Closely held companies, part 2: owners and entities are not alter egos

In the first part of this post, we outlined the basic considerations involved in defining when an organization is “closely held” for tax purposes.

In this part of the post, we will look in more detail at how the Tax Court and the IRS have differed recently in interpreting and applying this definition.

Let us return, then, to the Tax Court case involving a closely held company that we began discussing in last week’s post. In that case, a married company owned a company together – and got behind on paying both their own taxes the company’s payroll taxes.

Seeking to resolve the tax compliance issues, the couple transferred funds to the company. The transfer was done in conjunction with written designations that the money was to be used voluntarily for certain debts involving the couple’s tax withholding obligations.

The IRS declined to recognize these designations. But the Tax Court disagreed. The court reasoned that allowing such designations is important in order to avoid double taxation: namely, taxing the owners and their company twice for the same underlying income.

Even after the Tax Court ruled, however, the IRS refused to accept the court’s reasoning. The IRS issued an Action on Decision (AOD), stating that it accepts the court’s result in the particular case but does not consider that result determinative in comparable cases.

Obviously this makes for a confusing tax compliance landscape – one in which it is critical to get counsel from an experienced tax attorney.

It is fair to say that the IRS seems to be seeking to rebut the notion that closely-held entities and their owners are merely alter egos of each other. But how the agency will clarify the relationship between those owners and their organizations is far from clear.