My wife has spent her COVID time organizing efforts to celebrate Earth Day next April in our fair city of Lubbock, Texas. Her efforts are paying off. She and her colleagues are now to the point where they need to operate through a tax-exempt entity. Well-meaning friends tell her “oh, it’s easy, just go fill out some forms and submit them to the IRS.” Those friends think that forming a nonprofit entity is a one-step process, done at the federal level. They do not realize that it is a two-step process: one must first form the entity under state law and then ask for tax-exemption from the IRS. Today we learn that the choice of entity formation will affect the federal tax treatment of that entity.
In Clinton Deckard v. Commissioner, 155 T.C. No. 8 (Sept. 17, 2020) (Judge Thornton), the effect of state law was to preclude the taxpayer from electing S Corporation status. There Mr. Deckard formed a nonprofit corporation under Kentucky law but soon started operating it for profit. After a couple of years of losses, he tried to elect S Corporation status for the entity so he could pass through and deduct those losses. Judge Thornton held he was bound to the corporate form he had created under Kentucky law. State law matters. Details below the fold.
Law: Profit v. Nonprofit Corporations
A corporation is a legal fiction created to enable collective action. While some corporations are charted under federal law, most are created under state law via general incorporation statutes.
The collective action does not have to be pursuit of profit. The idea of corporations has never been limited to the idea of aggregation of capital simply for the purpose of producing profits for identified shareholders. Famous early corporations such as the Virginia Company were organized to accomplish both public purposes (settlement) and private purposes (enriching the settlors). When the collective action to be pursued under the corporate form is a purpose other than profit, we call such corporations by the sensible appellation “nonprofits.”
States allow their nonprofit corporations exemptions from a variety of state and local taxes and, in some cases, from state regulations that would be applicable to a for-profit corporation engaged in the same activity. Some states condition their state tax exemptions on the nonprofit obtaining a certain category of tax exemption under federal law. Thus, the two-step process becomes a three-step process: form the state entity, obtain federal tax exemption status, then use the federal exemption to obtain the state tax benefits.
The benefits of operating as nonprofit---especially the state and federal tax benefits---create an understandable incentive to disguise for-profit activity in a nonprofit form.
Currently, state general incorporation laws---many following the provisions of the Model Nonproft Corporation Act--- contain two important guard rails to prevent the nonprofit form from disguising the for-profit substance of an entity’s activity.
First, nonprofits may not have a category of ownership that creates rights to participate in profits. They might have members (or not: they might operate with just directors). But members are not “shareholders” or “stockholders.” Unlike the sale of stock, acquiring membership in a nonprofit does not promise something of value in return for the membership even if the membership requires monetary or other contribution. For example, Kentucky (the state at issue here) explicitly prohibits nonprofits from issuing shares of stock. Ky. Rev. Stat. Ann. §273.237.
A second important constraint on nonprofits under state law is the prohibition on distributions of income, profits, or assets to members or officers or directors, even on dissolution of the entity. In Kentucky, for example, no part of a nonprofit’s income may go to its members, directors, or officers. Ky. Rev. Stat. Anno. §273.161. Of course, nonprofits can pay reasonable salaries. The prohibition is against distribution of profit. Some states are stricter about this than others. Some states allow distribution of entity assets to members if the entity is dissolving. Other states, such as Kentucky, do not even allow that. They require all assets be distributed either back to the donors or to other nonprofits engaged in similar collective action as the dissolving entity. See Ky. Rev. Stat. Anno. §273.303.
Law: Federal Taxation of Corporations
I don’t know much about corporate taxation. I don’t teach it. What I don’t know would fill your hard drive. What I do know would fill a 5.25 floppy disk from my first computer in 1986. Fortunately, that’s all one really needs to know for today’s lesson. Section 11(a) imposes a tax on the taxable income “of every corporation.” And while the definition of corporation in §7701(a) and associated regulations is surprisingly capacious, §11 does not sweep as widely as the phrase “every corporation” implies. First, §501(a) totally exempts from taxation any nonprofit corporation as described in §501(b) or in it’s more famous sibling §501(c). Second, §1363 provides that “an S corporation shall not be subject to the taxes imposed by this chapter.” S corporations are simply those for-profit corporations who properly elect to be treated as an S corporation. See §1361, 1362. The myriad rules surrounding S corporation elections are not important for today’s lesson. But since an S corporation is exempted from taxation, that means it passes its profits through to its shareholders, who then pay tax on the profits. S Corporations also pass through losses and shareholders may get to deduct those losses from their other sources of income.
Per what appears to be his LinkedIn profile, Mr. Deckard runs a construction company in Louisville, Ky. It does business in waterfront development among other types of projects.
In February 2012, Mr. Deckard started promoting a high-fashion event in the fall to support the Waterfront Development Corporation (WDC), a well-established nonprofit that since 1986 has overseen the renovation of Louisville’s abandoned industrial riverfront. According to this local newspaper story, Mr. Deckard envisioned starting a tradition of yearly Fashion shows with the profits from the show going to support the WDC.
In May 2012, after consulting with an attorney, one D. Kevin Ryan, Mr. Deckard formed Waterfront Fashion Week, Inc. (WFWI) as a nonprofit non-stock corporation under Kentucky state law to run the Fashion Week event and raise money for the WDC. It was not a membership organization but was instead operated solely by a 3-person board of directors, one of whom was Mr. Deckard. The plan was to get federal tax-exemption. It appears Mr. Deckard was advised he needed to operate in this way in order to get businesses to sponsor events or tents or particular shows during Fashion Week. It appears no one told Mr. Deckard about §162.
Problems ensued. Mistakes were made. In Tax Court Mr. Deckard testified that he soon had to take “complete control” of operations and that he put up some $275,000 of his own money. He testified that he abandoned plans to acquire federal tax exemption status and started to in fact run WFWI with a view to making a profit. For purposes of deciding the cross-motions for summary judgment Judge Thornton accepted this testimony as true.
Under Mr. Deckard’s leadership, WFWI did produce a well-received Fashion Week event in October 2012. Here’s a laudatory magazine story on it. But the event was a financial failure. Mr. Deckard got burned and apparently the dream died. WFWI organized no more Fashion Weeks, it failed to file required state reports in either 2013 or 2014 and was dissolved by the Kentucky Secretary of State in 2014.
In late 2014 Mr. Deckard caused WFWI to elect into S Corporation status for 2102 and 2013. He then had it file corporate tax returns showing a net operating loss of $278,000 in 2012 and $3,000 in 2013. He then claimed those as pass-through losses on his untimely filed 2012 and 2013 returns.
On audit, the IRS denied the deductions because, it said, neither WFWI nor Mr. Deckard were eligible to elect S corporation status. Mr. Deckard petitioned the Tax Court.
Lesson: State Law Controls The Form
Mr. Deckard raised two arguments to Judge Thornton on why the IRS was wrong to disallow the S Corporation election. First, he argued that he was the equivalent of a sole shareholder of WFWI and, per applicable regulations and case law “would have been deemed a beneficial owner of shares in the corporation, entitled therefore to demand from the nominal owner the dividends or any other distributions of earnings on those shares.”
Mr. Deckard lost this argument because...state law matters. First, Judge Thornton finds that Mr. Deckard owned no stock or shares because “as a Kentucky nonstock, nonprofit corporation subject to the provision of the Act, [WFWI] had no stock and could issue no stock. Consequently, petitioner does not fall within the four corners of the regulation.” Op. at 17 (emphasis supplied). Second, Judge Thornton points that Mr. Deckard was an officer and director of WFWI and Kentucky law explicitly forbids “any part of [WFWI’s] income or profit from being distribution to him or inuring to his benefit.” Op. at 18.
Mr. Deckard’s second argument was a substance over form argument. He asked Judge Thornton to disregard these annoying “formalities of corporate law” and treat WFWI as a for-profit entity...so he could deduct the losses he incurred! He pointed out that he never applied for federal tax exempt status and claimed he should be treated just like entities that lose their tax exempt status because they are found to be for-profit entities.
Once again, Judge Thornton rejects Mr. Deckard’s argument because...state law matters:
“Petitioner’s argument confuses Federal tax-exempt status with status as a nonprofit corporation under State law. ....at all relevant times [WFWI] was subject to the provisions of [Kentucky law]. The decision not to seek Federal tax-exempt status...has no bearing on its status as a nonprofit corporation under [Kentucky law] or on the ownership constraints imposed thereunder.”
Mr. Deckard had been free to chose any form in which to conduct the Waterfront Fashion Week and he chose to form a nonprofit corporation. Judge Thornton points out just because he did so under a mistaken assumption that he needed tax-exempt status to convince businesses to sponsor the event did not matter. Mr. Deckard, like all taxpayers, was “free to organize his affairs as he chooses” but “once having done so, he must accept the tax consequences of his choice, whether contemplated or not.” Op. at 21 (internal quotes and cites omitted).
The form under which one chooses to do business is controlled by state law. While federal law tells you the tax consequences of the form you choose---be it tax-exempt, or pass-through, or otherwise---you must first form the form! And the source of law governing that form is a critical part of the federal tax analysis.
Coda 1: What would you have done? I would be curious how readers might have advised Mr. Deckard differently on how to try and recoup the money he put into WFWI. Should he have lent the $275k to WFWI? Could WFWI generate NOLs? If so, would there be a way to effectively sell them, through a Chapter 11 bankruptcy or otherwise? I welcome any thoughts. Poor Mr. Deckard apparently received what now is evidently dubious tax advice. But I do not know what he might have done differently.
Code 2: A corporation is a legal fiction. As with most works of fiction, disagreements arise in interpretation. And that can affect the tax analysis. For two nice articles that will get you to thinking about this, see Philip T. Hackney, “What We Talk About When We Talk About Tax Exemption,” 33 Va. Tax Rev. 115, 121 (2013)(exploring what justifies tax exemption for nonprofit corporations and linking that to theories of the corporation); and see Reuven S. Avi-Yonah, Corporations, Society, and the State: A Defense of the Corporate Tax, 90 Va. L. Rev. 1193 (2004).
Coda 3: The concept of nonprofit entity is also in flux. The ABA Business Section has an ongoing project to revise its Model Nonprofit Corporation Act. Here is an illuminating PowerPoint presentation I found from William H. Clark Jr., who is the Reporter for the Revised Model Nonprofit Corporation Act.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return to TaxProfBlog each Monday for a new Lesson From the Tax Court.