PIERCING THE CORPORATE VEIL

Is a shareholder always protected from corporate liabilities by the “corporate shell”?

A corporation and an LLC is a legal person or entity that exists separately from its shareholders. It may, therefore, contract or otherwise incur obligations apart from a shareholder. As a result, one desired aspect of a corporation is that shareholders (or in the case of an LLC, the members) are not individually liable for the debts or obligations of the entity. For purposes of our discussion, references herein to corporations will apply similarly to LLCs.

In some circumstances, however, courts will ignore the corporate identity and hold the individual shareholders liable for the debts and obligations of that corporation by applying a legal theory that is commonly referred to as the “alter ego doctrine.” Under this theory, if a party whose interest has been injured due to the acts of a corporation can prove that the corporation entity is the “alter ego” of one or more individuals, the court may hold the individuals themselves personally responsible for the injurious conduct.

Typically, an alter ego allegation is made against a corporation and its shareholders when the corporation’s assets or insurance are inadequate to respond to a claim or to pay a debt. A creditor who would otherwise go unpaid by the corporation will seek to hold its shareholders personally liable for the claim based on the theory that:

• The shareholder has not treated the corporation as an entity separate and apart from themselves so why should the Court,
•  When maintaining the corporate veil would be inequitable.

Piercing the corporate veil has been granted in 40% of the cases where the issue was raised. Piercing initiated by the federal government is effective in almost 60% of the cases it has raised and more than 80% of the time when raised in a regulatory context or in environmental litigation and in fraud cases.

The equitable remedy of piercing the corporate veil is applied in New Jersey in situations where the principal, i.e. owner, uses the corporation (or his LLC) as his “alter ego” and thus abuses the corporate form in order to advance his own personal interests. See Walensky v. Jonathan Royce International, Inc., 264 N.J. Super. 276 (App. Div. 1993). The two primary factors that weight in favor of an “alter ego” finding are the use of the business as a personal business conduit and a lack of a separate corporate identity. Judge Stripp distinctly summarized the criteria for piercing the corporate veil under New Jersey common laws as follows:

• A shareholder disregarded the corporate entity and made it into a mere instrumentality for their own affairs.
• There was such a unity of interest and ownership that the owners and the corporation have no separate existence; and
• Upholding the corporate veil would protect fraud or promote other injustice.

Piercing The Corporate Veil In Bankruptcy

In Bankruptcy proceedings, the court uses a concept called “substantive consolidation” to in effect pierce the veil. This doctrine permits the bankruptcy court to pool all of the debtor’s assets as well as the assets of affiliated entities owned by the debtor, in order to satisfy claims against the debtor. Substantive consolidation will be allowed when:

• The creditor dealt with the entities as a whole, and not as separate entities, and
• The affairs of the debtor are so intertwined that the consolidation would benefit all of the creditors.

A fruitful discussion of piercing the corporate veil in a bankruptcy case in New Jersey can be found in Buildings by Jamie, Inc., United States Bankruptcy Court, District of New Jersey, Case No. 96-39381. In Buildings by Jamie, Inc., the creditors of the bankrupt debtor sought to recover monies loaned to the debtor. The debtor was a close corporation which constructed homes for sale to third parties. During a certain period of time preceding the bankruptcy, loans were made to the debtor for use exclusively in the construction of these homes. The debtor did not repay the loans. The creditors allege that the debtor transferred the net proceeds of sale of several homes to Jamie, Inc. (not the debtor) for no consideration, which in turn transferred $100,000 to the individual owners again for no consideration. The creditors further allege that the debtors transferred accounts receivables to a related corporation for no consideration. The creditors further argued that the individual debtors used the loan money from a guaranty for their personal benefit including construction of their personal residence and the purchase of real property and renovation of business property which was not owned by the debtor. Finally, the creditors alleged that in a series of transactions the debtor transferred all of its cash and several thousand dollars worth of assets to a related corporation for no consideration. During the period in question, the debtor ceased operations but the related corporations continued operations virtually indistinguishable from the debtor’s business. These corporations were operated from the same location, by the same employees, shared the same offices and had the same shareholder.

The plaintiff sought to compel the debtor to repay the loan obligations and the transfers among debtor and non-debtor defendants. In doing so, they allege that the individual shareholders were liable for the debtor’s debts based upon an “alter ego theory.” The plaintiffs relied on lack of corporate formalities among the debtor and the non-debtor defendants as well as the free transferability of assets and share ownership, use of the same employees, same location and same line of business.

The plaintiffs sought to pierce the corporate veil based upon the complete disregard of corporate formalities, free transfer of assets among the corporations and the shareholders and the interchangeable use of corporations.

In reviewing New Jersey alter ego law, Judge Stripps sitting in the Bankruptcy Court reaffirmed the principal that it is well settled in New Jersey that the doctrine of piercing the corporate veil is employed when fraud or injustice has been perpetrated. The court stated that the principal (owner) could be held liable under theories of piercing the corporate veil and successor liability because the principal “was using the corporation as his “alter ego” and thus was abusing the corporate form in order to advance his own personal interest.” Factors which weighed heavily included the principals treatment of the corporation as a personal business conduit and that the corporation was a mere instrument through which the shareholder conducted their own affairs and furthermore the principal failed to maintain an identity separate and apart from the corporation. The court also noted that in New Jersey courts generally pierce the corporate veil where such unity of ownership exists where the corporation operates as an instrument of the shareholders’ personal business such that the failure to disregard the corporate entity would promote fraud. Finally, a court concluded that the bankruptcy trustee had the power to reach beyond the debtor corporation into the pockets of the corporation’s shareholders.

HOW TO AVOID HAVING THE CORPORATE VEIL PIERCED

Shareholders are not liable for corporate debts or lawsuit liability if the corporation is properly established and maintained. To help insure that creditors cannot pierce the corporate veil and seek judgments against the shareholders, corporate formalities must be observed, the corporation must be treated as an entity separate and apart from its shareholders. Make sure the corporation has done the following:

• Documentation and Formalities. Create By-Laws, issue stock, maintain an up to date corporate minute book (do not wait for the night before an audit to create them), have separate books of account, file annual reports, have regular board meetings with all directors.
• Avoid co-mingling. Do not co-mingle corporate assets with those of shareholders, all corporate assets should be titled in the corporate name. Corporations should have its own separate bank account. If you borrow from, or lend to the corporation, record an appropriate Resolution, sign a promissory note, charge fair market rate interest, make regular payments.
• Capitalization. Appropriately capitalize the corporation and purchase appropriate liability insurance.
• Employment Agreements. Enter into one between you and your corporation.
• Multiple Corporation. Avoid identical stock ownership of several corporations. Avoid having similar officers and directors. Use different business addresses, telephone numbers and employees.

In addition, the fact that a business is being operation as the corporation should be made evident. The words “Inc.” or “Incorporated” should be present on letterheads, business cards and corporate signs. Those who operate the entity should sign all contracts and documents in a corporate capacity indicating their corporate position.

In these uncertain times, the valuable advice you give your clients can pay dividends. An important part of estate planning and wealth preservation is the protection of assets. Keeping corporate liabilities separate from shareholders is an important part of the asset protection plan.

 

Is a Sale Price of a Residence Evidence of Its True Value for Purposes of Real Property Tax Assessments?

The residence sale price standing alone is insufficient to provide reliable evidence of market value in the absence of other corroborative evidence.

The New Jersey Tax Court has affirmed a municipality’s determination of true value of a residential property after finding that the purchaser’s sale price standing alone was insufficient to provide a reliable evidence of market value.

In these difficult economic times for homeowners and municipalities, the payment and receipt of real property taxes are important. Real property taxes are assessed and paid based on a property’s full and fair value which is defined as the price of the property would sell for at a fair and bona fide sale by private contract on October 1. However, taxable value is a fixed percentage of true value. Hence, how true value is determined is critical in a challenge of the assessed value of a residence.

Recently, in Gibbons v. City of East Orange; No. 019151-2010, a residence located in East Orange was assessed at $262,100 but was purchase for $125,000. Within a month after the assessment, the owner challenged the assessment however the Board of Taxation entered a judgment affirming the assessment. The owner appealed to the Tax Court maintaining that the assessment should be the purchase price of the residence, namely, $125,000 not the assessed value.

The Tax Court noted that it is well-established that "[o]riginal assessments and judgments of county boards of taxation are entitled to a presumption of validity." The scope of this presumption has been stated as follows:

● The presumption attaches to the quantum of the tax assessment.

● Based on this presumption the appealing taxpayer has the burden of proving that the assessment is erroneous.

● The presumption in favor of the taxing authority can be rebutted only by cogent evidence, a proposition that has long been settled.

● The strength of the presumption is exemplified by the nature of the evidence that is required to overcome it. That evidence must be definite, positive and certain in quality and quantity to overcome the presumption.

The Tax Court found the assessment to be correct because "in tax matters it is to be presumed that governmental authority has been exercised correctly and in accordance with law." Pantasote Co. v. City of Passaic, 100 N.J. 408, 413 (1985). The presumption remains "in place even if the municipality utilized a flawed valuation methodology, so long as the quantum of the assessment is not so far removed from the true value of the property or the method of assessment itself is so patently defective as to justify removal of the presumption of validity." Transcontinental Gas Pipe Line Corp. v. Township of Bernards, 111 N.J. 507, 517 (1988).

To overcome the presumption, the property owner must provide "sufficient competent evidence to the contrary." Little Egg Harbor Twp. v. Bonsangue, 316 N.J. Super. 271, 285-86 (App. Div. 1998). The evidence "must be 'sufficient to determine the value of the property under appeal, thereby establishing the existence of a debatable question as to the correctness of the assessment.'" West Colonial Enters, LLC v. City of East Orange, 20 N.J. Tax 576, 579 (Tax 2003).

After the presumption is overcome with sufficient evidence, the court must "appraise the testimony, make a determination of true value and fix the assessment." Rodwood Gardens, Inc. v. City of Summit, 188 N.J. Super. 34, 38-39 (App. Div. 1982). The court must decide “based on a fair preponderance of the evidence." Ford Motor Co. v. Township of Edison, 127 N.J. 290, 312 (1992). The burden of proof remains on the taxpayer throughout the entire case to demonstrate that the judgment under review was incorrect.

The comparable sales approach is generally accepted as an appropriate method of estimating value for a residence. In this approach, the market value for the subject property is derived by comparing similar properties that have recently sold with the property being appraised, identifying appropriate units of comparison, and making adjustments to the sale prices of the comparable properties based on relevant, market-derived elements of comparison.

In Gibbons, the Plaintiff did not offer any comparable sales or any other evidence to establish that the assessment on the residence was incorrect, or that its market value should be $125,000 (the residence’s purchase price) as of the date of assessment. The Plaintiff contended that because the residence’s sale was between a willing seller and herself, a willing buyer, the residence’s sale was a reliable indicator of its market value.

The Tax Court noted that the "sales price of a property may be the best indicator of its true value in some circumstances." Passarella v. Township of Wall, 22 N.J. Tax 600, 603 (App. Div. 2004). However, while a property's sale price may be evidence of market value, it still requires that the sale meets the other requirements of market value. As stated in Romulus, 7 N.J. Tax at 316-18, the sale price of the subject "is a guiding indicium of fair value and ordinarily is merely evidential although it might under peculiar circumstances become controlling, subject to the limitation that the determination properly involve[s] the weighing and appraising of all component factors and adventitious circumstances." The weight, if any, to be afforded the sale must depend upon all of the facts and circumstances surrounding it.

The municipality argued that the sale of the residence, while not a sham, was nonetheless unusable to determine its market value because it lacked “market exposure,” and it was not an arms' length transaction because the seller was ill and eager to dispose of the vacant property as quickly as possible. The owner countered that there were no special circumstances or conditions for the sale as she was given no financing or other concessions by the seller. She argued that the residence had been sufficiently exposed to the market because it was listed and sold through real estate brokers and had other offers besides hers.

The Court noted that an arms' length transaction is one between a knowledgeable buyer, under no compelling obligation to buy, and a willing knowledgeable seller, under no compelling obligation to sell. Coastal Eagle Point Oil Co. v. West Deptford Tp. 13 N.J. Tax 242, 301 (Tax 1993).

In Gibbons, the Court said the evidence as to the surrounding circumstances of the sale of the residence tended to establish that the sale price was not a reliable indicator of the residence’s market value. It noted that the residence was vacant and in need of repairs/maintenance. The MLS also noted the need for fixing up of the residence. It was also not disputed that the owner was ill and in a nursing home. There were no negotiations with the seller or his daughter. Rather, plaintiff's first offer was immediately accepted. These facts, the Court noted, corroborate the statement in the MLS that the owner was "anxious" to sell. The evidence thus indicated that the seller desired to make a quick sale, which tends to prove that the residence was sold by one who was under a compelling obligation to sell.

Finally, that plaintiff was a willing and knowledgeable buyer did not overcome the evidence that the seller's daughter desired to make a quick sale of her father's vacant house. The Court emphasized each party must not be under any urgency or compulsion to finalize the transaction.

Therefore, the residence’s sale price, standing alone, was insufficient to provide a reliable evidence of market value in the absence of any other corroborative evidence of comparable sales or of market conditions. The court found that the plaintiff has not met her burden to prove by a fair preponderance of the evidence that the judgment of the Board of Taxation was incorrect.

The result reached by the Tax Court while not surprising underscores the difficulty a property owner has in challenging a real property tax assessment especially where the purchase price is less than the assessed value. One would think that sale price would carry more weight but in the final analysis it is only evidence of value and not determinative.

Yet Another Wealth Tax!

In today's Wall Street Journal in an article entitled "The Conservative Case for a Wealth Tax"

the author, a Stanford Professor, argues for the introduction of yet another tax system to “hit old wealth along with new wealth.” His proposal, an annual “modest” tax of 3% of wealth over $3,000,000 is just the “key to flattening the income tax to make it more revenue efficient.”

The author conveniently fails to mention that we already have a “wealth tax;” its call the Estate Tax!

Putting aside the social and political issues, implementation is nearly impossible. We estate planners have enough trouble obtaining valuation for gifts by donor’s; imaging having to valued everything you own each year until the day you die and to then have your estate and heirs continue this problematic and expensive exercise.

Do we really need yet another tax system?

Don’t Know Whom You Are Giving Your Bonus to Until After Year End? No Problem, Take a Deduction!

In Rev. Rul. 2011-29, 2011-49 IRB 1, the IRS has ruled that an employer can establish the "fact of the liability" under §461 for bonuses payable to a group of employees even if the employer does not know the identity of any particular bonus recipient and the amount payable to that recipient until after the end of the taxable year.

Under section 461(a), the amount of any deduction or credit must be taken for the tax year that is the proper tax year under the method of accounting the taxpayer uses to compute taxable income. Hence a liability is incurred under the accrual method of accounting when:

(1) all the events have occurred that establish the fact of the liability,

(2) the amount of the liability can be determined with reasonable accuracy, and

(3) economic performance has occurred for the liability.

This is sometimes referred to as the “all events test.” The ruling dealt with the first prong of the all events test.

Generally, all events occur to establish the fact of a liability when (1) the event fixing the liability (performance or some other event) occurs, or (2) payment is unconditionally due.

In the ruling the employer uses an accrual method of accounting for federal income tax purposes and pays bonuses to a group of employees for services performed during the tax year. The minimum total amount of bonuses payable to the employees as a group is determinable either through a formula that is fixed before the end of the tax year or through other corporate action, such as a resolution of the board of directors. Bonuses are paid after the end of the tax year in which the employee performed the related services but before the 15th day of the third calendar month after the close of that tax year.

Relying principally on Washington Post Co. v. United States, 405 F.2d 1279 (Ct. Cl. 1969) and United States v. Hughes Properties, Inc., 476 U.S. 593 (1986) The IRS found that the employer's liability to pay a minimum amount of bonuses to the group of eligible employees was fixed at the end of the year in which the services are rendered. It is irrelevant, the IRS noted, that the identity of the ultimate recipients and the amount, if any, each employee will receive cannot be determined before the end of the tax year. Accordingly, for purposes of the first prong of the test under reg. section 1.461-1(a)(2)(i), all the events have occurred by the end of the tax year that establish the fact of the employer's liability to pay the minimum amount of bonuses.

The IRS also indicated that any change in an employer's treatment of bonuses for the purpose of conforming to Rev. Rul. 2011-29 is a change in method of accounting that must be made in accordance with sections 446 and 481, as well as the applicable regulations and administrative procedures.

New Jersey Couple Scores a Victory Against Bernie Madoff and the Division of Taxation

The New Jersey Tax Court recently held that a married couple was entitled to recover the Gross Income Tax (GIT) paid on dividends and capital gains reported as earned through their investments with Bernie Madoff. The taxpayers filed a claim for refund of gross income taxes paid by them for the tax years 2005, 2006 and 2007 with respect to capital gains and dividend income reported as earned through their investments with Madoff. They learned in 2008, that, in fact there had been no earnings, and that Madoff’s report to them of various security transactions and income earned from those transactions were fictitious. The Division of Taxation denied their refund claims.

The Division refused to stipulate to the facts surrounding the operation of the Madoff Ponzi scheme, however, the Director implicitly accepted the factual underpinnings of the plaintiff’s case in his official pronouncements with respect to the Madoff scheme; the court concluded that those facts constituted stipulated facts.

The taxpayers argued that they were entitled to refund of taxes paid on their factitious income. They also argued that their election to treat the loss as a theft loss on their federal income tax return did not preclude them from claiming refunds under the GIT Act. The Division of Taxation contended that the dividends and capital gains income were taxable because the taxpayers constructively received the income. They also argued that pursuant to its April 15, 2010 notice, victims of the Madoff fraud may only report a capital loss in 2008, the year in which the fraud was discovered and in accordance with the federal procedures for theft losses.

The Tax Court held that the taxpayers were entitled to income tax refunds because the dividends and capital gain income reported on their tax returns simply did not exist. The Tax Court found that there was never any sale, exchange or other disposition of property because the transactions reported by Madoff sent to the taxpayers never took place. The court then held that the Division of Taxation’s position that the only relief available to the taxpayers was to claim a capital loss in accordance with federal procedures was unreasonable. It found that there was no principal reason why the taxpayer should be required to use a federal procedure that relies upon federal tax code concepts that are not recognized by the Gross Income Tax Act. The court then found in favor of the taxpayers allowing the theft losses against the taxpayers gross income tax.

IS THE $5 MILLION GIFT TAX EXEMPTION ABOUT TO END?

The Tax Relief Act of 2010 made significant changes to the gift, estate and generation-skipping transfer tax regimes by increasing the amount each individual can give without incurring tax from $1 million to $5 million.  The increase was not permanent however, and rumor has it that it may be in jeopardy.  To avoid any risk, those who have decided to use their full exemptions should do so no later than December 31, 2011, and, if feasible, November 22.

The Rumors

Rumors circulating recently within the financial and estate-planning communities have suggested the $5 million exemptions may be in immediate jeopardy.  Democratic staff on the U.S. House Committee on Ways and Means recently proposed decreasing the $5 million gift, generation-skipping transfer tax and estate tax exemptions to $3.5 million, effective January 1, 2012.  There also are rumors the Joint Select Committee on Deficit Reduction (the Super Committee) may recommend a drop down in the gift tax exemption to $1 million, effective at year end, or possibly as early as November 23, 2011, when its recommendations are scheduled to be released, though there is no confirmation this rumor is true.

As we all know "everything" is on the table before the super-committee (although they would not admit it), I would caution you to advise your clients of these developments and act sooner rather than later.

Unlike the Federal Tax Treatment of Bad Debts, New Jersey Taxpayers Are Not Entitled to a Bad Debt Deduction

The New Jersey Appellate Division in Waksal v. Director, Division Of Taxation determined that a New Jersey couple could not report losses to offset capital gains on their New Jersey income tax return.

In January 2002, Harlan W. Waksal loaned $14,769,320 to his brother, who signed a promissory note and agreed to repay the loan on or before January 31, 2004. His brother then defaulted on the loan. Subsequently, plaintiffs filed a 2004 Federal Individual Income Tax Return and reported a short term capital loss of $14,769,320. They also filed a 2004 New Jersey Gross Income Tax Return and reported the same amount as a loss from the "sale, exchange or other disposition of property," pursuant to N.J.S.A. 54A:5-1(c). After using the loss to offset capital gains, they reported $6,644,022 as a net gain in their New Jersey tax return.

The New Jersey Appellate Court affirmed the summary judgment granted to the Director, Division of Taxation. The Waksals argue primarily that their nonbusiness bad debt was "a sale, exchange or other disposition of property" under N.J.S.A. 54A:5-1(c), and, as a result, they are allowed to report the loss on their New Jersey Gross Income Tax Return and offset capital gains. Because the New Jersey Gross Income Tax Act (the Act), N.J.S.A. 54A:1-1 to -10, does not permit such a deduction, the trial court’s decision was affirmed.

The trial court relied in part on Walsh v. Director, Division of Taxation, 15 N.J. Tax 180 (App. Div. 1995), and King v. Director, Division of Taxation, 22 N.J. Tax 627 (App. Div. 2005), which held that a loss from a nonbusiness bad debt could not be used to offset gains "derived from the sale, exchange, or other disposition of property" under N.J.S.A. 54A:5-1(c). The trial judge indicated that "net gains or income from disposition of property" is considered taxable income under N.J.S.A. 54A:5-1(c), which provides in part that New Jersey gross income consists of certain categories, including:

Net gains or net income, less net losses, derived from the sale, exchange or other disposition of property, including real or personal, whether tangible or intangible as determined in accordance with the method of accounting allowed for federal income tax purposes.

The judge reasoned that the Act "does not mirror federal taxing statutes" and observed that the Supreme Court explained in Smith v. Director, Division of Taxation, 108 N.J. 19, 32 (1987), that:

Even a cursory comparison of the New Jersey Gross Income Tax and the Internal Revenue Code indicate [sic] that they are fundamentally disparate statutes. The federal income tax model was rejected by the Legislature in favor of a gross income tax to avoid the loopholes available under the Code.

The court recognized that in Walsh the Legislature determined that the New Jersey Gross Income Tax should contain fewer deductions from income than the federal income tax. This was seen as a way of making the Gross Income Tax fairer. The Legislature did not explicitly provide for a deduction of a nonbusiness bad debt. Thus, in view of the legislative history, it would appear that the Legislature did not intend for N.J.S.A. 54A:5-1c to be read broadly to include a deduction for nonbusiness bad debts.

On appeal, plaintiffs contend that the decision of the judge conflicts with N.J.S.A. 54A:5-1(c) and the Supreme Court's clear direction to apply substantive federal tax rules to determine net gains and loses.

In Walsh, the taxpayers sought to deduct a nonbusiness bad debt following a personal loan to a corporation in which they were also shareholders. The corporation then transferred its assets to a second corporation, "but [the taxpayers] remained liable as . . . guarantor[s] on the bank loans." After the second corporation defaulted on the bank loans that the taxpayers guaranteed, the taxpayers paid off the debt and deducted the losses on their New Jersey Gross Income Tax return.

Quoting the Tax Court, the Appellate Court held that the worthless debt, although treated as a loss from the sale or exchange of a capital asset held for not more than one year . . . under the Internal Revenue Code, does not fit the statutory rubric of sale, exchange or other disposition of property" found in N.J.S.A. 54A:5-1(c).

Because Waksal's loss from their nonbusiness bad debt cannot be used to offset gains derived from the "sale, exchange or other disposition of property" under N.J.S.A. 54A:5-1(c), the judge concluded that plaintiffs could not report the loss to offset capital gains on their New Jersey income tax return.