The Determination of Whether an Entity Is a Ture Entity - Essay Example

Understanding Corporations as Legal Entities Name: Course: Tutor: Date: Introduction Corporations are the principal form of organization for the simple reason that they have been in existence for a long time, and consequently, they are numerous and the laws that regulate them are well developed (Beatty & Samuelson, p. 306). One of the aspects of the law regards taxation. Corporations are subjected to a different form of taxation as compared to other business structures. In essence, corporations are types of businesses that must pay their income taxes on accrued profits. On the other hand, sole proprietorships, partnerships, and limited liability companies or LLCs are not taxed on the business profits they earn. Instead, the profits have to pass through the business establishment to their owners, who eventually report the business profits or losses on their individual tax returns (Kaplan, 2003; Beatty & Samuelson, p. 306). The reason for the differences in methods of taxation as regards corporations is that the corporation is a distinct legal entity from its owners. Thus, the company’s profit is taxed in such a manner that the company cannot deduct it as business expenditure. In general, taxable profits encompass money maintained by the company and which is used to cover expenses or the business’s expansion, referred to as retained earnings as well as profits that are shared by the owners (called shareholders) in the form of dividends (Beatty & Samuelson, p. 306; Hopkins, 2009, p. 67; Van Weeghel, 1998). As per the federal income tax regime, every component of gross income that is received, whether by a commercial entity or an individual, is subject to being taxed, save if there is an express legal provision that exempts from taxation either that type of income or the kind of person involved (Hopkins, 2009, p. 67). There are instances however, where corporations can be exempted from some form of taxation. This is not automatic though. It involves analysis of various sections of the law and may entail long lawsuits. For example, the Internal Revenue Service (IRS) does not grant the tax-exempt statue. Instead, it is the United States Congress that defines the nature of organizations that can be granted that status, and Congress also determines whether an exemption from a certain form of tax should be continued, in part or whole, or whether a tax exemption should be created in the first place (Hopkins, 2009, p. 67). Differences can therefore occur between the taxpayer and the IRS in view of the fact that the IRS does not enact tax laws, its role is only to recognize whether entities are taxed or are exempted from the same. Individuals who are not satisfied with taxation laws involving corporations usually move to court. Examples of cases involving corporation taxation include Moline Properties v. Commissioner of Internal Revenue, 319 U.S. 436 (1943) and Commissioner v. Bollinger, 485 U.S. 340 (1988). In view of the complex issue of corporation taxation, this paper will revisit the aforementioned cases and others that bring the taxpayer and the IRS at crossroads. In particular, issues arise over the manner in which corporations, as legal entities, are taxed. Nature of corporations Limited liability A corporation’s shareholders have limited liability. This implies that incase the corporation cannot pay its bills; its shareholders lose their investment in the firm, but not actually their assets (Hopkins, 2009, p. 67). A point to note however is that the individuals in a corporation are always held responsible for their actions. Hence, if for instance a careless employee who is also shareholder in the company is involved in an accident at work, being a shareholder per se does not protect him or her from their misdeeds. Both the individual and the company would be liable. There are also other issues related to the operations of corporations such as transferability of interest, duration of operations, and logistics, which are quite unique from the operations of other forms of business ownership; but of particular interest in this paper is the issue of taxation. Taxes There is no gainsaying that fact that corporations are taxable entities. Powell (2008) notes that all corporations are liable to taxation, save for situations in which they are expressly exempted by statute (p. 3). Hence, taxation is the rule, and exemption is but an exception. This was the situation in many cases in which courts made rulings over in the past, including People ex rel. Manhattan Fire Ins. Co. v. Com’rs, 76 N.Y. 64 (1879) (Powell, 2008, p. 3). There is also a point that there is no intent to exempt a corporation’s property from taxation as ruled in People ex rel. 23rd St. R. R. v. Com’rs. 95 N. Y. 554 (1884). In others cases, there is a presumption that all property located within the territorial limits of the state is subject to the state’ taxing power, as ruled in People ex rel. Metropolitan St. Ry. Co. v. State Board of Tax Com’rs. Such a case is classified under the Special Franchise tax cases (Powell, 2008, p. 3). Since corporations are taxable entities, they are under obligation to pay taxes and file the tax returns. This is a simple statement that does not necessarily need an intricate explanation. As opposed to the manner in which sole proprietorships or partnerships are taxed, corporations are taxed based on their profits, and the shareholders have to pay tax on the dividends they earn from the corporation. This means that a dollar is taxed only once prior to reaching the partner’s bank account, but twice prior to being deposited by any shareholder (Beatty & Samuelson, p. 306). Classifying which entity belongs to which tax regime An important question in scheming the income tax on business as well as other entities is the establishing of which entities should be subjected to taxation on legal persons and which should be treated on a flow-through basis (Thuronyi, 1998, p. 931). In essence, entities that are not legal persons may still be subjected to taxation as if they were, and in some cases, entities that are legal persons may be treated on a flow-through basis (Thuronyi, 1998, p. 931). After individuals have set up a corporation of any type, the organization should in deed act like a corporation. The corporation has to fulfill all requirements to ensure that both courts and the IRS approve of its functions. A point worth noting is that it is the legal status of the corporation that allows it to be treated as an entity separate from its directors, employees and officers and enables it to be taxed (or not taxed), and sue or be sued on its own (Mancuso, 2009, p. 210). The IRS and courts do occasionally scrutinize the organization as well as operations of a corporation, especially if it is operated and directed by a small number of people who fill more than one position. The IRS may be involved incase the corporation does not keep adequate records or generally neglects its theory and practice as a corporation. In addition, the IRS gets actively involved in assessing taxes and other penalties at a personal level against those associated with managing the affairs of the corporation incase it concludes that the corporation is not a legitimate legal or tax entity (Mancuso, 2009, p. 210). In legal terms, when the IRS for instance gets involved in the operations of a corporation by holding individuals responsible for misdeeds within the corporation, this is referred to as piercing the corporate veil (Mancuso, 2009, p. 210). Thus, it is essential that a corporation acts like one in its operations particularly with reference to taxation. The following section will address some cases involving such issues. Moline Properties v. Commissioner of Internal Revenue, 319 U.S. 436 (1943) In the case (Supreme Court), the petitioner wanted to have the proceeds on sale of its material goods taken care of as the as the revenue of its sole stockholder while ignoring its corporate being (of Moline Properties). The petitioner sought to ignore the existence of Moline Properties as mere fiction. In this case, certiorari was granted due to the volume of related litigation in the lower courts and due to alleged conflict based on the decision a given by the Supreme Court and other previous court decisions (Ault, Arnold & Gest, p. 149). The petitioner was prepared by Uly Thompson in 1928 for purposes of being used a collateral in connection with a certain Florida realty owed by Thompson. The property mortgagee suggested an arrangement under which Thompson channeled the property to the petitioner, which assumed the mortgagees due on the property. Thus, Thompson received all except the qualifying shares of the stock, which he then transferred to a voting trustee that was appointed by the creditor (Lutter, 2006, p. 224). Thompson intended to hold the stock as security for an extra loan in order to pay back taxes that were due on the property. In addition, Thompson owned other real property that was entitled to him individually. In the year 1933, the loan that resulted in the creation of the petitioner was repaid while the accruing mortgages were refinanced through a different mortgagee, and control of the petitioner was reverted to Thompson (Ault, Arnold & Gest, p. 149; Lutter, 2006, p. 224). The resultant mortgage debt was settled in 1936 through sale of a portion of the property that was held by Moline Properties. The other holdings belonging to Moline Properties were sold in a period of three years (1934 to 1936), and the proceeds were received by Thompson and conveyed to his personal bank account. The corporation performed business with an assumption of the responsibility of Thompson to the original creditor (Lutter, 2006, p. 224). Moline Properties did not transact any business since 1936 after selling off the last of its holdings. The firm did not do bookkeeping and had no bank account during the period it existed and had no other assets other than those so far described. Due its operations, it made gains as well as losses. A question therefore arose as to whether the gains realized by the firm could be treated as taxable income to the corporation, as argued by the government; or as part of Thompsons income. In this very interesting lawsuit, the court ignored the entity’s existence on grounds that it was not formed for a business purpose and had no business activity (Ault, Arnold & Gest, p. 149). As earlier mentioned, a corporation as legal entity has to portray the true features expected of it. In this case, it can be noted that Moline Properties failed even in the most fundamental aspects of a corporation such as bookkeeping and maintaining its own account, hence the decision by the court. Courts can also base their rulings on other factors. For instance, the Supreme Court denied favorable taxation to a transaction that fulfilled all the literal requirements of the governing statute for the reason that the transaction did not have a business purpose (the case is Gregory v. Helvering, 293 US 465 (1935)) (Ault, Arnold & Gest, p. 149). Commissioner v. Bollinger, 485 U.S. 340 (1988) Since Kentucky’s usury law had a limit for the annual interest rate for non corporate borrowers, lenders who were willing to provide money at interest rates needed such borrowers to employ the services of a nominal employee as the nominal debtor as well as title holder of the managed property. Therefore, respondents who were involved in a series of partnerships to form Kentucky apartment complexes, each entered into a commitment with a corporation that was fully owned by Bollinger. The agreement provided that the corporation would be the title holder of the property both as the partner’s nominee and as an agent solely responsible for securing finances. The agreement also detailed that the corporation would be the principal owner during all manner of transactions including construction, financing and operation (Samansky & Smith, 1985, p. 2-35). With the agreement, all the parties related to the complexes such as lenders, managers, contractors, tenants and employees regarded their associations as the owners and understood that the corporation was just the various partnerships’ agent, that is if at all they were aware of the corporation. Losses and incomes from the complexes were reflected on the tax returns of the partnerships and the various respondents presented their share of income as well as losses to their individual returns. Bollinger and the corporation entered an agency agreement, in which the corporation would hold title to the property but only as an agent to secure financing. The agreement also stated that securing of finances would be subject to the control of the principal and would also be indemnified by the same. In many ways, the partnership and not the corporation was portrayed to lenders as well as other third parties as the owner of the property (Samansky & Smith, 1985, p. 2-35). Controversy arose in that the Commissioner of Internal Revenue rejected the losses incurred by the respondents on grounds that they were related to the corporation as the owner of the various properties. On the other hand, the Tax Court was of the opinion that the corporation existed as the partnerships’ agent and was therefore not worthy being taxed. The Court of Appeals affirmed this by disregarding the corporations since it only acted as an agent for the partnerships (Block, 2004, p. 27). The Service argued that the arrangement violated the National Carbide requirement that the relationship between the corporate agent and the principal must be depended upon the fact that it is owned by the principal (Samansky & Smith, 1985, p. 2-36). The court ruled that when a corporation acts as an agent for its shareholders with respect to a given asset, the corporation operates as an agent and not principal as pertains all the assets for all purposes (Samansky & Smith, 1985, p. 2-36). Although there were three factors listed by Bollinger sufficient to make the corporation a nontaxable agent of its shareholders, only two had real content: that there was a written agreement and that the corporation was portrayed as an agent to third parties. Thus the Bollinger case creates an avenue for corporations that act as agents for their shareholders. However, the opinion does not provide information to rationalize the result or to provide overall guidance to tax payers as well as the government. But the case presents interesting facts with regards to a corporation being a separate entity. The fact that the partners consistently presented themselves as principals to the third parties made it easy for the corporation to argue out its case as an agent and not owner of the businesses. Conclusion In conclusion, the laws regarding corporations are intricate and shareholders and other players in the business have to understand the laws’ fine details. Shareholders have to ensure that the corporation is registered and fulfills all the requirements that make it to be treated as a separate entity. As it has been discussed, any violation of the law regarding corporations may mean that they will be not be treated as legal entities. In addition, owners of corporations may violate the laws regarding corporations to avoid taxation or to involve other shareholders without their knowledge. References Ault, H. J. & Arnold, B.J. & Gest, G. (2004). Comparative income taxation: A structural analysis (2nd edition). New York: Kluwer Law International, Beatty, J. F. & Samuelson, S. S. (2009). Introduction to business law (3rd edition). New York: Cengage Learning. Block, C. D. (2004). Corporate taxation: examples and explanations (3rd edition). Aspen Publishers Online Hopkins, B. R. (2009). Starting and managing a nonprofit organization: A legal guide (5th edition). New York: John Wiley and Sons. Kaplan, M. S. (2003). What the IRS doesn't want you to know: A CPA reveals the tricks of the trade (edition 9). New York: John Wiley and Sons. Lutter, M. (2006). Legal capital in Europe London: Walter de Gruyter. Mancuso, A. (2009). How to form a nonprofit corporation. New York: Nolo. Powell, H. M. (2008). The taxation of corporations in New York. New York: BiblioBazaar, LLC. Samansky, A. J. & Smith, J. C. (1985). Federal taxation of real estate. New York: Law Journal Press. Thuronyi, V. (1998). Tax law design and drafting, Volume 2. New York: International Monetary Fund. Van Weeghel, S. (1998). The improper use of tax treaties: with particular reference to the Netherlands and the United States. New Haven: Kluwer Law International. Read More