The Treatment of Nominee Corporations for Income Tax Purposes

• Publication year: 1992

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 16, No. 2WINTER 1993

The Treatment of Nominee Corporations for Income Tax Purposes(fn*)

Norton L. Steuben(fn**)

I. Introduction

Nominee corporations are often used in real estate transactions to hold title to property for the benefit of the actual developer.(fn1) The typical reasons for forming these corporations are to avoid personal liability, circumvent usury laws, and conceal the identity of a developer. The nominee corporation will usually enter into an agreement with the developer to hold title to the property as the nominee or agent of the developer and to treat the property and all revenues and expenses of the property as belonging to the developer.

If, however, the nominee corporation is treated as the "true" owner of the property for income tax purposes, the earnings will be subject to a double tax: first, when earned by the corporation; and second, when distributed as dividends to the shareholders.(fn2) In addition, the nominee corporation, rather than the developer, will be entitled to the various deductions that result from the ownership and operation of the property.(fn3) Lastly, the conveyance of the property from the nominee corporation to the developer may be treated as a taxable event.(fn4) To sustain the treatment of the developer as the "true" owner of the property for income tax purposes, developers who have used nominee corporations have argued that these corporations should be treated as "nonentities" for tax purposes(fn5) or, alternatively, as agents acting on behalf of the developers of the property.(fn6)

An individual could be substituted for the nominee corporation for any of the purposes described above, other than the avoidance of usury limits. The use of an individual as a nominee or agent, however, may result in significant problems. For example, an individual might refuse to convey the property to the developer when the developer requests the conveyance. Moreover, an individual might convey the property that he or she holds as an agent to a third party. Finally, an individual acting as an agent or a nominee might have creditors who attempt to levy on the property held by the agent or nominee. Because of these problems, and because individuals are subject to usury limits, a developer will prefer to use a nominee corporation, particularly a nominee corporation controlled by the developer.

If a nominee corporation is considered a nonentity or an agent, any expenses paid while the project property is held by the nominee corporation can be deducted or capitalized by the developer.(fn7) If, however, the nominee corporation is considered an entity and not an agent, the expenses incurred while the property is held by the nominee corporation can only be deducted or capitalized by the nominee corporation, and the payment of these expenses by the developer may be considered capital contributions by the developer to the nominee corporation.(fn8) Any income received from the property during the time it is held by the nominee corporation will be treated as the developer's income if the nominee corporation is considered a nonentity or an agent. On the other hand, if the nominee corporation is considered an entity and not an agent, it will be regarded as the owner of the income derived from the property during the time the property is held by the nominee corporation. The problem presented is getting the income out of the hands of the nominee corporation and into the hands of the developer without incurring a second tax on the income.

A conveyance to the developer of the property held by the nominee corporation will not be considered a taxable event if the nominee corporation is considered a nonentity or an agent of the developer. If, however, the nominee corporation is considered an entity and not an agent of the developer, then the conveyance of the property to the developer could be considered, in the appropriate situation, a dividend paid by the nominee corporation to the developer. In the alternative, the conveyance of the property by the nominee corporation to the developer might be treated as a sale to the developer. Lastly, the conveyance of the property by the nominee corporation to the developer might be considered a liquidation of the nominee corporation rather than a dividend or a sale.

This Article traces the development of the nonentity and agency approaches to the treatment of nominee corporations. The nonentity approach had a short lifespan and is of little use today.(fn9) The agency approach, in contrast, experienced a period of development that resulted in a complex six-factor test that was employed in at least three circuits.(fn10) When a conflict in the application of the six-factor test developed, the Supreme Court in Commissioner v. Bollinger(fn11) enunciated a different approach and established a new, more workable standard.(fn12) This Article explores the limitations of that standard as well as its practical application for planners.(fn13)

II. The Road to Bollinger

Prior to Bollinger, the federal courts addressed two theories through which developers could be treated, for income tax purposes, as the owners of property, the title to which was held by nominee corporations: the nonentity theory and the agency theory. These theories are addressed in turn.

A. The Nonentity Approach

While a nominee corporation may hold record title to a real estate development, the developer would like to personally have the income tax benefits flowing from the development and ownership of the real estate. One means of achieving this goal is for the developer to successfully assert that the nominee corporation should be disregarded for income tax purposes.(fn14) The developer will assert "that because of its limited purpose, the [nominee] corporation [is] a mere fig-mentary agent which should be disregarded in the assessment of taxes."(fn15) As a practical matter, the developer will assert that the nominee corporation does not exist for income tax purposes because the nominee neither develops nor operates the real estate, but only holds the real estate for a limited incidental purpose.

Moline Properties, Inc. v. Commissioner(fn16) presented the Supreme Court with an opportunity to consider the nonentity theory. In Moline, a creditor of Mr. Thompson suggested that he convey certain of his individually owned real estate to Moline Properties, Inc., which would assume the outstanding mortgages on this real estate. Mr. Thompson did as the creditor suggested and received in return almost all of the stock of the corporation. He transferred this stock to a voting trustee appointed by the creditor. The stock was to be held as security for a loan to Mr. Thompson that was used to pay back taxes on the real estate conveyed to the corporation. In 1933, this loan was repaid, the mortgages on the real estate were refinanced with a different mortgagee, and control of the stock of Moline Properties, Inc., reverted to Mr. Thompson. The real estate held by the corporation was sold in three parcels, one each in 1934, 1935, and 1936. The proceeds from these sales were received by Mr. Thompson and deposited in his bank account.(fn17)

Until 1933, the corporation's business consisted of the assumption of the mortgages on the real estate conveyed to it, the defense of certain condemnation proceedings, and the institution of a suit to remove restrictions imposed on the property by a prior deed. The expenses of the suit were paid by Mr. Thompson. In 1934, a portion of the real estate owned by the corporation was leased for use as a parking lot. The corporation kept no books, maintained no bank account, and owned no other assets during its existence.(fn18)

In deciding who should be taxed, the Supreme Court held that the corporation, rather than Mr. Thompson, was taxable on the gain from the sales of the real estate titled in the name of the corporation, stating: 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.(fn19)

Moline set practitioners and the courts on a quest to determine how much activity would be permitted before a nominee corporation was treated for income tax purposes as a separate taxable entity rather than a nonentity. To the dismay of practitioners, the courts concluded that it took very little activity to cause a nominee corporation to be treated as a separate taxable entity rather than a nonentity. For example, in Paymer v. Commissioner,(fn20) two brothers were in a partnership that owned and managed real estate. The brothers organized two corporations. The first corporation was called Raymep Realty Corp., Inc., and the second was called Westrich Realty Corp. The brothers conveyed to each of these corporations a parcel of income producing real estate. In return, each of the two partners received half of the stock of each corporation. The brothers conveyed the property to the corporations because one of them had been a co-signer on a note and a guarantor of an account, both of which were...