Defining ‘Alter Ego’ and Its Application to Determine Corporate Taxability

By Jeffrey A. Galant

Like many things in life and the law, context is important, including, for our purposes, the defining of “alter ego” and its application to determine taxability.
To legal scholars and practicing attorneys alike, “piercing the corporate veil” is certainly not an unfamiliar concept.
Creditors of corporate entities will, at various times, pursue the controlling shareholders to satisfy an undercapitalized corporation’s indebtedness. Following along these lines, when it comes to income taxation, it is always important to be able to identify the proper taxpayer. Alter ego concepts may aid in any such determination, i.e., determining whether a corporation that presumably realizes the income should be taxed, or whether the controlling shareholder realized the income and, therefore, should bear the tax liability.
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Nominee or Alter Ego Status As Taxpayer Tool

From a tax planning perspective, it is not unusual for corporations to be utilized as nominees (an equivalent of alter ego) for individuals, partnerships or other entities, especially in connection with the financing of real estate development projects.
Historically, maximum interest rates chargeable to corporate entities far exceeded the rates that were chargeable to individuals without violating state usury laws. (Today, limited liability companies may also be charged higher rates.) A finding of usurious rates could possibly render the underlying loan unenforceable. Usury laws vary from state to state.
Because of usury laws, lenders may require that the borrowing entity be a corporation. This was all well and good from a developer’s or investor’s perspective so long as the project could be operated through a non-corporate entity, i.e., a pass-through entity such as a partnership, so the double taxation aspects of a C corporation were avoided.
Further potential deductions such as depreciation could be utilized directly by the owners, most notably allowing the owners to withdraw proceeds of a refinancing without realizing gain and thereby incurring tax.
In other words, the corporate borrower, although recognized as the borrower for purposes of state usury laws, would be treated for federal income tax purposes as the nominee or alter ego of the operating partnership, the intended taxpayer. The U.S. Supreme Court has provided the roadmap of how to establish the nominee relationship. See, Commissioner v. Bollinger, 485 U.S. 340 (1988).
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Nominee or Alter Ego Status As IRS Tool

Reversing stances, the IRS does not shy away from ignoring an ostensible corporate taxpayer when it finds the controlling shareholder to be the proper taxpayer rather than the corporation, which it considers merely an alter ego. See, e.g., Jenkins v. Commissioner; Gentry v. Commissioner, T.C. Memo 2021-54 (Jenkins). Jenkins, admittedly an unusual and somewhat bizarre case involving massive fraud and criminal activity, is an interesting example of the IRS’ pursuit of the appropriate taxpayer.
First, a quick word about penguins and the more bizarre aspects of the case. Messrs. Jenkins and Gentry, in concocting their various schemes, acquired passports and license plates from the “Kingdom of Kerguelen” in their names and in the names of other individuals who they made up.
It turns out that the Kerguelen Islands are an overseas territory of France and neither a sovereign nation nor a kingdom. Located in the South Indian Ocean and suffering quite harsh weather, the island is inhabited only by some 50 to 100 scientists and engineers as well as many penguins. “If the penguins of those islands could speak, they would say: Something’s fishy (or perhaps ‘C’est chelou’), reports Judge Mark Holmes in Jenkins.
As concisely described by the Ninth Circuit in the criminal matter, the cases against Messrs. Jenkins and Gentry arose “… out of a ‘pump and dump’ scheme during which Randy Jenkins and Ira Gentry conspired to secretly acquire millions of shares of UniDyn Corporation stock, artificially inflate its value, sell it for a significant profit, and launder the proceeds.”
A jury convicted Jenkins and Gentry of multiple counts of securities fraud, wire fraud, and money laundering, as well as one count of tax evasion and for conspiracy to defraud the United States. Prison terms ensued for each of them. See, United States v. Jenkins, 633 F.3d 788 (9th Cir., 2011), affirming 455 F. Supp 2d 1018 (D. Ariz, Oct 5, 2006).
The Tax Court in Jenkins focused on the capital gains purportedly realized by Mr. Gentry in connection with the scheme and the sales of the UniDyn shares. On the face of things, the various capital gains were realized by four separate corporations when they sold the UniDyn shares. Each of the four corporations was controlled by Gentry through his ownership of voting shares.
The capital gains were realized in connection with the sale of the UniDyn Corporation’s shares held in the names of the four corporations. The IRS position was that Gentry, rather than the corporations, realized the capital gains since the four corporations were the nominees or alter egos of Gentry.
It is important to note, as explained by Tax Court Judge Holmes, that this was not a situation where the corporations were shams because, e.g., they lacked business purpose, the element required by off-cited Moline Properties, Inc. v. Commissioner, 319 US 436 (1943). To answer the nominee or alter ego assertion by the IRS, Judge Holmes’ mission was to determine first whether nominee status or that of alter ego was involved, and then, whether federal or state law applied, and finally if the latter, the law of which state.
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Nominee Analysis

To determine the rules of nominee ownership, an analysis of the applicable state law was necessary. According to Judge Holmes, it is the law of the state where the property whose ownership is at issue (i.e., the UniDyn shares) is located. As it turned out, the record was insufficient to help identify the applicable state law, e.g., “[t]here is not enough in the record of these cases to tell us where the stock itself was located: Toronto, where the corporations had their brokerage accounts; the three different jurisdictions where the corporations were incorporated; Arizona, where the corporations (presumably through Mr. Gentry) decided to buy and sell the stock; or where the shares (if this were even true) were located in physical form.”
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Alter Ego Analysis

Moving on to alter-ego, Judge Holmes began his analysis of the applicable law by first considering whether federal or state law applied. Finding there was no mandate to apply federal law, the good judge then analyzed which state law should apply. Fast-forwarding through his scholarly analysis, including his noting of the influence of the Restatement (Second) of Conflict of Laws (1971), he concluded that the Arizona law of corporate alter egos should apply.
According to Judge Holmes, Arizona’s alter ego law requires a finding that the owner exercises “substantially total control” over the corporation, and the giving of due deference to the purpose of the Arizona alter ego doctrine, i.e., “the prevention of fraud, misuse and injustice arising from the misuse of the corporate form of organization.” Applying those principles, Judge Holmes found that Arizona’s alter ego law did apply, and further, since Gentry controlled each of the four corporations and used them to commit tax evasion and other crimes, the capital gains were realized by Gentry rather than the corporations.
Gentry did raise a couple of clever arguments. First, he argued that the IRS was barred by res judicata from pursuing civil tax claims against him due to his convictions in federal district court. Second, he argued that since he forfeited the capital gain proceeds to the United States as a result of the convictions, he could not then be taxed on such proceeds. Judge Holmes quickly rejected each argument as contrary to existing law.
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Lessons Learned

Admittedly offbeat and perhaps beyond the pale, Jenkins does suggest how to plan to avoid an IRS alter ego assertion against a corporate entity that its owners want respected. It would seem helpful, assuming of course a more normal business circumstance, for the owners to assure that their corporate entity maintains:

• Adequate capitalization;
• An appropriate corporate governance structure;
• Adherence to corporate formalities;
• Accurate books and records;
• Accurate title to corporate assets, including bank accounts; and
• Leases and other contracts in corporate name.

For an interesting tale of alter ego, you may want to delve into the story of the relationship between the recently deceased prominent artist James Magee and his alter ego, the equally prominent artist Annabel Livermore. It is well worth the read.