Where Did I Leave That Asset?
Tell me this hasn’t happened to you. Individuals come together to start a business. One or more of them own an asset (for example, real estate) that is to be used in the business and that they intend to transfer to a newly-formed business entity as a capital contribution, in exchange for which they will receive an equity interest in the business. However, the formal transfer of the asset is never effectuated – the asset remains titled in their individual names – but the business owners never realize it.
The business entity employs the asset in its operations. It reports the income generated from the asset. It reports depreciation deductions with respect to the asset. It pays and claims deductions for other asset-related expenses. In the case of an S corporation, or an LLC treated as a partnership for tax purposes, the Forms K-1 issued to the business owners reflect the tax items attributable to the asset. The entity holds itself out to the public – for example, customers, tenants, parties to other contracts, insurance companies, banks, etc. – as the owner of the asset.
Years later, perhaps when the business is being audited by the IRS, or when the business is being sold, the owners realize that the business does not “own” the asset. At that point, one or more of them may take the-then self-serving position that the business does not own the asset for tax purposes.
The U.S. Tax Court recently addressed such a situation; specifically, it considered to whom the net losses from a cattle ranching operation were attributable: to a corporation owned by the Taxpayers, or to the Taxpayers themselves.
Home on the Range
Before the years in issue, the Taxpayers’ father transferred all of the cattle from his own cattle operation to the Taxpayers for use in their commercial cattle business.
The Taxpayers formed Corp. to operate their cattle business and, for the years in issue, the cattle operation had several employees that were paid by Corp., which also filed employment tax returns with respect to these employees and issued Forms W-2 to them.
Corp. held a workers’ compensation and employer’s liability insurance policy in its name with respect to the cattle operation employees. It purchased and held farm and ranch insurance in its name. It purchased vehicles and machinery in its name.
Corp. also bought and sold cattle for the cattle operation. These sales and purchases were made at livestock auctions and other public venues, and Corp. appeared as the recorded buyer or the recorded seller.
The cattle operation leased the land on which its ranches were situated. Corp. issued Forms 1099-MISC to the land owners with respect to its lease payments.
Corp. paid expenses of the cattle operation from its own account. Sometimes, Corp. paid personal expenses of the Taxpayers, which were invoiced to them, and then booked by Corp. as a receivable from the Taxpayers. The Taxpayers paid the amounts due shown on each of these invoices, and those funds were deposited in a bank account in Corp.’s name.
Receipts for sales of cattle sold by Corp. were deposited into Corp.’s account. When these sales deposits were entered, half of the revenue was booked directly into the general ledger of each of the Taxpayers, and a payable was created on Corp.’s books. All income from the sale of cattle was split equally between the Taxpayers. If total income exceeded expenses in a month, accountants prepared: (1) vouchers showing each of the Taxpayers as a vendor, (2) invoices for the Taxpayers reflecting a credit of the excess to them, and (3) corresponding account payable invoices for Corp. The Taxpayers would then each receive a check from the Corp. account in the amount shown on these invoices. This convention of Corp.’s transmitting of its remaining income to the Taxpayers would require the latter, when necessary, to advance funds to Corp. so that it could pay subsequent expenses.
The IRS Steps In
For the years in issue, Corp. timely filed Forms 1120, U.S. Corporation Income Tax Return. The returns reported no gross receipts or sales and no (or negative) taxable income. The returns described Corp.’s business activity and service as “Management of Cattle Ranch”.
The Taxpayers filed Forms 1040, U.S. Individual Income Tax Return, for the years in issue. On Schedules C, they reported the gross receipts and expenses (other than those claimed by Corp.) from the cattle operation, and identified their principal business as “animal production”. They offset other income with the cattle operation’s net losses.
The IRS audited Taxpayers’ returns for the years in issue, and made adjustments to them, asserting that the returns inappropriately reported income and expenses that belonged to Corp.
The Taxpayers argued that they, and not Corp., owned all the cattle during the years in issue and, thus, that they properly reported the income and expenses of the cattle operation on their own returns.
The Tax Court
The Court began by noting that, absent extraordinary circumstances, a corporation’s business is not attributable to its shareholders for tax purposes. Generally, when taxpayers choose to conduct business through a corporation, they will not be permitted subsequently to deny its existence if it suits them for tax purposes.
Exceptions exist where the creation of the corporation was not followed by any business activity, the purpose of creating the corporation was not a business purpose, or the corporation was the agent of the taxpayers.
The parties agreed that Corp. had a genuine business purpose and actually carried on business activity and, therefore, was a separate taxable entity. They disagreed, however, over what that purpose was. The IRS asserted that Corp. managed the cattle operation. The Taxpayers contended that Corp. was nothing more than their “accounting agent”.
It was unclear to the Court what the Taxpayers meant when they described Corp. as an “accounting agent”; i.e., whether Corp. performed billing for the cattle operation or whether it was used simply as a strawman to provide a temporary repository for the operation’s income and expenses.
In any case, the Court stated, any accounting function would have been only one aspect of Corp.’s overall business purpose, which was to manage the cattle operation. Its tax returns for the years in issue identified its business activity as “Management of Cattle Ranch”. Corp. bought and sold cattle under its own name during the years in issue. In addition, it carried out a cattle operation business in its own name, held a bank account, purchased and held title to vehicles, leased ranch property, and held ranch and workers’ compensation and employer’s liability insurance policies. Corp. paid for the services of employees, and it handled their employment tax and income tax documents. Any control over these employees by the Taxpayers would presumably have been exercised by them not as individuals, but in their roles as officers of Corp.
The Court next considered the issue of to whom the income, expenses, and resulting net losses of the cattle operation were attributable.
A fundamental purpose of the Code, the Court stated, is to tax income to those who earn or otherwise create the right to receive it and enjoy the benefit of it. Income from property is usually attributed and taxed to the person who, in substance, is the owner of the property generating the income.
For tax purposes, the true owner of income-producing property is the one with beneficial ownership, rather than mere legal title. It is the ability to “command the property”, or enjoy its economic benefits, that marks a true owner, the Court stated.
“Corporate entity” cases dealing with income-producing property have attributed such property’s income and expenses to the corporation instead of its shareholders where: (1) the corporation has held some type of title to that property; or (2) the shareholders have held the corporation out to others as the owner of that property.
Corp. had command over the cattle to the degree that it was the recognized seller and purchaser of this income-producing property. It deposited all income from the cattle sales into its own account, directly paid cattle operation expenses from that account, and exercised its power of ownership over the funds by directing payment of the excess thereof to its stockholders – all recognizable economic benefits.
Moreover, the Taxpayers caused Corp. to hold itself out to the public, including the livestock auctions and brokers, buyers, sellers, and vendors, as the legal entity that owned the cattle – either by its direct purchase of the livestock or by its right to sell them. Nothing in the record indicated that the Taxpayers took any steps to make third parties aware that the cattle were not owned by the selling/buying corporation, Corp.
The Taxpayers also argued that they were “synonymous” with Corp. and that all the vendors and buyers that they did business with understood that a business transaction with Corp. was actually a transaction with the Taxpayers.
The Court, however, replied that the Taxpayers chose to do business using a separate corporate entity; they benefited from that choice (e.g., limited liability); therefore, they could not disregard the corporation whenever it was beneficial for them to do so.
In considering all the evidence, the Court was satisfied that the taxpayers sufficiently held Corp. out to others as the owner of the cattle during the years in issue and that Corp. had significant control over the cattle. Therefore, Corp. was deemed to be the owner of the cattle for tax purposes and, as a separate taxable entity, was the taxpayer to whom the net losses that stemmed from those assets for the years in issue were attributable.
The Taxpayers alternatively argued that the cattle operation losses were nonetheless attributable to them as individuals because Corp. functioned only as their agent.
An exception to the separate taxable entity principle exists where a corporation serves as the agent of the taxpayers. Generally, if a corporation is merely the shareholders’ agent, then income or expenses generated by the corporation’s assets would be income and expenses of the shareholders as principals.
The Court acknowledged that there was such a thing as “a true corporate agent of its owner-principal” and set forth four judicially-developed indicia and two requirements of agency: (1) whether the corporation operates in the name and for the account of the principal; (2) whether the corporation binds the principal by its actions; (3) whether the corporation transmits money received to the principal; (4) whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal; and, if the corporation is shown to be a true agent, then (5) its relations with its principal must not be dependent upon the fact that it is owned by the principal; and (6) its business purpose must be the carrying on of the normal duties of an agent.
It is uncontested, the Court stated, that the law attributes tax consequences of property held by a genuine agent to the principal. The genuineness of the agency relationship is adequately assured, it went on, and tax-avoiding manipulation is adequately avoided, when the fact that the corporation is acting as agent for its shareholders with respect to a particular asset is set forth in a written agreement at the time the asset is acquired, the corporation functions as agent, and not as principal, with respect to the asset for all purposes, and the corporation is held out as the agent, and not principal, in all dealings with third parties relating to the asset.
The Court considered whether Corp. was the agent of the Taxpayers. The latter asserted that an agency relationship existed where the principals and agent, through their course of conduct, established a usual, customary, and authorized procedure pursuant to which the agent directly received funds and then disbursed those funds to the principals through a check drawn on the agent’s operating account.
The gross receipts generated by the cattle operation, however, were not transmitted from Corp. to the Taxpayers. Receipts for sales of cattle sold by Corp. were deposited into the Corp.’s account. It then used those funds to pay monthly expenses. The Taxpayers received only the excess of receipts over expenditures, and then only because of their ownership of the corporation.
Taxpayers claimed that Corp. operated in the name and for the account of the Taxpayers. However, the record showed that Corp. acted for its own account. It incurred its own debts, entered into its own contracts with third parties for the purchase of goods and services, and bought and sold cattle in its own name – not as an agent.
The Taxpayers alleged that they were liable for the expenses of the cattle operation and that any expenses incurred by Corp. become their liability. However, they offered no proof of this allegation.
Regarding the indicium of whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal, the Taxpayers argued that Corp.’s receipt of income was attributable to the sale of cattle owned by the Taxpayers. The Court determined that the cattle were, or were held out to be, assets of Corp.; thus, any cattle operation income that the Taxpayers eventually received was not attributable to assets that they owned as principals.
The Taxpayers next argued that Corp. functioned as an agent and not a principal with respect to the cattle because “[t]here is no evidence to the contrary.” Corp., however, performed the “nitty gritty” of the cattle operation, and it acted as the controlling entity with respect to the cattle. Moreover, “any instructions that the [Taxpayers] gave to [Corp.] regarding the cattle would most likely have been in their capacity as officers of [Corp.], and the record does not reflect otherwise.” Thus, Corp. did not serve as an agent with regard to the cattle.
Finally, the Taxpayers claimed that Corp. was not held out as the principal in dealings with third parties relating to the cattle. They asserted that the employees on the ranch viewed the Taxpayers, and not Corp., as the owners of the cattle operation, and that vendors who did business with the cattle operation knew that the Taxpayers, and not Corp., would honor any business obligation.
Again, the Court noted that it was unclear how the employees differentiated between the Taxpayers’ acting as officers of Corp. and their acting on their own as principals. Additionally, the record had several examples of how Corp. appeared to be the principal at auctions and with buyers, sellers, and vendors. Nothing reliable in the record showed that Corp. was identified to any third parties as an agent, just as nothing showed that the Taxpayers were identified as its principals.
. . . You Get The Horns
On the basis of the foregoing facts, the Court properly rejected the Taxpayers’ arguments that Corp. be disregarded, and that its operations be reported on their individual income tax returns.
If the Taxpayers wanted to position themselves to utilize losses generated by the business, they should have considered electing “S” status for their corporation, or they should have chosen to use a partnership or an LLC to begin with. For whatever reasons, however, the Taxpayers chose to run Corp., not as a flow-through entity, but as a taxable corporation.
As the Court stated – and as every taxpayer must recognize – they “cannot now escape the tax consequences of that choice.”