Taxpayers often establish business entities to shield themselves personally from liabilities of the business. The laws of different states provide differing degrees of protection from claimants attempting to “pierce the corporate veil” and sue shareholders personally.
Lawyers advise business owners to try and observe corporate formalities – don’t mix business and personal accounts, expenses, etc. Nevertheless, we see clients all the time who use their businesses as personal pocketbooks; moving funds in and out (mostly out) without regard to the appropriateness or proper tax treatment of such transactions.
As a reminder of the potential impact of such a cavalier approach we now have the Lothringer case – first decided in federal district court but now upheld by the Court of Appeals. (As a jurisdictional note, the courts in question are in Texas and they were applying Texas law to the facts; your results may vary.)
Mr. Lothringer ran a business selling used pick-up trucks aptly named Pick-Ups, Inc. He was the only shareholder, officer, and director of the company. He assumed some debts of the company. The company paid some of his personal loans. The company wrote checks to his wife even though she wasn’t an employee or shareholder. Those funds, it turns out, were used for personal and household expenses.
Based on these facts, the court found that he was the business’s alter ego. Not only was that not the best Halloween costume, it also created a basis for the court to make him personally liable for all the unpaid federal income taxes of the corporation. As the district court put it, “[a]lter 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… 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.’”
In varying contexts we have discussed the importance of good documentation. Add to that respect for the taxpayer’s chosen form of transaction/business organization. In this case, it cost Mr. Lothringer $1,777,047.98, plus penalties and statutory additions, and additional prejudgment and post-judgment interest not to heed that advice.
Should you have questions about separating your business and personal affairs, contact your attorney or Friedman LLP advisor for guidance.
*Apologies to Kings Solomon and Louis XIV