Saturday, August 25, 2012

Collecting Taxes from Alter Egos: A Pyrrhic Victory for the IRS?

The government can usually only collect taxes from the person who owes them.  This makes sense - nobody wants the IRS showing up with a bill for someone else's taxes.  But there are exceptions to this rule - one of the most powerful being the "alter ego" doctrine. In short, the alter ego doctrine permits the IRS to seize the property of a shareholder for taxes owed by a corporation. This may surprise a lot of people.  After all, isn't the whole point of a corporation to provide limited liability to shareholders?  Can the IRS just ignore limited liability?

Unfortunately, the answer isn't entirely clear.  This is due, at least in part, to a conflict between two fundamental principles of tax law: first, that a validly formed corporation under state law is respected as a separate taxpayer from its shareholders and, second, that pure shams, even if they are valid for state law purposes, are disregarded for federal tax purposes. Owners of corporations, supported by most Courts of Appeals, tend to assert that state corporate law applies under the first principle, while the IRS claims that federal law applies and permits collection under the second.  This disagreement has recently bubbled into a controversy (subscription required).

A Fifth Circuit case from 2000 seemed to foreshadow the rise of this controversy (full disclosure: I clerked for Judge Dennis during the term this case was decided).  In that case, the Fifth Circuit held that the IRS needed some evidentiary basis to claim that a corporation was an alter ego before levying its property, rejecting the argument of the IRS that it could rely on subsequently discovered facts to justify its actions.  A separate concurrence went even further, concluding that the Fourth Amendment applied, meaning that the IRS had to meet the even higher "probable cause" standard of alter-ego status before imposing the levy.

It seems odd that the IRS can disregard state law, but that seems pretty well established (at least in certain contexts).  But I do think the IRS should be careful what it wishes for.  If a corporation exists as a separate entity from its shareholders under state law, even if it is an alter-ego for federal purposes, it is difficult to see why the Fourth Amendment would not apply to protect its shareholders.  In such case, the IRS would need probable cause that the corporation is an alter ego of the shareholder before starting any collection procedures against the shareholder.  But if the corporation didn't even exist for state law purposes, this would not be an issue and the IRS could collect against the shareholder.  So could insisting that federal law apply to alter-egos prove a pyrrhic victory for the IRS?

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