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When a taxpayer has an outstanding tax liability, the IRS has authority, subject to due process considerations, to seize the taxpayer’s personal assets such as bank accounts, wages, and property to satisfy the tax debt. Under an alter ego theory of liability, the IRS will also have authority to seize assets of a third-party entity to pay the taxpayer’s tax debt when the entity is found to function as the alter ego of the taxpayer.
Alter ego liability typically arises out of the relationship between a business owner and his or her corporation or a limited liability company where there is such unity of interest and control that they are no longer considered separate. Accordingly, the IRS will treat them as one and the same for purposes of tax collection. In effect, business accounts and assets may be vulnerable to IRS levy for the personal tax obligations of the business owner. This is confounding to many given that one of the main purposes of forming a corporation or limited liability company is to limit liability as between the business and its owners.
This article explores the specific circumstances that give rise to an alter ego theory of liability in the context of tax collection and explains how a taxpayer might successfully challenge IRS tax liens and/or levies against third-party entities.
Alter Ego Theory of Liability Defined
The general principle behind the alter ego theory of liability in the context of tax collection, and other IRS theories of third party liability, is that when a taxpayer who has an unpaid tax liability transfers assets to a third party for the purpose of concealing or protecting those assets from the reach of the IRS, in the interest of equity and under certain circumstances, the IRS has authority to seize property of the third party in order to satisfy the debt of the taxpayer.
The Internal Revenue Manuel section 5.17.14 Fraudulent Transfers and Transferee and Other Third Party Liability identifies the basis for 5 different kinds of third party liability: transferee theory, fiduciary liability theory, successor liability theory, nominee theory, and alter ego theory.
The alter ego theory of liability asserts that the taxpayer and the alter ego are so intermixed that their affairs cannot easily be separated. They will be treated as one and the same for purposes of IRS collection. If the IRS determines that alter ego liability applies, it may seize any property that is held in the name of a third party (the taxpayer’s alter ego) for the purpose of satisfying the taxpayer’s tax debt.
When Does the Alter Ego Theory of Liability Apply
Alter ego liability can theoretically exist between the individual taxpayer and any other entity such as a corporation, a limited liability company, a trust/trustee, another individual), most commonly it is associated as between an individual and a corporation or limited liability company.
Business owners often form separate legal entities such as corporations in order to protect their personal assets from the debts and obligations of the business and conversely to protect business assets from any personal liabilities. This legal protection afforded by the corporation requires that the owner(s) adhere to corporate formalities and guidelines which serve to maintain the separate and distinct identity and nature of the third-party entity.
Under certain circumstances, the IRS can apply the alter ego theory of liability to treat the corporation’s assets as those of the owner and vice versa. This is commonly referred to as “piercing the corporate veil.” In effect, the IRS treats the corporation and the owner as one and the same (one is the alter ego of the other) thereby permitting collection from either. The IRS must find that there is such a unity of ownership and interest that the individual and entity are no longer separate.
As per the IRM, the two elements of the alter ego doctrine include:
- Unity of ownership and interest; and
- Fraud or inequity that would result from the failure to disregard the corporate entity.
A finding of unity of ownership and interest be based on whether the taxpayer and third party have conducted themselves in an arms-length fashion that evidences the separate and distinct natures of each of the parties. For example, how they maintain records, how they have set up bank accounts, their transactions and history, as well as the transfer or sharing of property between them, will be relevant.
Factors that courts will consider in determining whether there is sufficient unity of ownership and interest include the following:
- Whether funds were transferred between the taxpayer and the entity to suggest a commingling of assets;
- Whether the taxpayer and the entity maintained separate accounts, separate books, and separate records;
- For property in the name of the entity, whether the taxpayer’s money was used for the property;
- For property in the name of the entity, whether the taxpayer enjoyed the benefit and use of the property;
- Whether the taxpayer exercised control over the property;
- Whether there is a close family relationship between the taxpayer and the third party or the third-party entity’s officers;
- Whether the taxpayer treated the entity’s assets and property as his own;
- Whether the third party’s assets were used to pay taxpayer’s expenses;
- Whether there were unsecured, interest free loans between the third party and the taxpayer;
- Whether property was transferred between the taxpayer and the third party for little or no consideration;
- Whether the third-party entity had internal controls and adhered to corporate formalities.
Challenging IRS Collection Based on Alter Ego Theory of Liability
The IRS is precluded from filing a notice of federal tax lien against a third party under the alter ego theory of liability without obtaining legal review and direction from Area Counsel regarding the need for a supplemental assessment, a new notice and demand (which must occur before filing a tax lien), language to be included on the notice of federal tax lien filing.
If the IRS files a notice of federal tax lien or notice of intent to levy against your corporation or other third party with which you are affiliated for the purpose of collecting your personal tax debt, you may challenge the tax lien and/or levy by requesting an appeal.
You will have 30 days from the name of the notice to file a Collection Due Process Appeal and one year from the date of the notice to file an Equivalency Appeal. You will have an opportunity to challenge the basis for alter ego theory of liability on appeal at a hearing. While the request for Collection Due Process Hearing will prevent the IRS from proceeding with any tax levy pending the outcome of the appeal, the request for Equivalency Hearing may not.
Do You Need a Tax Attorney?
A tax attorney can help you ensure that the proper safeguards such as accounting practices and adherence to corporate formalities, are undertaken to protect against alter ego theory of liability. If a third-party entity with which you are affiliated has received a notice of tax lien or levy which aims to seize property in satisfaction of your personal tax liability, a tax attorney can advise whether you have a viable defense to alter ego liability and how to challenge the IRS collection activity in this regard.
The experienced tax attorneys at Segal, Cohen & Landis have helped clients defend and resolve IRS assessments and related collection based on alter ego theory of liability by providing the following services:
- Review the accounts, transactions, books, and structure of clients and their businesses to determine that proper accounting practices and corporate formalities are in place;
- Determine to what extent a client may have a viable defense to alter ego theory of liability;
- File a Collection Due Process Appeal to challenge an IRS tax lien or levy against a third party;
- File an Equivalency Appeal to challenge an IRS tax lien or levy against a third party;
- Resolve outstanding liabilities via collection alternatives such as offer in compromise, installment arrangement, or not collectible status.
If you are interested in having a complimentary consultation with one of our partner attorneys regarding your tax matter, please feel free to contact us at 866-505-1872. We would be happy to advise you as to how we can resolve your case and how much it would cost.