Commissioner of Internal Revenue v. Bollinger

PETITIONER:Commissioner of Internal Revenue
RESPONDENT:Bollinger
LOCATION:Chelsea, Michigan

DOCKET NO.: 86-1672
DECIDED BY: Rehnquist Court (1988-1990)
LOWER COURT: United States Court of Appeals for the Sixth Circuit

CITATION: 485 US 340 (1988)
ARGUED: Jan 13, 1988
DECIDED: Mar 22, 1988

ADVOCATES:
Alan I. Horowitz – on behalf of the Petitioner
Charles R. Hembree – on behalf of the Respondents

Facts of the case

Question

Audio Transcription for Oral Argument – January 13, 1988 in Commissioner of Internal Revenue v. Bollinger

William H. Rehnquist:

The opinion of the Court in Westfall against Irwin in No. 86-1672, Commissioner of Internal Revenue v. Jesse C. Bollinger.

Mr. Horowitz, you may proceed whenever you’re ready.

Alan I. Horowitz:

Mr. Chief Justice, and may it please the Court:

The issue in this case concerns the two-tiered structure established by Congress to govern the tax treatment of a corporation and its shareholders.

To briefly summarize that structure, it treats a corporation as a separate taxable entity that must recognize on its own return the tax consequences of its business activities.

The shareholders’ individual taxes are affected by this business activity only indirectly, that is, in connection with their own dealings with the corporate entity.

Corporate income is recognized by the corporation.

The shareholders pay tax on corporate income only when they receive a distribution of corporate earnings, either as dividends or liquidating distributions.

Similarly, when a corporation suffers net operating losses in a given year, that loss is deductible by the corporation on its own return and may be carried back to earlier years or carried forward for up to 15 years to be offset against corporate income in future years.

Such a loss would be reflected on the shareholders’ return, only if they dispose of their interest in the corporation or liquidate it.

Back in the 1940s, this Court in the Moline case, considered the question whether this two-tiered tax structure applied in full to so-called dummy corporations.

That is, situations where a closely-held corporation’s interest are essentially congruent with those of its shareholders or perhaps in many cases a sole shareholder, and where the business activity of the corporation is quite limited.

The facts of the Moline case are in many respects quite similar to those of the instant case.

In Moline, the Court held that the separate entity doctrine was fully applicable to the facts there.

In that case, the mortgagee had required an individual borrower to set up a corporation to hold title to mortgaged property.

The corporation engaged in little other business activity, and its expenses were paid directly by the individual shareholder.

Despite this limited activity and the undisputed fact that the individual was the beneficial owner of the property, the Court held that the corporation had to pay tax on the gain when the property was sold.

The Court summarized its holding, as follows, and I quote:

“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. “

The Court went on to say that once the taxpayer had chosen the corporate form for his own business purposes, he was bound by the tax consequences of this choice.

William H. Rehnquist:

There the corporation held the title to the property in its own name, the dummy corporation, didn’t it?

Alan I. Horowitz:

That’s right.

William H. Rehnquist:

So what this Court said was that the Code simply required the taxpayer to recognize the record state of affairs.

Alan I. Horowitz:

That’s right.

The corporation was the owner of the property and the fact that it really didn’t do anything other than operate for the individual shareholder didn’t mean that that could just be transferred to the individual shareholder.

When the property was sold, the gain had to be recognized by the corporation and a corporate tax paid on the gain.

Now, this principle of Moline was reaffirmed several years later by the Court in the National Carbide case, and it’s now a well-settled proposition, and indeed, a proposition that respondents do not directly challenge, although, as I’ll explain later, we think the thrust of their argument here would seriously undermine the Moline principle.

We believe that this case is governed by the rule of Moline.

Respondents in this case chose the corporate form for their own business purposes, and now they seek to avoid the tax consequences of that choice.

In short, they want to have their cake and eat it too.

Sandra Day O’Connor:

Mr. Horowitz, do you recognize the exceptions spoken of in dicta in National Carbide for a true agent?

Alan I. Horowitz:

We do.

We do recognize that exception.

There’s no question that two parties can deal with one another as an agent and a principal, in which case, the actions of the agent are imputed to the principal and the principal would take the tax consequences of that.

Sandra Day O’Connor:

Well, do you accept the explanation in National Carbide of when a true agency might exist?

Alan I. Horowitz:

You mean the so-called six factors that are set out in National Carbide?

Sandra Day O’Connor:

Right.

Alan I. Horowitz:

Yes, we have no quarrel with those.

We obviously quarrel with respondents over what the proper interpretation of those factors are.

We do think that that, in the case of a controlled corporation, that was intended to be a fairly narrow exception by the National Carbide Court, which I hope to explain in more detail a little bit later.

But we don’t back away from National Carbide.

William H. Rehnquist:

But here the dummy corporation if you’re right in saying, it did follow record state of title.

It reported income, did it not, to itself?

Alan I. Horowitz:

In this case?

William H. Rehnquist:

Yes.

Alan I. Horowitz:

I don’t think the corporation reported any income in this case.

All the income that came in and all the expenses that were expended in constructing the apartment complex and the interest paid on the loan was all reported on the partners’ individual returns.

William H. Rehnquist:

On the partners’ individual returns.

Alan I. Horowitz:

Now, basically the partners treated the corporation as a non-existent shell.

Now, they say in their brief that they concede that under Moline it was a separate taxable entity, and all they are quibbling about is were the particular transactions involved with these apartment complexes should be attributed directly to the partners, or not.

But the fact is is that that’s all there was in the corporation, that’s all that was going on.

There was no other income or any other business activity.

So essentially, they’re saying that the corporations have to be disregarded.

Antonin Scalia:

What would be needed here in order to make it separately taxable, or reportable on the individuals’ returns?

Alan I. Horowitz:

In order for it to be a true agent relationship?

Well, we think where there’s a controlled corporation situation, we think there is a pretty heavy burden to be borne by the taxpayer in showing that there’s actually a true agency.

The problem that requires this heavy burden, and we think this was set forth in the National Carbide case, is that the relations between a principal and his agent and the kind of control that a principal exerts over his agent is quite similar to the kind of control that a sole shareholder would exert over a closely held corporation, just in the exercise of the normal shareholder-corporation relationship.

So it’s kind of an easy expedient for avoiding the Moline rule to say, well, we’ve got this corporation, we set it up, we’re controlling it, but we’re not controlling it as shareholders, we’re controlling it as agents, and we’re going to write up a little agreement and call it an agency agreement.

That’s what the taxpayer tried to do in National Carbide and the Court rejected that.

Now, if you use an unrelated agent, then the situation is a lot clearer because there is no other basis for the control that the principal is exerting over the agent, so it’s easy enough for the Court or for the Service to credit the agency agreement.

William H. Rehnquist:

Well, the income here was received by a partnership, wasn’t it?

It wasn’t received by the corporation.

It was received by Creekside as CNA, whatever that is?

Alan I. Horowitz:

Well, what happened was the corporation went out and it got a loan from the bank in its own name, didn’t purport to be acting as an agent or anything like that, and then it took the loan proceeds and deposited them into an account that was called a construction account.

And that was not denominated as a corporate account, it was denominated as an individual account.

And then all the transactions sort of flowed out of that account.

Income from the apartments were funneled through–

William H. Rehnquist:

I thought it was Creekside Apartments, a partnership, the account.

Am I wrong?

Alan I. Horowitz:

–The account was in the name of the partnership.

That’s correct.

William H. Rehnquist:

So it wasn’t a corporate account?

Alan I. Horowitz:

It was not labeled as a corporate account, but the property was owned by the corporation and the corporation was the obligor on the loan.

So basically the Government’s position is that although they called it an individual account, they’re basically skipping a step.

I mean, that money all rebounded to the corporation.

William H. Rehnquist:

Well, this isn’t certainly a direct parallel to Moline?

Alan I. Horowitz:

I think it is.

In Moline, the Court specifically stated that the corporation there had no bank accounts.

William H. Rehnquist:

Yes, but there, the gain was recognized or property to which the corporation held title.

Here, this corporation didn’t receive the income.

Alan I. Horowitz:

Well, in both cases, the income was attributable to the property in which the corporation held title.

William H. Rehnquist:

Why do you say that?

Alan I. Horowitz:

Because the corporation here owned the apartment buildings and the apartments were rented out and the tenants paid rent to the owners–

William H. Rehnquist:

Well, you say, it was quote attributable close quote.

Is that just a descriptive word or is it a word that means something in the IRC?

Alan I. Horowitz:

–No, that’s just, I would say that’s a descriptive word.

The partners because you’ve got a controlled corporation and the corporation obviously doesn’t take any action that’s not directed by its officers.

John Paul Stevens:

Mr. Horowitz, the partnership didn’t own the stock in this corporation, did it?

Wasn’t one of the individual partners the owner?

Alan I. Horowitz:

Well, I mean, the facts are somewhat confusing.

John Paul Stevens:

In the other cases, in one more, I don’t remember the number, there are five or six cases, one of the cases the sole shareholder is the beneficial owner, and in the other case, some of the other cases, there’s a partnership that is treating it as income and the partnership didn’t own the corporation, just one of the partners.

Alan I. Horowitz:

Well, in most of the cases the corporation was solely–

John Paul Stevens:

Well, factually, am I correct?

Alan I. Horowitz:

–Yes.

In most of the cases, the corporation was solely owned by Bollinger and some of the apartment complexes, the partnerships were solely Bollinger, and some he had other partners who did not nominally own stock in the corporation.

Although, as we explained in the brief, and this discussions also reflected somewhat in the National Carbide decision, I think that the partners would be viewed by State law and by Federal Income Tax Law as constructive shareholders in these partnerships.

Because they were making payments all along out of their own pockets to pay corporate expenses.

That’s normally considered–

John Paul Stevens:

Well, the argument’s whether they were corporate expenses, or the corporation was an agent, and therefore they’re the principals’ expenses.

That’s the issue.

Alan I. Horowitz:

–That’s what you get down to, that’s the bottom line, but we believe–

John Paul Stevens:

And they paid the expenses of a corporate entity that they did not own.

Alan I. Horowitz:

–No, there’s no dispute that the corporation was the obligor on the loan.

John Paul Stevens:

And also that it was personally guaranteed by the partners in one case, and by the individual shareholder in the other, is that not true?

Alan I. Horowitz:

Yes.

John Paul Stevens:

So they were personally liable for the debt?

Alan I. Horowitz:

In part.

John Paul Stevens:

And they made the regular payments, and they were looked to as the principal obligors, even though they were even though the were in the form of–

Alan I. Horowitz:

Well, I think I have to disagree with that statement.

I mean even respondents concede in their brief that the principal obligor on the loan was the corporation.

John Paul Stevens:

–Was there a guarantee in the Moline Properties case?

I can’t tell from the opinion.

Alan I. Horowitz:

Well, in the Moline Properties case originally the loan was taken out directly by the individual, and then the bank asked them to set up this corporation and so the corporation then assumed the liability, assumed the mortgage.

John Paul Stevens:

Do you know from the opinion whether the individual, after the assumption by the corporation, remained liable on the note in the Moline case?

Alan I. Horowitz:

I don’t know whether there was a personal guarantee that was reflected in writing, but the Moline case is clear that the corporation had no bank accounts and had no money in its own name, so it’s clear enough that the individual was paying the loan and that the lender was looking to the individual for the payment of the loan.

John Paul Stevens:

Yes, but the ultimate security was the property whereas here, the ultimate security well–

Alan I. Horowitz:

No.

Here, the ultimate security is also the property, and that is why the corporation had to hold record title to the property.

Otherwise, title could have been held by the partners and they could have avoided some of these problems.

But a lot of these questions are focused on the income from the apartment complexes.

Alan I. Horowitz:

And of course, this case is really, at least the particular years involved here about the deduction of the expenses and the losses suffered by the corporation or the partners, as the case may be in the early years.

Certainly a large portion of those expenses was the interest expense paid on the loan on which the corporation was the obligor and the whole system wouldn’t work unless the corporation was the obligor.

William H. Rehnquist:

–Was that paid out of the CNA account, the interest?

Alan I. Horowitz:

It was paid out of this construction account to which the loan proceeds were dumped as soon as they were received.

And that gets you back to the original conundrum, I suppose, that we were talking about.

The corporation was directed to dump its money into this account that was in the partners’ name.

Now, if it was an unrelated corporation–

John Paul Stevens:

Mr. Horowitz, I interrupted you and I apologize, but I didn’t give you a chance to answer Justice Scalia’s question.

Alan I. Horowitz:

–At this point, Justice Scalia will have to remind me.

John Paul Stevens:

Which was what more should the taxpayer have done in order to make it a true agency relationship in your view?

Alan I. Horowitz:

Well, as I started to say–

Antonin Scalia:

You know, not ten things.

What’s the minimum they could have done that would have made you happy?

Alan I. Horowitz:

–Well, with an unrelated agent, it’s very simple, I think.

In the case of a controlled corporation, we agree that it’s a very heavy burden that they have to bear.

They have to show that the relationship was equivalent to an arm’s length relationship and that is hard to do in a case like this where the corporation was set up for no other purpose than to handle these loans of these particular partnerships that controlled it.

Byron R. White:

Sounds just like an agency, doesn’t it?

Alan I. Horowitz:

Not to me.

It doesn’t sound like an agency because of the peculiar and special tax structure that Congress has set up between corporations and shareholders in which I think you can say in a certain loose sense that a relationship between a corporation and its shareholders is always like an agency in the sense that you’re referring to.

The corporation is a legal person, but it’s not a real person, and it’s always operating for the benefit of its shareholders.

Byron R. White:

Well, I interrupted you again, and I’m sorry.

Alan I. Horowitz:

Well, you keep giving me the opportunity to avoid answering this question.

We gave an example in our brief of the sort of situation where we think it would be pretty clear that a controlled corporation could still operate as an independent agent, and that is one where it was already established as an agent and was operating not only for the partners that controlled it, but also for unrelated parties.

Antonin Scalia:

Cases where it’s a clear agent, I mean, but what facts in this particular case would be–

Alan I. Horowitz:

In this particular situation–

Antonin Scalia:

–If you just had to change a couple of facts, what would do the trick?

Alan I. Horowitz:

–No.

Well, we don’t think they can just change a couple of facts.

I mean, in this case, we think it’s the fact that they didn’t even bother to pay a fee to the Agency we think makes it crystal clear that there was no arm’s length relationship.

But even if they had paid a fee,–

Antonin Scalia:

But it has to be a compensated agency.

I mean, you can be an agent without getting compensated for it.

Alan I. Horowitz:

–You can be an agent without being compensated but it’s hard to describe it as an arm’s length relationship, if there’s no compensation.

Sandra Day O’Connor:

Well, Mr. Horowitz, wouldn’t even in an arm’s length relationship, the fee for holding bare legal title seems to me could be quite minimal.

And I’m not sure I see the significance of–

Alan I. Horowitz:

Well, I don’t think it would be zero, because the corporation is doing things.

It’s exposing itself to liability, for example, if a tenant trips on the ice in front of the apartment building and then sues the corporation.

Now, I mean, here because the corporation was hardly different from Bollinger, that may seem like not a big deal.

But that gets you back to the argument that the corporation shouldn’t be distinguished from the shareholders because they are all kind of intertwined together, mixed up in the same thing.

That’s the argument that the Court rejected in Moline.

Byron R. White:

–But you’d be satisfied, I take it, if one of these partners had a father who owned a title company and they just went over to the title company and said, would you please hold the title to this property for us, and the company said, sure.

And we won’t charge you anything either.

You’d be all right?

Alan I. Horowitz:

And the title company doesn’t charge any of its clients anything?

Byron R. White:

Well, it doesn’t charge this one.

Alan I. Horowitz:

Well, if it doesn’t charge this one, it seems to me, it’s not really acting as an arm’s length agency.

Byron R. White:

It’s not an agency?

So you mean, it won’t be enough for you even if it’s an independent corporation not controlled at all?

Alan I. Horowitz:

Well, no.

If it’s an independent corporation–

Byron R. White:

Well, it’s an independent corporation.

It’s owned by the man’s father, but the man’s father’s not part of the partnership.

He’s just a good guy, a good dad.

Alan I. Horowitz:

–Well, that’s probably all right then.

I mean, the whole concern of National Carbide is distinguishing the control of the corporation, that the stockholders exert over–

Byron R. White:

So if they went through these same motions they went through here with this title company that I talked about, it would be all right.

Alan I. Horowitz:

–If it was an unrelated–

Byron R. White:

And the only problem is the controlled corporation, is that it?

Alan I. Horowitz:

–That’s the problem under the so-called fifth factor of National Carbide.

And I really want to emphasize that that’s a serious problem because it’s that problem that is what undermines Moline.

Alan I. Horowitz:

In Moline, you’ve established a tax structure in which the corporation and shareholder despite their identity of interest need to be treated as separate taxable entities.

And in this case, you have shareholders that are trying to get around that rule essentially by saying, well, we’ll just call it an agent, even though our relationship with the corporation is really no different.

Antonin Scalia:

You’re asking for some special rule.

You’re saying that what might be enough to establish agency in the ordinary situation where there’s not a corporate control relationship isn’t enough in the corporate control relationship.

That because of the difficulty deciding how much of the control comes from agency and how much comes from the stock ownership, you’re going to require a specially high burden of proof, is that principally what you’re saying?

Alan I. Horowitz:

I think that’s right.

We’re saying that there’s at least a presumption, a burden that the shareholders have to overcome and they use a controlled corporation as a purported agent that they need to show like it’s really like dealing with an unrelated agent.

Antonin Scalia:

So even if it might be enough if your father did it for you, it wouldn’t necessarily be enough if a controlled corporation did it for you because you have no other way of controlling your father, whereas you do have another way of controlling a controlled corporation.

Alan I. Horowitz:

Well, that’s right.

And the so-called agency adds nothing to the other ways that you have of controlling the corporation and therefore it doesn’t provide a reason to depart from what would ordinarily be the tax consequences of using your corporation.

I really would like to emphasize that although this is a heavy burden that may be difficult to meet, we don’t think that that’s unfair or unreasonable.

If you look at this from the perspective of the shareholders, they have two choices.

They can use a controlled corporation, if they really want to use an agent, let’s say, they can use a controlled corporation as an agent or they can use an unrelated corporation as an agent.

John Paul Stevens:

Now, there’s another choice, they could use an employee, they could use the secretary in the office as the nominee and give her all the protections, all the guarantees, agree to insure the property and all the rest.

Would she be an agent or not?

Alan I. Horowitz:

Here, they needed to use a corporation.

John Paul Stevens:

But assume you had a situation for a different reason other than usury that you felt it necessary to use the nominee.

You’d say that… I don’t know why that would be any different that you’d then have an individual who’d have to report the income and so on.

Alan I. Horowitz:

Well, if you’re using an individual as an agent, you don’t run into any of the problems that you have here.

And the concern here is whether the separate tax identity of a corporation is going to be disregarded.

John Paul Stevens:

You might have different brackets.

Maybe you don’t anymore, but depending on who got the income first.

Alan I. Horowitz:

Well, you might have different brackets, but I don’t think we’d be taking… I mean, it’s just not a concern.

The concern here is that this is a way of avoiding corporate tax.

John Paul Stevens:

You don’t think there’s any tax avoidance motive here do you?

Alan I. Horowitz:

In setting up the corporation, no.

The reason for setting up the corporation was to get the loan and avoid the Kentucky usury laws.

But the reason for this litigation is tax avoidance, not tax avoidance in a pejorative sense, but the tax consequences of being treated as a partnership are more advantageous to the respondents than being treated as a corporation.

What they wanted to do was they wanted to be able to take their losses immediately and offset them against other income that they have rather than if it’s treated as a corporation, they’ll have to wait to take the losses until the apartment complexes begin to show profit a few years down the road.

So it’s an opportunity to accelerate the losses that the take.

Alan I. Horowitz:

I’d still like to say one more thing in response to Justice Scalia’s question.

I think basically at least if you’re going to use a corporation as an agent, you’ve got two choices.

You can use a controlled corporation, you can use an unrelated corporation.

Now, if it’s truly an arm’s length relationship, there’s really no reason not to use an unrelated corporation.

And therefore we think the fact that these kind of partnerships always use a controlled corporation and the facts in this case and the facts in the Frink case that’s also pending before this Court, both reflect that the partnerships were unwilling to enter into these kind of agreements unless they could use a controlled corporation.

They reflect that there’s more going on than just an arm’s length agency relationship.

If they’re going to choose to use a controlled corporation, there ought to be a presumption that there is a degree of control that’s being exercised that’s different from the normal principal agent relationship.

John Paul Stevens:

What’s wrong with the motive that it may be a little cheaper to form a corporation than to ask some national corporation to use one of their subsidiaries or something like that?

Isn’t that a legitimate business justification for doing it?

Alan I. Horowitz:

Well, why is it cheaper, Justice Stevens?

It’s cheaper only because the corporation is related, and therefore–

John Paul Stevens:

That’s right.

Alan I. Horowitz:

–Well, and therefore the agent is giving them a break because of the control that the stockholders exert over it.

John Paul Stevens:

If all of the legal incidents of the relationship are identical, whether there’s compensation or not, why is one an agency and the other not?

I just don’t understand.

If all of the controls and all of the potential liability and risks of the profit and loss and everything else are the same, I don’t understand why the fact you may pay somebody like Corporation Trust Company $100 a year for performing this service should change the relationship?

Alan I. Horowitz:

Well, I would agree that $100 a year here or there should not, that the Court should not come up with a ruling that’s going to make it turn on that.

But I think I have to go back to the basic principle that there’s this entire structure set up that recognizes corporations as separate entities, even though they may be doing things on behalf of their shareholders, they’re not very different from the kinds of things that an agent might do for someone.

And that’s structure is seriously undermined if you can allow the shareholders to treat some of the operations as agency operations, and not treat the corporation as a separate entity for that.

If you’re using an unrelated agent, then the agent really has no personal interest in what he’s doing, and kind of turns it all over to the principal and acts in the name of the principal.

But when you’ve got a corporation–

John Paul Stevens:

But the case might be different if the law firm that represented these people formed a corporation and the partners in the law firm just served as stockholders and so forth, and then used this corporation for this purpose.

Would that be a different case?

Alan I. Horowitz:

–Well, I think that would be a more difficult issue because you wouldn’t have the apparent control there.

John Paul Stevens:

You’d have exactly the same control.

Alan I. Horowitz:

Well, I’m not sure what position the Service would take there because I don’t think those cases have come up, but it might be that the fact that the partners were paying all the expenses and everything would make them constructive shareholders–

John Paul Stevens:

No, they’d get reimbursed by their clients.

They’re not going to do this as a matter of generosity just they’d be sure that all expenses are paid by the people who have an interest in having the business go forward.

Alan I. Horowitz:

–Well, that’s what I’m saying, and the fact that they’re paying all the expenses, I think, might well make them constructive shareholders of the corporation.

William H. Rehnquist:

Mr. Horowitz, in Arizona when I practiced, it was a very common practice to have subdivision trusts where a title company would hold title to a large piece of property and charge virtually nothing for holding it because they were going to make their money out of insuring titles in the houses that were built ultimately on that vacant land.

William H. Rehnquist:

Now, would the Government feel that the title company ought to have to recognize income and losses on property, that it held that sort of nominal title to?

Alan I. Horowitz:

Well, if it’s an unrelated corporation that held it clearly as an agent–

William H. Rehnquist:

Well, of course–

Alan I. Horowitz:

–Did it take out the loans?

William H. Rehnquist:

–No, no.

It’s an unrelated corporation in one sense; it isn’t the same entity, but it has every reason to cooperate with the subdividers because that’s where it’s going to get its income from.

Alan I. Horowitz:

Well, that sounds like an agency relationship to me because you don’t have the Moline problem of needing to recognize the corporation as a separate taxable entity, because you don’t have a dealing with a controlled corporation.

I mean, Moline arises only in the case of or it addressed the relationship between the corporation and the shareholders that control it, and how the tax consequences are to be allocated between those two.

When you don’t have that kind of relationship, you don’t run into the sort of problems that National Carbide dictum is concerned about and the government is concerned about in this case.

I guess my time’s about expired.

I’d like to just make two other quick points.

One is that quite apart from the issue we’ve been discussing here, we think in this case, the respondents fail the sixth factor of the National Carbide test which is that the corporation’s here did not act as agents at all, they acted as principles.

It was essential to the success of the whole scheme that the corporation be holding the title in its own name and take out the loans in its own name, not on behalf of the partners because that would not have satisfied the Kentucky usury laws.

And second, I’d just like to point out that Congress has dealt with these kind of issues in some detail in Subchapter S of the Code in which they have recognized that in certain situations, businesses should be entitled to operate as corporations and still have the tax consequences flow through to the individuals as partnerships.

But Congress did not view this kind of situation as one to which Subchapter S should apply.

And because of a specific provision, they are not eligible for Subchapter S treatment.

We think Subchapter S would be somewhat undermined if respondents can use this agency mechanism to get around it.

I’d like to reserve the remainder of my time.

William H. Rehnquist:

Thank you, Mr. Horowitz.

Mr. Hembree, we’ll hear from you now.

Charles R. Hembree:

Mr. Chief Justice, and may it please the Court:

I should like to use my time this morning to concentrate on four areas.

That is, the attempt to clarify what the issue is in this case, to focus on some of the undisputable facts in the case, comment on the Sixth Circuit’s holding in the case which held for the taxpayers in holding that they were the taxpayers and that they were entitled to the deductions claim, and point out some of the numerous fallacies that are contained in the petitioner’s brief and in petitioner’s argument here this morning.

First, I think it’s very important in this case to understand that the underlying issue is an issue of who is the taxpayer.

This I think is a much more ingrained principle in this case than the two-tier tax system.

And once you get to the point of looking to who is the taxpayer in the case, and then look at the facts as found by the Tax Court and accepted by the Sixth Circuit, there is no question but what the income was earned and the expenses were incurred by the partnerships and the proprietorships, and not by the corporation which had a very very minor part in this whole picture insofar as its activities.

It held nominal legal title and put a mortgage on the property to secure a loan in each instance to secure a loan that was taken out for the benefit of the partnership or the proprietorship.

Byron R. White:

Would you be in great trouble if you went into Court in this tax case in Kentucky and said this corporation that was set up to hold title is just the alter ego for the partnership?

Charles R. Hembree:

Yes, Justice White, I believe that we would be in terrible trouble because in five of the six projects, the owners of the partnership were two or three individuals only one of whom was Mr. Bollinger who was the sole shareholder in the corporation and there was a nominee in–

Byron R. White:

Would you be in any trouble under Kentucky usury laws?

Charles R. Hembree:

–No, Your Honor.

Byron R. White:

So Kentucky wouldn’t mind.

They’re willing to go just on the record.

Charles R. Hembree:

There has not been a case insofar as I know that–

Byron R. White:

So everybody knows the way around the usury law in Kentucky.

Charles R. Hembree:

–The method used here to comply with the usury statute, and I think it was a compliance, we complied with it by having the loan made in the name of a corporation.

Now, there was a nominee agreement in each of the eight projects, and the nominee agreement specifically provided that the corporation was to act as the nominee and agent in holding bare legal title and in placing the mortgage on the property for the benefit of the partnerships.

The one thing that gets lost in the argument I have to say the catacombs of the petitioner’s argument because of the areas that are so unknown is that this principle of the one who earns the income is the proper taxpayer gets completely lost.

Antonin Scalia:

Is that really true?

I mean, let’s suppose I form a corporation in which I’m a sole shareholder.

I just decide to incorporate my business.

Previously, I’ve been doing it as just a sole proprietor.

I incorporate.

I become the chief executive officer, I’m the sole shareholder.

It’s really me.

I’m still making the money, but I formed a corporation.

Now, who gets taxed, me or the corporation?

Charles R. Hembree:

In that situation, Judge Scalia, you have Moline Properties because there you are doing business as a corporation.

The corporation is the one which earns the income even though the individual maybe is in the picture.

Antonin Scalia:

So the reality has nothing to do with it, does it?

The reality has nothing to do with it.

In that case, I’m really I’m the whole thing.

I own all the stock, I put in all the work and I don’t get taxed.

The reality has nothing to do with it at all.

We’re dealing with an artificial creation here anyway, aren’t we?

So we just have to decide what rules govern this artificial creation.

Charles R. Hembree:

I think that is true, Your Honor.

Antonin Scalia:

All right.

So long as we know we’re not talking about reality.

Charles R. Hembree:

A corporation itself is a fiction, it is a recognized fiction which has separate entity classification for tax purposes, and we recognize that.

Charles R. Hembree:

We never have questioned that.

But the question comes back when the corporation is formed, what does that corporation do and the mere fact that there is a corporation there does not change the fact that an individual who is the sole shareholder can do things on his own, can own property without it being in the corporation, and can transact a completely separate proprietorship operation, or be in, as in this case, a partner in other types of businesses that the corporation is not in.

Harry A. Blackmun:

Mr. Hembree, the tax years involved here are some time ago, a decade or so.

Has the Kentucky usury law been changed in the meantime?

Charles R. Hembree:

Yes, Justice Blackmun.

The Kentucky usury law was changed in 1972 which was right in the middle of this period, and I think that indicated that the Kentucky law, as most of the laws in various states involving usury became antiquated because of the high rate of increase in the interest rates, and as soon as the legislature could get around to it, it did correct the problem that existed at that time.

Harry A. Blackmun:

So you wouldn’t have to do this in order to, as you put it, to comply with the Kentucky usury law, rather than to avoid it.

Charles R. Hembree:

Yes, that is correct, Your Honor.

Harry A. Blackmun:

Today you wouldn’t have to do it.

Charles R. Hembree:

Yes.

Harry A. Blackmun:

All right.

Charles R. Hembree:

Now, the issue in this case is not whether the nominee corporations can be disregarded as separate entities.

We have made it clear throughout our brief that they are recognized as separate entities.

It’s only a question once they are recognized, you do not actually have to attribute to them, income that they did not earn.

And this is the principal emphasis that I want to make on that point.

The real issue, the one that was tried in the Tax Court, and the one that was considered in the Circuit Court, is whether the proprietorships and the partnerships which generated the income and expenses may have the deductions for the net losses that were generated in the earlier years of construction and operations of the apartment complexes.

Now, it’s important to understand that there were eight apartment complexes and each of them was owned by separate entities in the terms that two of the projects were owned and operated by Mr. Bollinger, as separate proprietorships.

Six of them were owned by the partnerships in which Mr. Bollinger was only one of the partners.

As far as the operation of the five partnerships which were using Creekside, Inc. as the corporate nominee, Mr. Bollinger did not have control of four of those in the sense of ownership.

He didn’t have control of any of them in the sense of voting power, because in the most he had in the five partnerships, the most he had in four of the partnerships was a fifty percent ownership interest, and he had a sixty-six and two-thirds interest in one of the partnerships.

But in that one, under Kentucky law in the absence of specifying otherwise, each partner, irrespective of the percentage interest, had equal vote.

So we feel that in those five cases or five situations, there was a lack of control of the partnerships by Mr. Bollinger.

Now, the Government makes a comported argument that there should be some kind of a constructive ownership implied which we think is completely without merit.

Now, I’d like to just mention briefly some of the very what I consider to be crucial facts that were found by the Tax Court and accepted by the Court of Appeals for the Sixth Circuit, and they are that the proprietorships and the partnerships were the owners of the apartment complexes, and they remained the real and true direct owners upon the transfer of the bare legal title to the nominee corporations.

And the transfers to the nominee corporations were for the limited purposes of holding title and placing mortgages on the properties to secure the loans taken out for the benefit of the partnerships or the proprietorships.

The proprietorships and the partnerships constructed the businesses of constructing and operating the apartment complexes in proprietorship form or partnership form and not in corporate form.

This is a specific finding that was made by the Court.

All of these are.

The proprietorships and the partnerships constructed the apartment buildings, they operated and managed the apartment buildings, they generated the income and the expenses from the operations of the apartment buildings.

They received the income and they paid the expenses in connection with the construction, the development and operation of the projects.

Charles R. Hembree:

They made all the interest and principal payments on the loans.

They paid all expenses otherwise for the projects.

John Paul Stevens:

Mr. Hembree, maybe they were agents of the corporation.

Maybe they were agents of the corporation, I say.

Charles R. Hembree:

On that point, Justice Stevens, the only way that they could be agents of the corporation would be if the corporation were the owner of the property and they were operating under that type of an arrangement.

Here they were not because under the nominee agreement that was present in each one of these projects, the only owner of the project was the partnership or the proprietorship.

The only ownership that the corporation had was bare record title, nothing more.

By the same token, none of the operations were made in the name of the corporation, and everyone who dealt with the partnership or the proprietorship was dealing with them as such.

The corporation was not involved and did not become liable for what the partners were doing.

So for that reason, I think just the opposite is true.

John Paul Stevens:

Well, do you mean to say that, suppose, as your opponent suggests, that somebody slipped on the ice in front of the building and brought suit, and they searched the title records, and found… I suppose the record title showed in the corporate entity?

Charles R. Hembree:

That is true, Your Honor.

John Paul Stevens:

I suppose if they filed a lawsuit against the corporate entity and then the Statute of Limitations ran before the found out who the real true owner was, you’d say they couldn’t recover because they sued the wrong party?

Charles R. Hembree:

I believe they might be able to recover, but they would be able to recover in the final effect only from the partnership or the proprietorship because–

John Paul Stevens:

If they didn’t name the other people as defendants, just got a judgment against the corporate entity, you don’t think they could recover on that judgment and foreclose against the real estate, if they had to.

Charles R. Hembree:

–Any liability that the corporation became liable for, they were indemnified under–

John Paul Stevens:

They’re indemnified but would it not be true that a judgment would be a lien against the real estate, if it was just against the corporation?

Charles R. Hembree:

–I believe that would be the correct result, yes, Your Honor.

John Paul Stevens:

So you can’t totally ignore the corporation.

Charles R. Hembree:

No, we don’t attempt to ignore the corporation.

We accept the corporation for what it was, and for what it did.

The thing about it is, it did so little.

It held bare legal title, operated to get the loans on the books, and that was it.

And for that limited purpose, the petitioner is contending that all of the income generated from the operations of the entire apartment complex should be then treated as if it had been earned by the corporation, the nominee corporation.

Byron R. White:

How do you distinguish Moline?

Charles R. Hembree:

I don’t distinguish Moline, Your Honor.

I say that Moline supports us because Moline Properties is a case which the issue to start with in that case was, who is the taxpayer, and the Board of Tax Appeals held that the taxpayer was the sole shareholder and the basis for that holding was that you ignored the separate entity.

Byron R. White:

Yes, but the Board got reversed.

Charles R. Hembree:

And a very important aspect of that and this gets over to a point that was brought up by Mr. Horowitz.

Byron R. White:

And of course, the Government in that case was on your side.

Charles R. Hembree:

I didn’t–

Byron R. White:

I think the Government’s position didn’t stand up in the Court of Appeals.

Charles R. Hembree:

–It did before this Court Your Honor.

Byron R. White:

I know, but not the Court of Appeals.

Charles R. Hembree:

Well, I think the thing that we’re interested in here is what this Court held in Moline Properties, and in that case,–

Byron R. White:

Oh, yeah, all right, go ahead.

Charles R. Hembree:

–this Court, in reversing, or in affirming the Circuit’s reversal of the Board of Tax Appeals, held that the separate entity must be recognized and that the income of that separate entity must be reported by it.

And the big distinction between that case and our case is that there, the income was the income of Moline Properties, the corporation.

Here, the income that is sought to be shifted from, or the losses attempted to be shifted from these partnerships.

Byron R. White:

Of course, that solves the whole case.

The government says that the income was the corporation’s.

Charles R. Hembree:

That’s where that assertion is completely and diametrically opposed to the findings of fact of the trial court which were accepted by the Court of Appeals, and there’s no basis being pointed out for contesting those facts.

Antonin Scalia:

Suppose the stock of this corporation had been sold after it had been set up and the money was coming in from the properties.

Do you think the shareholder wouldn’t be able to get that money and say it’s money from the property my corporation owns?

Charles R. Hembree:

No, Your Honor.

Because the only rights the corporation had was what rights it got under the nominee agreement and the nominee agreement limited completely everything the corporation was insofar as the property to holding bare record title and establishing the loans, the mortgage on the loans.

John Paul Stevens:

Counsel, isn’t that your distinction with the Moline case, not the fact that they called in the income coming from one or the other, in that case, there was no agency agreement, whereas there was in this case.

Isn’t that true?

Charles R. Hembree:

Well, I think that’s a part of it, Your Honor.

I think we’re dealing really with different–

John Paul Stevens:

I thought the argument in that case was that they should be treated as an agency simply because they were wholly owned by the individual, and that was not enough to establish agency.

And here you say a), you’re not wholly owned, and b) we’ve got a separate nominee agreement.

Charles R. Hembree:

–Well, Justice Stevens, I believe there are two aspects over the Moline Properties case, number one and the principal part of it was that the sole shareholder was attempting to say I am the sole shareholder and I have the complete beneficial interest of everything the corporation has.

Therefore, we should be treated as one, and the fact that there has been a sale of property by the corporation on which there was a gain, there shouldn’t be a separate tax, it should be taxed to me directly.

John Paul Stevens:

And in other words, the mere fact that I own all the stock is not enough to make me the principal in the corporation an agent.

Basically, that’s what–

Charles R. Hembree:

That’s true.

And the argument was made as an alternative that there was an agency relationship that would bring the money back and the corporation was merely acting as agent, but there was no agreement.

And this Court in affirming the reversal by the Court of Appeals pointed that out, that there was no agency agreement or any other restriction on the title and ownership that the corporation had.

So there is I think why the Moline Property case is not from the factual standpoint of any bearing in this case, but the principle that was established there, I think, was an affirmance of the basic principle that whoever earns the income is the one who must report it.

Antonin Scalia:

–Well, they have to do from year to year for one reason or another under the tax laws or because of my peculiar circumstances, it becomes advantageous from one year to another to shift the income to the corporation or to me, all I have to do is write up the nominee agreement with the corporation saying, you know, I’m the sole shareholder.

This year, the income will belong to the corporation.

The next year, the income will belong to me.

Can I do that from year to year, and that’s all it takes?

Charles R. Hembree:

No, Your Honor, not in terms of shifting the income of the type that we’re talking about here.

Because if you can each year surely you could as a sole shareholder, enter into a new agreement with the cooperation and once you enter into that agreement, then it depends on what the relationship is that’s created by that agreement.

If you–

Antonin Scalia:

Well, it’s the same thing here.

It just says, all the income from this property this next year is going to be mine.

And you say, so long as I do that before the tax year, it’s okay.

Charles R. Hembree:

–If that’s the agreement, then, it does not stand up because in that instance because it’s nothing more than an anticipatory assignment of income, and that is not a proper relationship under the National Carbide case.

The National Carbide case, that would make it really fall right into the category of being solely dependent this relationship under that kind of an agreement would be solely dependent upon the fact that there is the ownership.

Antonin Scalia:

Well, why isn’t this just as much?

The only reason the corporation is letting these people have the income is because these people are the sole shareholders.

You don’t think any corporation in its right mind would say, well, we own the property but other people can have the income.

It’s the same thing, it seems to me.

Charles R. Hembree:

Well, I think the big distinction, Justice Scalia, is that the income was not anything that the corporation had any right to under the agreement that is involved.

Now, I know this doesn’t fully answer your question, but the reason that it doesn’t go to the corporation and can’t go to the corporation in this instance is because the corporation had no right to it.

Now, if there is an agreement that gives the corporation the right to it, and the corporation earns it, now, the agreement has to be one that reflects a relationship and this is what National Carbide is all about is the relationship that is created by the agency agreement must be one that is reflecting the activities that are involved.

And I think in this instance, the Sixth Circuit came up with the right results and that is that you look to the overall situations to see if the normal indices of agency have been satisfied.

And if they have been satisfied, then the agency is going to be recognized.

The way you determine that is comparing that with whether or not an unrelated entity would be willing to do the same thing that the related entity has done.

And you do not get into the consideration, and incidentally, this is the only real basis that the petitioner has pointed out for this failure of the so-called Fifth Circuit on the relationship aspect is that there was no consideration paid.

The consideration, as you, Justice Scalia, have pointed out is not necessary insofar as establishing a valid agency relationship consideration is pure black letter restatement agency law.

That you don’t need the consideration.

So that being the only thing that the petitioner is relying on, we get back into an area where we get lost on trying to use a principal that is set up in Moline Properties, and then another principle that is set up in National Carbide they tried to pull together but they don’t mesh because of the different situations that were involved, and because of the different principles.

On the one hand, you’re talking about a separate entity, and on the other hand, you’re talking about the basically an anticipatory assignment of income in National Carbide.

I should like to… I don’t like to spend much of my time pointing out errors that have been made in the brief of the petitioner… but I do feel that it is very important to point out certain misstatements arid distortions that are contained in the brief filed on behalf of the petitioner.

Petitioner states on page 18 as a fact that the corporation’s incurred interest expense on loans.

However, the Tax Court specifically found that the partnership made all interest payments and is contrary to the statement by petitioner in the brief.

Charles R. Hembree:

Petitioner also states that the corporation owned the properties.

However, the Tax Court specifically found that the corporation owned no assets and also found that the partnership, and not the corporations were the owners of the apartment complexes.

Now, those just don’t square when you talk about the statement is made in the brief and what the actual facts are as found by the Court.

Also, at page 18 of the brief, petitioner states that the Court of Appeals stated,

“that this supposed principal agent relationship superceded Moline Property special entity rule. “

There is no such statement made by the Court of Appeals.

I don’t know how to deal with statements that are made in the brief, how to respond to them, when they refer to matters in the lower Court’s opinion which just do not exist.

Petitioner also states that the Sixth Circuit concluded that even if the corporations were viable separate entities, their income and expenses could be attributed directly to Bollinger and his partners under the agency theory.

That was not the holding of the Sixth Circuit at all.

The holding of the Sixth Circuit was that the proprietorships and the partnerships conducted the business of constructing and operating the apartments in the partnership and proprietorship forms, and not in the corporate form, and that the income realized was attributable to the efforts and assets of the proprietorships and the partnership.

Thus, I think it is completely erroneous and misleading for the petitioner to say in his brief that the income and expenses were considered by the Sixth Circuit to be those of the corporation and that it attributed the corporation’s earnings to the partnerships and proprietorships.

One other thing which I briefly mentioned before, but this gets to the very heart of it, at page 2 of his reply brief, the petitioner states that respondents note, at page of the brief, that

“corporate ownership of properties was specified by the lenders as a prerequisite of making the loans. “

This is a complete misstatement of what was said in respondents’ brief.

The statement in the respondent’s brief referred only to nominal debtor and that the nominal debtor be a corporate nominee of the partnerships and that record title to the property be held by the corporate nominee.

Now, nominal debtor and corporate nominee do not add up to ownership, and that I think also is a very misleading statement.

Recognizing that the time is just about gone, I want to make one statement that clears this whole brings the whole case I think into perspective in terms of what we’re dealing with and the interpretation of the National Carbide case.

There this Court was attempting to set up certain rules that would be useful in determining whether a valid agency arrangement existed.

The reason they were doing it was to try to determine who was the taxpayer with regard to the income that was involved in that case, and the income in that case had been earned by the agents.

And because it had been earned by the agent and the agency agreement did nothing more than make an anticipatory assignment of it, the Court held that the agency agreement would not be recognized, because certainly the assignment was based on joint ownership of the two entities and nothing more.

What the petitioner is attempting to do in this case, in using the so-called fifth factor and the so-called sixth factors in National Carbide to support–

William H. Rehnquist:

Thank you, Mr. Hembree, your time has expired.

Charles R. Hembree:

–Thank you.

William H. Rehnquist:

Mr. Horowitz, you have three minutes remaining.

Alan I. Horowitz:

Thank you, Mr. Chief Justice.

I’d like to make two quick points.

One is that the essence of the holding in Moline is that a dummy corporation, a corporation that does very little has to be recognized for tax purposes if it engages in business activity.

So Mr. Hembree’s contention here–

Byron R. White:

–took the contrary position there.

Alan I. Horowitz:

–I’m sorry.

Alan I. Horowitz:

I didn’t have a chance to check that, Justice White, since you mentioned it before.

I don’t think that was right.

I thought the–

Byron R. White:

Well, the Tax Court got reversed in the Court of Appeals.

Alan I. Horowitz:

–That’s right.

Byron R. White:

And the Tax Court agreed with the Government’s position because the Government there was trying to stick the taxpayer, the individual, trying to ignore the–

Alan I. Horowitz:

My recollection is that the dispute was over whether the corporation would have to pay corporate tax and it was the Government that wanted to collect the corporate tax, but I could be wrong.

I’m not sure.

I will check.

Byron R. White:

–You may be, you may be.

Alan I. Horowitz:

The point I want to is that Mr. Hembree’s statement that the corporation should not be recognized here because it did so little is exactly the contention that was accepted by the Board of Tax Appeals in Moline and reversed by this Court.

That’s exactly inconsistent with Moline, and the more general proposition that what the Code wants to do is–

Sandra Day O’Connor:

Well, there wasn’t an agency agreement in Moline was there?

Alan I. Horowitz:

–No, there wasn’t.

That’s the second point I wanted to make actually which goes to Justice Steven’s question about Moline.

Is that I think the precise holding of National Carbide, is that you can’t avoid Moline simply by having an agency agreement.

There was an agency agreement in National Carbide.

That was exactly the argument that the taxpayer tried to make there.

And what National Carbide said is that that’s not good enough because the agency agreement there didn’t reflect anything different than the kind of control that the shareholders exert over the corporation.

They just put it on a piece of paper and said that the subsidiaries will do x, y and z as agents.

But it’s the same thing that the shareholders could have told them to do because of their control.

It has to be something different from a shareholder corporation relationship.

And that is, I admit, difficult to show where you take the tack of setting it up as a controlled corporation for these purposes.

It’s better to use an unrelated agent.

But that’s, you’re stuck with it if you need to set up a corporation for some business purpose as the taxpayer certainly had to do here, then you are stuck with the tax consequences of that.

And with respect to the question of whether they complied with the Kentucky Usury laws, they certainly did comply with the Kentucky Usury laws.

William H. Rehnquist:

Thank you, Mr. Horowitz, your time has expired.

The case is submitted.