C Corporations file their own tax returns and pay their own federal income tax on profits, separate from their owners. That fact along with the second tier of tax that occurs when an owner, a natural person, receives those profits, typically as a dividend, has long made the C corporation less attractive for tax optimization for small business operators. A key exception has been businesses with extremely risky cash flows where there was concern that there wouldn’t be sufficient funds to pay the business income taxes along with other debts. Cannabis businesses have been the prime example of this scenario in recent years. Many of these companies have opted for the C Corp tax structure in a misguided attempt to shield the owners from responsibility for meeting the businesses income tax obligations.
Some lawyers and consultants, divorced from the operating realities of most small businesses and cannabis companies in particular, have relied too heavily on the conceptual notion that because the federal income tax obligation of a C Corp is a debt of the Corp, state laws prevent the IRS from pursuing the owner’s for unpaid taxes. While I agree that this magic shield is theoretical possible under the law, it is functionally impractical for the vast majority of small businesses needing to use it in that way.
A recent federal tax case in the Firth Circuit illustrates the point. Pick-Ups, Inc. was a used car business structured as a C Corp that was owned by a single person, who was the corporation’s official officer and director. The District Court and later Court of Appeals concluded that the owner was individually liable for the corporations income tax, about $1.7 million. The key factors the courts weighted were
(1) The individual taxpayer was the sole shareholder, officer, director and owner of Pick-Ups
(2) He exercised complete dominion and control over Pick-Ups
(3) He failed to observe corporate formalities
(4) He loaned substantial money to Pick-Ups
(5) He paid personal loans using the corporation's bank account.
The courts ruled that the corporation under these circumstances was just the individual taxpayers, “alter ego.” First I would point out that one or more of these factors are fairly common in small businesses. I can also envision Operators reading this and thinking, well, I don’t have any of these factors so I’m good. It’s important to understand that the Courts were not providing an exclusive list of what could cause the corporation to be considered nothing but an individual taxpayers alter ego. The failure to observe corporate formalities and transactions between the company and it’s owners are ubiquitous within small businesses.
So you will do everything “right” you say?
But have you considered the cost?The problem with this entire concept is the lack of experienced appreciation for the compliance costs in maintaining the appropriate accounting and legal documentation on an ongoing basis that would be required to truly defend this structure and make this magic shield.In other words what the lawyers and consultants aren’t telling you is that the fees you paid upfront to setup this structure are not the end of it.To make it work, you would need to continue incurring substantial professional fees from accountants and lawyers to correctly operate this structure.From a business standpoint, I have rarely seen where that is worth it and let’s face it operators… you aren’t going to do it.