Lesson From The Tax Court: Honor The Corporate Fiction

A corporation has no soul to be damned and no body to be kicked.  So supposedly said Baron Thurlow long, long ago.  It is but a  legal fiction.  It’s not the Borg (which is science fiction, not legal fiction).

The fictional nature of corporations creates all kinds of gnarly problems in criminal law, in constitutional law and, as we learn today, in tax law.  When I was in practice my clients often confused their personal selves with the closely held corporate doppelganger I created for them.  They repeatedly ignored the corporate fiction.  They were the kings of their empires and, like Louis XIV, they felt they were the corporation and the corporation was them.  I am sure many readers can relate to that!

In John E. Vorreyer and Melissa D. Vorreyer, et al. v. Commissioner, T.C. Memo. 2022-97 (Sept. 21, 2022) (Judge Greaves) two of the “et al” taxpayers ignored the corporate fiction to their detriment: they paid debts of their S Corporation from their personal funds and attempted to deduct those payments on their personal income tax returns as a §162 deduction. While the payments were in fact ordinary and necessary expenses for the carrying on a farm business, the corporate fiction prevented the taxpayers from taking the deduction on their individual returns.  It was not their farm business.  It was their corporation's.  Details below the fold. 

Law: The Corporate Fiction
Corporations are legal entities created by state law.  There are a variety of ways to think about them.  For those who want to start swimming in those waters, a great place to dive in is William Bratton’s fine article The New Economic Theory Of The Firm: Critical Perspectives From History, 41 Stan. L. Rev. 1417 (1989).  For today’s lesson, however, readers just need to understand three points.

First, the strength of the legal fiction that corporations exist separately from their shareholders has waxed and waned over time.  For example, in Dodge v. Woolsey, 59 U.S. 331 (1855) (the date of the case given in Justia is incorrect), the Supreme Court permitted a shareholder of a bank to assert an equitable claim that a state tax levied on the corporate bank was illegal.  In doing so, the Court disregarded the legal fiction in favor of viewing the corporation as a collective of shareholders, thus deeming any alleged wrong done to the corporation as a wrong done to the shareholders personally.

By 1903, however, the Court had abandoned that position and decided to enforce the corporate fiction strongly.  Shareholders could only bring such “derivative” suits when the suit was “founded on a right of action existing in the corporation itself, and in which the corporation itself is the appropriate plaintiff.” Corbus v. Alaska Treadwell Gold Mining Co., 187 U.S. 455, 461 (1903) (emphasis supplied).  There the Court insisted that shareholders must solve their problems within the structure of the corporation, even though the Court admitted “it is not a trifling thing for a stockholder to coerce the directors...to an act which their judgment does not approve.”  Id. at 463.

This change in legal doctrine mirrored the changes in the U.S. economy and reflected the changes in how corporations were formed.  In the early days—say the start of the 19th century—corporations were only created by special legislative action after a group of individuals begged the legislature to grant the group certain collective (and quasi governmental) powers to help achieve a particular object.  That might be trading (East India Company) or settlement (Massachusetts Bay Company) or education (e.g. Trustees of Dartmouth Collect v. Woodward, 17 U.S. 518 (1819).  So under that model, it was easier to see through the legal fiction to see the set of relationships.

But by the end of the 19^th century, almost all states had enacted general incorporation laws and anyone who could pay the filing fee could get a state charter.  See generally, David McBride, General Corporation Laws: History and Economics, 74 Law & Contemp. Probs. 1 (2011).  The massive increase in corporations—and corresponding increase in shareholders—threatened to clog the courts with derivative suits.  Thus the shift in legal doctrine enforcing the fiction of a corporation as a separate legal actor.

The current strength of the legal fiction can be seen in free speech cases where corporations, while having no body to kick or soul to damn, are deemed to have mouths to speak.  See e.g. Citizens United v. Federal Election Com'n, 558 U.S. 310, (2010) (finding statute unconstitutional because it “does not allow corporations to speak.”); First National Bank of Boston v. Belotti, 435 U.S. 765, 777 (1978) (Political speech is “indispensable to decisionmaking in a democracy, and this is no less true because the speech comes from a corporation.”).  The fiction has become strong indeed.

Second, the strength of the corporate fiction in non-tax law carries into tax law as well. Moline Properties v. Commissioner, 319 U.S. 436, 438 (1943).  There, the taxpayer was a corporation that owned certain real estate it sold for a gain.  It was totally owned by an individual who had created it solely to hold those properties as security for loans he obtained.  The corporation had no business, no bank account, kept no books and records.  It was not a sham or alter ego.  It just that it's only job was to hold title.  It disputed its obligation to pay taxes on the gain because it had been formed solely for the purpose of holding the property.  Despite that, the Supreme Court agreed with the IRS that the corporation was a separate taxable entity and thus it, and not the individual sole shareholder, should be taxed on the gains.  The fiction held.

The fiction works the same way for items of deduction.  For example, in Deputy v. du Pont, 308 U.S. 488 (1940) the taxpayer attempted to deduct under §162 the carrying costs he incurred in buying, holding, then selling certain publicly traded stock. He had bought the stock and then sold it to the corporation (of which he was a 16% shareholder) so that the corporation could distribute the stock to nine newly appointed members of the company's executive committee, to give them a stake in the corporation.  The Supreme Court held that the carrying costs were not deductible, reasoning in part that “they proximately result[ed] not from the taxpayer's business but from the business of the du Pont Company.” Id. at 494.  The shareholder was not the corporation.  The fiction held.

The Tax Court has consistently followed the fiction.  Thus in Rink v. Commissioner, 51 T.C. 746 (1969), the taxpayer paid the property taxes of his closely held corporation.  He tried to deduct those taxes on his personal returns.  He asked the Tax Court to disregard the corporate entity because he owned almost all of the outstanding stock of the corporation (he was the 95% shareholder), and because the corporation had gone “dormant” in the years he paid the property taxes.  The Tax Court said nope, citing to both Moline and Du Pont.  It held that “a shareholder, even a majority or sole shareholder, is not entitled to a deduction from his personal income for his payment of the expenses of his corporation....”  Id. at 751.

Third, the legal fiction does not depend on how a corporation is taxed.  Put another way, the fiction is just as strong for an S corporation as for a C corporation.  It is true that in Rink, the Tax Court was not so sure.  There the corporation was a C corporation and Judge Simpson wrote that it “therefore may not avail himself of any benefit which section 1374 might otherwise offer.”  But when confronted squarely with the question, the Tax Court held there was no difference: a corporation was a corporation was a corporation.  Russell v. Commissioner, T.C. Memo. 1989-207.  There the Court emphasized that the corporation “remains a separate taxable entity regardless of whether it is a subchapter S corporation or a subchapter C corporation.”  The fiction held.

Other courts agree with the Tax Court.  In Morowitz v. U.S. Gov't, 2019-1 USTC ¶50,167 (D. R.I. 2019), a lawyer incorporated his practice under state law and elected for it to be taxed as an S Corp.  During the tax year at issue he personally paid bonus compensation to some of his employees.  He then tried to deduct that on his personal Form 1040.  The IRS disallowed the deductions.  In the eventual refund suit Mr. Morowitz argued that he had meant to actually practice law separate and apart from his S Corp. although he had not taken formal steps to dissolve the corporation...or change the bank account where he deposited retainers...or change the representation agreements he signed with clients.  In rejecting this refund claim, the district Court wrote “While a taxpayer is free to organize her business as she chooses, once having done so, she must accept the tax consequences of her choice, whether contemplated or not, and may not enjoy the benefit of some other route she might have chosen to follow but did not.” Id. at 4.

Let’s see how this all plays out in today’s case.

Facts
This case was a consolidation of eight petitions, all involving farming operations in Illinois run by eight individuals.  The lesson for today involved taxpayers named Chris Dowson and John Dowson, who together operated their farm through their corporation called, naturally enough, Chris & John Farms, Inc. (“C&J Farms”).  They were apparently the only shareholders. The Corporation elected to be taxed as an S Corp.

During 2012, the year at issue, C&J Farms owned property in Sangamon County, Illinois.  That year the Corporation owed some $109,000 in property taxes to the County.  Chris and John paid the $109k in taxes from personal funds.  C&J Farms also owed its utility company almost $21,000.  Chris and John paid that, too.  On its 2012 tax return C&J Farms did not claim a deduction for those expenses.  On their 2012 individual tax returns both Chris and John did claim a deduction.  The IRS caught that as a very small part of a much larger series of errors that lead to an almost $14 million NOD involving all eight individuals and their various corporate entities.  Today's lesson involves only this one small issue.  Perhaps future opinions on other aspects of this case will give us more lessons to learn.  Or maybe just more variations on today's lesson.

Lesson: Honor The Fiction
The fact is that the expenses paid for by Chris and John Dowson were ordinary and necessary expenses in the carrying on the business of farming.  The problem was that these taxpayers forgot to honor the fiction that it was a corporation—with no body to kick or soul to damn—that was doing the farming.  Not them.  In holding that the taxpayers were not entitled to a §162 deduction Judge Greaves emphasizes the strength of the corporate legal fiction.  He writes:

“Although an S corporation’s income or loss eventually flows through to the shareholders, a corporation remains a separate taxable entity from its shareholders regardless of whether it is a subchapter S corporation or a subchapter C corporation.  *** Consequently, the income reaped by an S corporation must be matched at the corporate level against the S corporation’s expenses that were incurred to produce that income before the net income or loss amount can flow through to the shareholders.” Op. at 5. (quotes, citations, omitted; emphasis supplied).

Judge Greaves explains that sometimes a corporation may deduct an expense actually paid for by a shareholder under circumstances where the shareholder’s payment can be deemed a capital contribution to the corporation.  See Ferguson v. Commissioner, T.C. Memo. 2019-40.  That might have worked here if C&J Farms had deducted these expenses.  But it did not.

And sometimes an individual shareholder can deduct a corporate expense paid for by the shareholder.  But that happens only under the rare circumstances when (1) the corporation was unable to make the payment and (2) the expenses paid were also ordinary and necessary to the business of the shareholder.  See, e.g., Lohrke v. Commissioner, 48 T.C. 679 (1967).  That is uncommon.  See, e.g., West Covina Motors, Inc. v.  Commissioner, T.C. Memo. 2008-237 (calling Lohrke the “rare” case).

Fundamentally, the fiction is strong.  A corporation is a separate entity from its shareholders.  It’s business is not shareholders’ business.  So it will usually be impossible to meet that second prong of Lohrke.  In a related context, the Supreme Court has explained that putting in “time and energies to the affairs of a corporation is not of itself, and without more, a trade or business of the person so engaged.” Whipple v. Commissioner, 373 U.S. 193, 202 (1963).  In Whipple, the taxpayer had claimed a business bad debt deduction for an un-repaid loan to his corporation.  The Supreme Court rejected the argument that an investor was in the same trade or business of the entity he invested in.  According to the Court, “[a]bsent substantial additional evidence, furnishing management and other services to corporations for a reward not different from that flowing to an investor in those corporations is not a trade or business.” Id. at 203.  In other words, the trade or business of an S Corporation is not the trade or business of its owners.

Honor the fiction. 

Bryan Camp is in fact the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return every Monday (or Tuesday when Monday is a federal holiday) for another Lesson From The Tax Court.