Moline Requirement to Recognize Existence of Entity Applies to S Corporations per IRS Memo

The IRS issued a memorandum (CCA 201747006) that takes the position that the Court of Claim’s 2011 opinion in the case of Morton v. United States, 98 Fed. Cl. 596 (2011), is in error when it takes the position that, for an S corporation, an entity doesn’t have to be strictly recognized as unique form its owners. Rather, the memorandum argues that the opinion should not have distinguished the treatment of S corporations from that given by the U.S. Supreme Court in the case of Moline Properties v. Commissioner, 319 U.S. 436 (1943).

Moline generally holds that a taxpayer is not able to ignore the existence of separate entities that he/she has set up when analyzing a tax issue.  Rather, each entity is treated as a unique entity from the taxpayer’s perspective and the taxpayer must live with the consequences of that fact.  Unlike the IRS, the taxpayer was involved in creating the structure in question.

The Morton case involved the question of whether a taxpayer’s aircraft activity (which was conducted in an S corporation) ran afoul of the hobby loss rules of IRC §183.  While there were substantial losses from the activity, the taxpayer argued that he should be able to look beyond that single entity to the sizeable number of other, very profitable, entities he controlled, as the aircraft was used in support of those enterprises. 

The Court of Claims found this approach appealing, noting:

Case law supports Plaintiff's 'unified business enterprise' theory and would allow him to take deductions for aircraft use that furthers the business purposes of entities other than RWB. This deduction may be allowed despite the fact that the aircraft is titled in RWB's name, and RWB did not use the aircraft to further its particular profit motive. As long as Plaintiff used it to further a profit motive in his overall trade or business, the deduction is allowed.

The Court of Claims decided that Moline did not limit the ability of the taxpayer to look outside the S corporation because Moline dealt with a C corporation.  It’s reasoning, which lead the IRS to produce this memo, reads as follows:

The taxpayer in Moline Properties was trying to avoid a corporate-level tax (in addition to the shareholder-level tax), whereas in Plaintiff's case, the corporation is only taxed on the individual level and is not avoiding any other level of taxation. The fact that the Moline Properties court stresses the corporation was not the 'alter ego' of the taxpayer actually supports an outcome in Plaintiff's favor: Plaintiff's entities are 'alter egos' of Plaintiff; they all have the same business purpose.

The IRS disagrees with the implication of the holding that Moline simply doesn’t apply to S corporations, allowing the taxpayer to “lump” the entities together to come up with a “unified business enterprise” when it serves the taxpayer’s interests.

The memo cites a series of Tax Court opinions issued after Moline that applied the rule that the entity must be respected in S corporation situations.  The memo also cites an article published in Tax Notes in 2011 by Professor John Gambino that was critical of the Court of Claim’s holding in Morton shortly after it was issued.

The IRS thus concludes that the agency should not follow the Morton holding, so far as it holds that the separate existence of an S corporation can be ignored.  The memo concludes with the following analysis:

there is no support of the Morton theory of the non-applicability of Moline Properties and DuPont to S corporations in prior case law or elsewhere. Prof. Gamino points out the explicit statutory requirements for even a single shareholder S corporation to file a separate return, and such a corporation may even have its own corporate level tax liabilities under some circumstances (see fn. 3), which vitiates the apparent rationale for the Morton distinction between S and C corporations.

Further, there is no justification for treating S corporations differently from C corporations, except to the extent there is specific authorization for doing so under the Code or other precedential authority. See § 1371(a) (subchapter C is generally applicable to S corporations). An example where subchapter S is inconsistent with subchapter C is § 1363(b), which generally provides that the taxable income of an S corporation shall be computed in the same manner as that of an individual. For the application of § 1363(b), see, e.g. Rev. Rul. 93-36, 1993-1 C.B. 187, in which an S corporation was treated like an individual for determining the deductibility of a nonbusiness bad debt under § 166. In contrast to Morton, the list of authorities detailed above, consistently decided before and after the 1982 revisions to subchapter S, clearly approve of applying Moline Properties and DuPont to S corporations, as it is consistent with Title 26 and subchapter S.

Excluding S corporations from Moline Properties also creates substantial uncertainties and potentially heavy taxpayer burdens. Even if the Service were to accept Morton for wholly-owned S corporations, it would create a compliance difficulty, as the same corporation and its shareholder(s) would gain or lose eligibility for tax benefits from year to year based on whether or not the corporation was wholly-owned for that year. But Morton's holding would not be limited to wholly-owned S corporations because Morton was described as only a majority shareholder in some of the entities which nonetheless were found to be part of the “unified business enterprise.” Morton does not offer any standard for determining the threshold level of ownership sufficient to enable taxpayers to claim a unified business enterprise. To administer a Morton rule, the Service would presumably have to adopt, by administrative fiat, some threshold ownership rule, perhaps the “80/80” voting and value test from § 1504(a)(2). But lacking statutory authorization, any such regime would be subject to challenge.