully by Spencer Tracey in Inherit the Wind) and Johnny Cochran ("If the glove does not fit, you must acquit!").  These real and fictional individuals have given the public the impression that lawyers are super men who can always overcome disadvantageous odds to secure victory.

Sadly, realty often intrudes into real life expectations.  For while I would love to tell clients that I am one of these supermen of yore, I am in fact greatly hampered by three elements: the facts and circumstances of a particular case, the law as it is (not as we want it to be) and the legal code of ethics.  Let me explain each of these in more detail.

Hypothetically, suppose I'm a defense attorney, called in to defend an accused murderer.   On the other side of the court sits the prosecution who has four witnesses, all of whom are nuns with 20/20 vision and perfect recall memory, none of whom were more than 10 feet from the incident when it occurred.  Three video tapes of the crime also exist (all of which can be substantiated at trial), all with a good angle to witness the event.  While the TV or movie lawyer would be able to overcome these facts, the real attorney would merely be trying to keep his client out of the execution chamber (assuming the state had the death penalty).  Although these facts are deliberately extreme, they illustrate a key point: we are always limited by the facts and circumstances of the case we are given.  On a far more mundane (and far more realistic) note, consider a potential client who wants to form a captive insurance company, but who is also in the middle of a lawsuit.  Under the Uniform Fraudulent Transfer Act, I can't do anything because this transaction could easily be construed as an attempt to "hinder, delay or defraud" a potential creditor.  As these illustrations highlight, the facts and circumstances of a particular fact pattern can severely limit my legal options.

The law as it exists (not how we theoretically want it to be) is another element that can provide a fair amount of constraint for legal representation.  Suppose a client wants to transfer money to an offshore jurisdiction that has very tight secrecy laws with the intent of not paying US income taxes.  The clients states this is his goal.  At this point, I have to advise him that 1.) going offshore to hide money is illegal, 2.) he will have to file an informational return to comply with US law, regardless of what he wants to do, and 3.) as the US has a world wide taxation regime, he'll have to pay taxes on his offshore funds.  The preceding three statements highlight the law as it is, so, as an attorney, I would have to tell the client that his motivation runs afoul of the law.  It also means I probably won't be representing this client.

As a first corollary to the preceding point, it's also important to note that I can't fix your behavior after it occurs so that it complies with the law.  Like most people, potential clients regularly "shoot first and ask questions later."  And while I don't expect to be consulted on mundane issues, being aware of a bigger decision before it's made to discuss its legal ramifications helps to prevent bigger problems from developing.  Regrettably, attorneys are usually the last people consulted on decisions.

Finally, there is the legal code of ethics, with the biggest prohibition I face as an attorney:

(a) A lawyer shall not knowingly:

(1) make a false statement of fact or law to a tribunal or fail to correct a false statement of material fact or law previously made to the tribunal by the lawyer;

.....

(3) offer evidence that the lawyer knows to be false. If a lawyer, the lawyer’s client, or a witness called by the lawyer, has offered material evidence and the lawyer comes to know of its falsity, the lawyer shall take reasonable remedial measures, including, if necessary, disclosure to the tribunal. A lawyer may refuse to offer evidence, other than the testimony of a defendant in a criminal matter, that the lawyer reasonably believes is false.

I realize it may sound like a joke that an attorney can't lie, nor can he coach others to lie.  But there it is, plain as day in the model code of conduct.  And it's something that I and other lawyers whom I know take very seriously.  There is also new formal guidance for attorneys regarding representation and its relationship to money laundering -- rules which are very similar to the "know your client" rules.

So, what exactly can I do?  Within the confines of the above stated concepts, a great deal.  First, I can develop and implement a strategy that is compliant with the law as it exists.  Unlike the impression given by such services as Legal Zoom, the law is not merely a series of interlocking forms; each element of a form has legal ramifications and is derived from a substantive area of law that must be understood.  Second, I can keep this plan compliant with the law at it develops.  Remember, the law is always changing, sometimes in substantive ways.   Third, I can keep you out of trouble so long as you consult me on big decisions.     

So, the above three points are really my vast legal super powers as they exist in the real world.  

 

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.