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Are Corporations Required to Have
at least One Employee for Tax Purposes?
The question under review is not one that is litigated
often. The reason for this is that corporations are formed under state
law and federal tax law generally will accept the state-level conclusion
of what constitutes a "corporation." Despite this, the relatively
few cases, which have addressed the issue, leave little doubt about
the conclusion that a corporation need not have any employees
for federal tax purposes.
Typically, if a corporation has a corporate officer
or someone taking meals, travel and entertainment expenses from the
corporation, that person will be viewed as an employee. There is much
misinformation about being an "independent contractor" taking employee
benefits. This will not work. Most corporations will have at least one
employee, but as you will learn from this article, there are few exceptions.
The starting point for the analysis is a venerable case
decided by the United States Supreme Court, Moline Properties, Inc.
v. Commn'r, 319 U.S. 436 (1943). Here, Uly Thompson "to be used
as a security device in connection with certain Florida realty owned
by him" organized the corporation at issue Moline.
Id. at 437. For
the first five years of its existence, the corporation, which held title
to a single piece of property, conducted very little business:
The business done by the corporation consisted of
the assumption of a certain obligation of Thompson to the original
creditor, the defense of certain condemnation proceedings and the
institution of a suit to remove restrictions imposed on the property
by a prior deed.
Id. A year later
a portion of the corporation's property was leased as a parking lot
for a rental of $1,000. Two years later the property was sold and the
corporation (which was not dissolved) transacted no further business
of any kind. While the corporation held title to the property, it had
no employees, kept no books, maintained no bank account, and never owned
any asset other than the one piece of property.
The issue before the court was whether the gain realized
from the sale of the property was attributable to the corporation or
to Thompson individually. The Board of Tax Appeals found that the gain
should be attributed to Thompson, as the corporation "was a mere
figmentary agent which should be disregarded in the assessment of taxes."
Id. at 438. The
Federal Circuit Court of Appeals reversed, finding "that the corporate
entity, chosen by Thompson for reasons sufficient to him, must now be
recognized in the taxation of the income of the corporation."
Id. The United States
Supreme Court agreed with the Court of Appeals:
The doctrine of corporate entity fills a useful purpose
in business life. Whether the purpose be to gain an advantage under
the law of the state of incorporation, or to avoid, or to comply with
the demands of creditors, or to serve the creator's personal, or undisclosed
convenience, so long as that purpose is the equivalent of business
activity, or is followed by the carrying on of business by the corporation,
the corporation remains a separate taxable entity.
Id. at 438-39 (citations
and footnotes omitted)(emphasis added). The court added:
In general, in matters relating to
revenue, the corporate form may be disregarded where it is a sham
or unreal. In such situations the form is a bald and mischievous fiction.
Id. at 439.
Since the corporation at issue carried on business (leasing
part of the property as a parking lot), it was not a sham, and its existence
had to be recognized for tax purposes.
The teaching of Moline is that so long as a corporation
carries on business or the equivalent of business activity tied to the
purpose of its creation, the corporation will be recognized for tax
purposes, whether or not it has employees. Cases decided after Moline
show this.
In Paymer v. Commn'r, 150 F.2d 334 (2d Cir. 1945), two
brothers formed a corporation of which they were the sole stockholders.
The property of the brothers' partnership was transferred to
the corporation in order to deter the partnership creditors of one of
the brothers. The court disregarded the corporation, as a sham, for
tax purposes. The court found that the corporation did nothing except
to take and hold title to the real property at issue and more importantly,
served no business purpose in connection with the property.
The existence of either business activity or a business
purpose is key to the recognition of a corporation for tax purposes.
In Gray Holding Corp. v. Clauson, 95 F. Supp. 928 (D. Me. 1951), the
corporation at issue was found not to have engaged in any business activity.
However, the court found that the corporation was created to hold stock
as a unit in order to insure majority control of another corporation.
Since this constituted a business purpose tied to the purpose of the
creation of the corporation, the corporation was recognized for tax
purposes.
The test employed by the courts today was well articulated
by the United States Tax Court in Bass v. Commn'r, 50 T.C. 595 (1968).
The court revealed that the test used in determining whether a corporate
entity should be ignored for tax purposes is not the personal purpose
of the taxpayer in creating the corporation but whether that purpose
is intended to be accomplished through the corporation carrying out
substantive business functions. Thus, if the purpose of the corporation
is to carry out substantive business functions, or if it in fact engages
in substantive business activity, it will not be disregarded for federal
tax purposes.
If a party wishes to have a corporation recognized for
federal tax purposes, it is imperative that the corporation carries
out some substantive function tied to the purpose of its creation. This
is not overly difficult to achieve; yet some still fail the test.
This was demonstrated in Davis v. Commn'r, T.C. Memo.
1970-170, 29 T.C.M. 749 (1970). Here, Alan Davis formed a corporation
to he a partner in a real estate joint venture. The purpose for the
formation was to limit Davis' liability with respect to the joint venture.
Davis contended that under the Moline doctrine, the corporation
should not be disregarded so long as the corporation fulfilled a useful
business function or carried on business in its own right. While Davis'
position was legally correct, the facts of the case caused the Tax Court
to disregard the corporation and attribute the joint venture's income
to Davis personally.
The corporation at issue had no funds, no employees,
no books or records and performed no business activities of any kind.
Furthermore, Davis personally guaranteed any losses that the joint venture
might incur. The court reasoned that since the corporation had no assets,
the guarantee amounted to Davis' personal agreement to share in the
losses of the joint venture. The crux of the court's decision was as
follows:
The only purpose served by [the corporation] shown
by this record was to retain the earnings from the joint venture for
the benefit of [Davis'] children to whom its stock had been transferred.
This function is merely receiving an anticipatory assignment of [Davis']
income for his children's benefit. It is not a function of a. joint
ventures in a building project.
Id. at 756 (emphasis
added).
Since the corporation carried out no
substantive function tied to the purpose of its creation (the real estate
joint venture); it was disregarded for federal tax purposes. Davis,
like the brothers in Paymer, supra, made a fatal mistake in that
he failed to marry the purpose of the corporation's creation to any
substantive business activity on the part of the corporation. Any
substantive activity on the part of the corporation on behalf of
the real estate joint venture would have changed the result in Davis.
The ease with which a corporation can carry out a business
purpose tied to its creation is demonstrated by Strong v. Commn'r, 66
T.C. 12 (1976), aff'd on the opinion below, 553 F.2d 94 (2d Cir.
1977). Here, a group of partners wished to construct and operate an
apartment complex. However, the partners, because of the limitations
on interest charges could not obtain the amount of financing required
to individuals under New York's usury law. However, this law exempted
corporations from the limits. Knowing this, the partners formed a corporation
in order to obtain the loan, which proved successful.
The question before the Tax Court was whether the ensuing
net operating losses were those of the partners or those of the corporation.
The court held that the losses belonged to the corporate entity, despite
the fact that the corporation kept no books or records, issued no stock,
kept no minutes, held no meetings, and had no employees.
The court noted that, in order to obtain the financing
for the project, the partners transferred the property on which the
complex was built to the corporation. The purpose for the creation of
the corporation was to obtain financing for the property. If the corporation
performed any business activity tied to this purpose, the corporation
could not be ignored for tax purposes. Since the corporation did, in
fact, obtain the financing, it did enough to be recognized under federal
tax law. The court wrote:
Cases following Moline Properties have generally
held that the income from property must be taxed to the corporate
owner and will not be attributed to the shareholders, unless the corporation
is a purely passive dummy or is used for a tax-avoidance purpose.
Id. at 22 (emphasis
in original). The court added:
If the corporation was intended to, or did in fact,
act in its own name with respect to property, its ownership thereof
will not be disregarded.
The degree of corporate purpose and activity requiring
recognition of the corporation as a separate entity is extremely low.
Thus, it has been stated that "a determination whether a corporation
is to be considered as doing business is not necessarily dependent
upon the quantum of business' and that the business activity may be
minimal." See Britt v. United States, 431 F.2d 227, 235,
237 (5th Cir. 1970).
In this case, the corporation's purpose and activities
were sufficient to require recognition of its separate ownership of
the property in question and, a fortiori, of its existence
as a taxable entity. The purpose to avoid State usury laws is a 'business
purpose' within the meaning of Moline Properties.
Id.
at 24. Thus, any business activity on the part of a corporation,
which is tied to the purpose of its creation, will cause the recognition
of the corporation for tax purposes, despite the absence of employees
or corporate formalities. This is especially true, as noted by the Strong
court, when "the business activity [is] the raison d’ętre
of the corporation."
Id. at 25 n. 10.
Lastly, in Ogiony v. Commn'r, 617 F.2d 14 (2d Cir. 1980), a case arose
identical to the Strong case just discussed.
Once again, a partnership could not obtain financing to develop a real
estate project, and utilized two corporations to achieve this purpose.
The partnership transferred title to the property to the corporation,
which then succeeded to obtain the financing. The court adopted the
holding from Strong, supra, and decided that the losses arising
from the project belonged to the corporation and not to the partners
individually.
As all of the above cases reveal, the presence or absence
of employees (or any corporate formalities) is not the key element for
the recognition of a corporation for tax purposes. Rather, the important
factor is whether the corporation undertakes any business activity,
which is tied to the creation of the corporation in the first place.
Barring the mistakes committed by the parties in Paymer and Davis,
supra, this is not a difficult thing to achieve.
Therefore, even in the absence of any employees, a corporation
can be recognized for tax purposes while conducting any activity that
a corporation can legally undertake. These would, of course, include
holding title to property or forming a company to hold a name in a jurisdiction
wherein the corporation does not yet operate. All that is required is
that the corporation undertakes, in fact, some business activity tied
to the purpose of its creation.
ADDENDUM
Some states, California among them, allow a corporation,
which is not operating within its borders to register its corporate
name in that foreign state in order to protect its name for any possible
future use. See, e.g., Cal. Corps. Code § 2101. In states where
this is allowed, there would be no reason to create a corporation to
hold a name.
- This research
attempts to answer the question of whether or not a state
can apply its own law regarding piercing an entity to so-called "pseudo-foreign" corporations.
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