A recent case shows how a shareholder and corporation, being considered alter egos, can cause unintended consequences. In Lothringer,[1]a corporate shareholder’s individual property was subject to enforced collection action by the IRS to satisfy corporate tax liabilities.[2] The court’s finding that the corporation was the shareholder’s alter ego allowed the IRS to hold the shareholder personally liable for the corporation’s tax debt.
Alter Ego Theory Generally
The case begins a discussion of the alter ego concept by stating that “the fundamental concept of corporate law is that the corporation is a wholly separate, legal entity. As such, the corporation, and not its shareholders, is liable for its own debts and torts.”[3] However, “a court may ignore the corporate form when it ‘has been used as part of a basically unfair device to achieve an inequitable result.’”[4] One such circumstance is when the corporation is the alter ego of its shareholder.
A recent case from the Sixth Circuit Court of Appeals differentiates alter ego cases from other theories of veil piercing by stating “a veil piercing claim seeks to hold a second party liable for another’s debt, while an alter ego claim asserts that the two parties should be treated as the same party, so the liability is direct, not vicarious…an ‘alter ego’ is simply an entity’s ‘other self.’”[5]
In explaining the alter ego theory, the Lothringer court stated:
Alter ego applies when there is such unity between corporation and individual that the separateness of the corporation has ceased and holding only the corporation liable would result in injustice. It is shown from the total dealings of the corporation and the individual, including the degree to which corporate formalities have been followed and corporate and individual property have been kept separately, the amount of financial interest, ownership and control the individual maintains over the corporation, and whether the corporation has been used for personal purposes. Alter ego’s rationale is: “if the shareholders themselves disregard the separation of the corporate enterprise, the law will also disregard it so far as necessary to protect individual and corporate creditors.”[6]
The Supreme Court of Nevada recently addressed a number of questions regarding application of the alter ego theory determining that: [7]
- Alter ego is properly asserted as a separate claim against a third party when the creditor holds an existing judgment against the primary debtor in order to afford the third-party due process.
- Alter ego applies to LLC’s and partnerships as well as corporations.[8]
- A transfer by a debtor’s alter ego, since the alter ego and debtor are one in the same (i.e. also the debtor), is considered a transfer by the debtor for application of fraudulent transfer laws.
- Transfers between the debtor and alter ego are transfers for application of fraudulent transfer laws.
It is worth noting that some of these questions answered by the Supreme Court of Nevada conflict with the law in other jurisdictions. While alter ego theory is fairly consistent across jurisdictions, there are certain differences.
As can be seen from these authorities, under alter ego liability, a debtor and third party are deemed to be one and the same. The alter ego is, in fact, the debtor. As a result, assets of the third party are considered to be assets of the debtor for purposes of a creditor’s right to collect.
Alter Ego Factors
The Lothringer court cited to factors used by the Fifth Circuit to question whether a subsidiary is the alter ego of its parent as follows[9]:
- the parent and the subsidiary have common stock ownership;
- the parent and the subsidiary have common directors or officers;
- the parent and the subsidiary have common business departments;
- the parent and the subsidiary file consolidated financial statements and tax returns;
- the parent finances the subsidiary;
- the parent caused the incorporation of the subsidiary;
- the subsidiary operates with grossly inadequate capital;
- the parent pays the salaries and other expenses of the subsidiary;
- the subsidiary receives no business except that given to it by the parent;
- the parent uses the subsidiary’s property as its own;
- the daily operations of the two corporations are not kept separate; and
- the subsidiary does not observe the basic corporate formalities, such as keeping separate books and records and holding shareholder board meetings.
Of course, while many of these factors are limited to a parent-subsidiary scenario, the concepts illustrated by these factors may be applied more broadly. Although not a parent-subsidiary situation, the Lothringer court used these factors as guides in rendering their decision.
The Mississippi Supreme Court has cited certain factors as “whether the two enterprises have substantially the same management; the same business purpose; and the same operation, equipment, customers, supervision, and ownership.”[10] Courts should look for “’such a unity of interest and ownership’ between the alleged separate entities that ‘adherence to the fiction of separate corporate existence would under the circumstances sanction a fraud or promote injustice.’”[11]
Discussion
In Lothringer, the court ultimately found the corporation, Pick-Ups, Inc. (“Pick-Ups”), to be the taxpayer’s alter ego stating that Lothringer:
- Was the only shareholder, officer, director, and owner of Pick-Ups;
- Exercised complete dominion and control over Pick-Ups;
- Organized Pick-Ups;
- Failed to follow certain corporate formalities, including failing to file federal income tax returns and Texas franchise tax public information reports for various years;
- Used corporate funds for personal expenses, including making distributions directly to his wife who was not an employee, officer, director, or shareholder of Pick-Ups
- Made payments on personal loans directly from funds of Pick-Ups;
- Commingled funds from a personal loan with the funds of Pick-Ups;
- Maintained inadequate business books and records for Pick-Ups (only a single page of minutes from one meeting in 2002 and unsigned bylaws); and
- Operated Pick-Ups in an illegal manner relating to certain felony convictions involving the business of Pick-Ups.
Seeing this list of problems Mr. Lothringer had in respecting the corporate form, it is not hard to see how the court reached its conclusion. However, reading the court’s opinion carefully, while all of these factors were present, many are not as damning as they may read. Nonetheless, based on the totality of these factors, the court allowed the IRS to satisfy Pick-Ups tax debt with Mr. Lothringer’s personal assets.[12]
Cases like Lothringer can provide important lessons. Many of the factors cited by courts in alter ego cases are present with almost all closely-held entities, especially single-owner entities. Often, someone starting a business will be the organizer of his or her solely owned corporation, serve as the sole-officer and director, control the corporation, not maintain meticulous records, possibly misses a compliance obligation, etc. Likewise, many LLC’s are formed as disregarded entities for tax purposes, meaning there is no need for the filing of an income tax return.
Many operating businesses separate their operations among various entities. This may be based on lines of business, locations, or other factors. Often this is accomplished by using holding companies which will own multiple subsidiaries for these purposes. However, when reading the factors used by the Fifth Circuit as cited above, a number of those factors may be present in a parent-subsidiary structure.
With respect to any entity, knowing that many of these factors could support the finding of an alter ego, it is important to respect the separateness of the entity as much as possible. Entity owners should maintain adequate books and records, document transactions even with their own entity, not commingle funds, maintain separate insurance, properly identify the entity in dealings with third parties (i.e. use the correct entity name on correspondence and do not accept payment made to other entities or the owner directly), etc. There are too many examples to cite in one place. However, we, as planners and attorneys, see routinely situations where care is not taken to respect the corporate form whether that is for a single closely-held entity or a multi-entity business enterprise structure. When many of the factors would favor an alter ego finding, and quite often that is the case, diligence is needed to carefully follow other formalities.
Conclusion
Mr. Lothringer unfortunately lost his personal assets to satisfy debts of Pick-Ups. Most people who form business entities do so specifically to avoid this result. Limited liability protection afforded by business entities allows business owners (and businesses themselves) to isolate liabilities to those affecting the relevant entity rather than subjecting the owner or other business entities to those liabilities. However, when a business entity is not able to satisfy those liabilities, creditors will look elsewhere. If the facts would support the finding of an alter ego, then the creditor may pursue the assets of the alter ego to recover.
To avoid these results, it is critically important that entities be operated as separate and apart from their owner or from other entities in an enterprise structure. It is rare that a closely-held business is operated with textbook perfection. Often, we find such businesses are operated rather loosely. However, cases like this shed light on the importance of following formalities and respecting the separateness of the entity. Valuable liability protection is at risk otherwise.
[1] U.S. v. Lothringer, 2020 WL 4677406 (W.D. Tex. Aug. 11, 2020).
[2] This case also has an interesting discussion of the interplay between enforcement of government debts against property protected by Texas’ constitutional homestead provisions. The IRS is allowed to force a sale of homestead property but will be required compensate the spouse for her community property interest.
[3] Citing W. Horizontal Drilling, Inc. v. Jonnet Energy Corp., 11 F.3d 65, 67 (5th Cir. 1994).
[4] Id.
[5] In re Blasingame, 920 F.3d 384 (6th Cir. 2019). I wrote about issues raised in the Blasingame case previously. https://esapllc.com/blasingame-asset-protection/
[6] Citing Castleberry v. Branscum 721 S.W.2d 270, 271 (5th Cir. 1990).
[7] Magliarditi v. TransFirst Group, Inc., 450 P.3d 911 (2019).
[8] The court left open a question raised in the litigation whether alter ego claims may apply with respect to trusts.
[9] Citing Century Hotels v. U.S., 952 F.2d 107, 110 (5th Cir. 1992).
[10] Smith v. St. Regis Corp., 850 F.Supp 1296 (S.D. Miss. 1994).
[11] See Liberty Mut. Ins. Co. v. Holliman, 765 So.2d 564 (Miss.App. 2000); citing FMC Finance Corp. v. Murphree, 632 F.2d 413, 422 (5th Cir. 1980).
[12] For a case reaching the opposite result involving IRS arguments that an alter ego existed, see U.S. v. Holland, 953 F.3d 397 (6th Cir. 2020), which respected the separateness of a partnership even though the taxpayer failed observe formalities with respect to the partnership.
