Risks of Unwanted Degrees of Affiliation
Having multiple legal entities under the umbrella of any business enterprise serves a number of useful purposes, but there is always a danger that such entities can be collapsed or ignored in certain circumstances, resulting in undesirable tax consequences or allowing the liabilities of one entity to impair the assets of another entity. Consequently, care must be taken to maintain the independent existence and activities of each entity.
The forced consolidation of tax returns or its equivalent is one potential problem. IRC §1561, for example, denies multiple tax benefits (with regard to corporate income tax brackets, and for purposes of computing the accumulated earnings credit and minimum tax) in the case of certain controlled corporations.
Additionally, there is a fairly broad power in the IRS to re-allocate items of income and expense among taxpayers "owned or controlled directly or indirectly by the same interests." IRC §482. This power is often used to impute interest income when loans are made between corporations below prevailing market rates. See §483. The prevailing rule is one of "arms-length transactions." These concepts are covered in extensive detail in regulations under §§482-483, and are probably best reviewed with accounting counsel.
Our purpose here is to review legal concepts which impact arms-length transactions, degrees of affiliation between entities, and alter-ego or sham corporation (piercing the corporate veil) potential.
The following are rules of thumb for maintaining an "arm's length" relationship:
Selected Case Examples
Independent review and approval of transactions by both corporations' boards and management.
A business enterprise should sell services, products or labor at fair market rates in inter-subsidiary transactions.
Any loans made by a business enterprise must be at fair market value.
Do not transfer funds between entities by internal account transfers rather than through bank drafts, etc.
Each corporation must maintain its own records, books of account, bank accounts, tax ID number. The records of each entity should be kept separate and apart from the records of every other entity.
Be careful about having multiple entities share office space, office equipment, or administrative staff. This is a real potential for commingling.
Every entity should file its own tax returns.
Maintain annual state filing requirements for each entity. Failure to file these reports will cause a technical dissolution, i.e., revocation of the state corporate charter. Even though good standing can usually be restored, you don't want to be sued while 'technically dissolved.'
In Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943), the court held that for federal income tax purposes, a parent corporation and its subsidiary are separate taxable entities so long as the purposes for which the subsidiary is incorporated are the equivalent of business activities or the subsidiary subsequently carries on business activities, unless the subsidiary is a sham or acts as a mere agent of the parent.
In Britt v. United States, 431 F.2d 234 (5th Circuit 1970) the court emphasized that where a corporation is organized with the bona fide intention that it will have some real and substantial business function, its existence may not generally be disregarded for tax purposes. However, where the parent corporation so controls the affairs of the subsidiary that it is merely an instrumentality of the parent, the corporate entity of the subsidiary may be disregarded.
Fact scenario: The subsidiary is a separate legal entity with its own board of directors, officers, and staff. No more than three of the seven members of its board of directors are also members of the parent's board of directors. The parent will have no involvement in the daily operations of the subsidiary. Both corporations will maintain separate accounting and corporate records. The subsidiary will pay dividends to the parent based on its 100 percent stockholding in the subsidiary. The subsidiary will pay the parent for the services of some the parent employees, on the basis of their prorated salary with the parent. Held: The activities of a separately incorporated subsidiary cannot ordinarily be attributed to its parent corporation unless the facts provide clear and convincing evidence that the subsidiary is in reality an arm, agent or integral part of the parent. PLR 200132040.