Many small business owners set up their operations as corporations to shield themselves from being held liable for their business’s debts. However, sometimes these business structures give their owners a false sense of security and they fail to take the steps necessary to keep their business’s finances separate from their own. When these businesses get into trouble with their taxes, the IRS can employ the “alter ego” doctrine to collect from the owners of an otherwise valid corporation.
While corporations are often set up to keep the business separate from its ownership, the IRS and other creditors can apply the alter ego doctrine to treat all the owner’s assets as those of the business. The alter ego doctrine is premised on the theory that the financial affairs of the business and its owner are so intermixed that they should no longer be treated as separate entities.
When the IRS uses the alter ego doctrine to collect debts from the owners of corporations, this is often referred to as “piercing the corporate veil.” There are also times when the IRS may seek to establish that a corporation or limited liability company (LLC) is the alter ego of an individual taxpayer who owns part or all of the business if it believes assets have been transferred to the business to avoid the owner’s tax debts.
IRM lays out factors used in applying alter ego doctrine
The IRS usually follows procedures laid out in the Internal Revenue Manual (IRM) when using the alter ego doctrine. According to the IRM, no single factor is controlling, but in most cases one or more of the following are used to make an alter ego determination:
- Comingling of business and personal finances and the use of company funds to pay personal expenses
- Unsecured, interest-free loans between the business and its owner
- The taxpayer is a shareholder, director, or officer of the corporation or otherwise exerts substantial control over its operations
- The business entity is undercapitalized relative to its reasonable anticipated risks
- Failing to follow the formalities required for operating a business as a corporation
- Continuing to treat the business as a corporation results in injustice or “fundamental unfairness”
The IRM explains that the alter ego question should be resolved by applying the federal common law rather than state law as explained in Chief Counsel Notice CC-2012-002. However, most federal courts address alter ego issues by either applying state law or both federal and state law.
Federal court decisions uphold IRS use of alter ego doctrine
A recent decision from the U.S. Court of Appeals for the Fifth Circuit shows how the federal courts will apply state law when taxpayers challenge the IRS’s efforts to use the alter ego doctrine to find them personally liable for their company’s unpaid tax obligations. The Fifth Circuit’s decision in United States v. Lothringer, No 20-50823 (5th Cir. Oct. 8, 2021), addressed Arthur Dale Lothringer’s claim that he was not personally liable for the $1.8 million of unpaid taxes owed by his used car business as its alter ego.
The appeals court upheld the Texas federal district court’s finding that it should use Texas law to determine whether Lothringer should be treated as separate from his corporation, Pick-Ups, Inc. The facts the district court relied on in concluding that the IRS correctly applied the alter ego doctrine included:
- Lothringer was the sole shareholder, officer, director and owner of Pick-Ups
- Lothringer exercised complete control over the business
- Pick-Ups failed to observe certain corporate formalities
- Lothringer loaned substantial amounts of money to the business
- The Pick-Ups corporate bank account was used to pay personal loans
A March decision by the U.S. District Court for the District of Arizona provides another good example. The court’s decision on TBS Properties LLC v. U.S., CV-20-00195-PHX-DWL (D. Ariz. Mar. 15, 2022), found that regardless of whether state or federal law is applied, the IRS needed to establish two elements for a finding of alter ego liability:
- The owner had unity of control over the company
- Recognizing the corporation as an independent entity would sanction fraud or promote injustice
The court found that the IRS had proven both elements in the case.
Information included in this article is accurate as of the publish date. This post is not reflective of tax law changes or IRS guidance that may have occurred after the date of publishing. All taxpayer circumstances are different, and NATP recommends contacting research services if you have specific questions about your clients’ tax situations.