United States

IRS pierces corporate veil for unpaid tax liabilities, upheld by Tax Court

Minority shareholders held liable despite not active participants in fraud

TAX ALERT  | 

In a recent Tax Court decision, Kardash v. Commissioner, T.C., No. 12681-10, the court upheld the IRS' ability to pierce the corporate veil and recover unpaid tax debts from the corporate shareholders. The company in question made distributions to its shareholders despite the fact that the company, after taking unpaid tax debts into account, was insolvent. Distributions out of an insolvent company are constructively fraudulent, and therefore, the shareholders were deemed transferees to the corporation's unpaid tax liabilities. Of the four total shareholders, two minority shareholders were paid distributions commensurate to their ownership and the success of the company while the two majority shareholders received large distributions far exceeding what they would have been entitled to based upon the same metrics.

Analysis

When a shareholder is deemed a transferee of the corporation's tax liability, the IRS can seek to recoup some or all of the unpaid amounts from the shareholders. In these cases, state law determines when the IRS may pursue a transferee. Most states do not require creditors to exhaust all reasonable methods of recovery from the company before pursuing the transferees pursuant to uniform fraudulent transfer acts enacted in the state. In addition, the court pointed out that because transferee liabilities are several in nature, the IRS may pursue any and all transferees in whatever order it chooses to protect the interests of the government.

Here the IRS was able to pursue the minority shareholders even though they were not the perpetrators of the fraud and the IRS had already reached a payment agreement with the corporation and the two majority shareholders. The court held that the agreements were not in satisfaction of the outstanding liability but rather a means to pay it down and reduce the amount that the IRS could recover from the other transferees. As such, the minority shareholders were held liable for payments that were received while the company was insolvent as partial satisfaction of the tax liabilities of the company.

Takeaway

The corporate veil exists to protect shareholders from actions taken against the corporation. However, as is seen in Kardash, this protection is not unlimited. Proper capitalization and record keeping, segregation of corporate and personal assets, and following corporate formalities are all requirements necessary to protect the veil. Where significant undercapitalization is present, specifically undercapitalization caused by fraud, the protections afforded by the veil are pierced exposing the shareholders to liability. Taxpayers should take note of the decision in Kardash as it serves as a reminder to respect the separate and distinct nature of the corporate entity.

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