Moline Properties separate-entity doctrine applies to S corporations

Plain-English summary

Chief Counsel considered whether wholly owned or majority-owned S corporations could be combined with their shareholders and related entities as a unified business enterprise when determining deductions. A Court of Federal Claims decision, Morton, had reasoned that Moline Properties did not control because S corporations generally lack a separate corporate-level income tax. The advice rejects that reasoning and explains that courts have repeatedly respected S corporations as separate entities before and after the modern subchapter S rules. Pass-through taxation does not erase the corporation's distinct tax identity or permit shareholders to blend its business and expenses with their own. The IRS should continue applying Moline Properties and DuPont regardless of ownership concentration, subject only to narrow established exceptions for protecting the taxpayer's own business or a genuine agency relationship.

Ruling snapshot

• Question: Does the Moline Properties separate-entity doctrine apply to wholly owned and majority-owned S corporations?
• Outcome: advice given, the doctrine applies and Morton should not be followed
• Key authorities: IRC §§ 162, 1363, 1366, 1371(a); Moline Properties v. Commissioner; Deputy v. DuPont; Morton v. United States; Steinberger v. Commissioner

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201747006
           Release Date: 11/24/2017
           CC:PSI:B03:                               Third Party Communication: None
           POSTU-119530-17                           Date of Communication: Not Applicable

 UILC:     162.25-18, 1361.01-00, 6037.00-00

  date:    October 24, 2017

     to:   Karen Carreiro-Smithson
           Supervisory Internal Revenue Agent
           (LB&I Deputy Commissioner)
           Passthrough Entities

  from:    Bradford R. Poston
           Senior Counsel
           (Passthroughs & Special Industries)
           Office of Associate Chief Counsel

           Mike Gould
           Attorney Advisor
           (Passthroughs & Special Industries)
           Office of Associate Chief Counsel


subject:   Applicability of Moline Properties to S corporations.

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.

           In conference calls on 7/20/17 and 8/28/17, we discussed with your office the holding of
           Peter Morton v. U.S., 98 Fed. Cl. 596 (2011), and its effect of excluding wholly-owned or
           majority owned S corporations from precedent set by Moline Properties v.
           Commissioner, 63 S.Ct. 1132 (1943). Based upon the authorities and analysis below,
           we conclude the Service should reject the Morton holding and continue to assert that
           Moline Properties is applicable to S corporations, regardless of degree of ownership

           ISSUE

           Moline Properties stands for the proposition that a corporation created for a business
           purpose or carrying on a business activity will be respected as an entity separate from
           its owner for federal tax purposes. Moline Properties predated the enactment of
POSTU-119530-17                              2

subchapter S in 1958, but it has been applied to S corporations in several cases. In
Morton, however, the Court of Federal Claims concluded that Moline Properties did not
apply to S corporations in the context of a § 183 “hobby loss” case, and that the
taxpayer was allowed to consider the activities of all of his wholly-owned or majority
owned S corporations together as a “unified business enterprise” in determining
whether the disputed expenses were attributable to an activity “engaged in for profit.”
This holding strongly implies that Moline Properties is only relevant in a situation where
the taxpayer is attempting to avoid a corporate-level income tax, which is rarely the
case because S corporations pass through income and deductions to shareholders.
This memorandum discusses the history of the Moline Properties doctrine, as it relates
to S corporations. We conclude that Morton is an aberration that the Service should not
follow, because Moline Properties is broadly applicable to S corporations, and not just to
situations involving a corporate level tax.

LAW AND ANALYSIS

1. Moline Properties & DuPont

Moline Properties is the case most cited for the treatment of corporations as entities
separate from their owners for tax purposes. A similar holding in Deputy v. DuPont, 308
U.S. 488 (1940), is also cited for the same type of holding.

In Moline Properties, an individual conveyed real estate to a corporation in 1928 as part
of a security arrangement at the suggestion of the creditor. The corporation assumed
the mortgages, with the individual receiving all the stock which he then transferred to a
voting trustee appointed by the creditor. The stock served as security for an additional
loan to the individual. That loan was repaid in 1933, with control of the corporation
reverting to the individual. The real estate was later sold, with the proceeds received by
the individual and deposited in his personal account. The business of the corporation
consisted of the assumption of the individual’s original obligation to the creditor, the
defense of the real estate in a condemnation proceeding, and the institution of a suit to
remove deed restrictions from some of the property, though the expenses of the suit
were paid by the individual. A portion of the property was also leased as a parking lot.
Once the last parcel of real estate was sold, the corporation did not transact any further
business, but it was never dissolved. Originally, the loss stemming from the real estate
for 1934 and the gain for 1935 were reported on the corporation’s return, but the
corporation filed a refund claim for 1935 with the individual including the gain on his
personal return for that year (and including the 1936 gain on his original 1936 individual
return).

The Board of Tax Appeals held for the taxpayer on the grounds that because of the
corporation’s limited purpose it “was a mere figmentary agent which should be
disregarded in the assessment of taxes.” 45 B.T.A. 647. The Fifth Circuit reversed,
holding that the individual, having formed a corporate entity for reasons sufficient to him,
was bound to his choice and the corporation must be recognized for tax purposes. 131
F.2d 388. The Supreme Court affirmed Fifth Court’s holding, stating that:
POSTU-119530-17                              3

       The doctrine of corporate entity fills a useful purpose in business life.
       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. 319 U.S. 438-39.

The Court did recognize an exception to its general rule when “the corporate form … is
a sham or unreal.” 319 U.S. 439.

With regard to Moline Properties, the Court found that the corporation had been created
by the shareholder for his advantage and served a special function. In particular, since
its inception, the corporation was not the shareholder’s alter ego, given that he
transferred voting control to the creditor and, thus, he did not exercise any control over
it. This fact led the Court to state, “It was then as much a separate entity as if its stock
had been transferred outright to third persons.” 319 U.S. 440.

The shareholder argued the corporation should be disregarded because its creation
was “coerced” by the creditors. The Court found that this emphasized rather than
vitiated the corporation’s separate existence, because “business necessity” made its
creation advantageous. Even after the payment of the mortgages led to the control of
the stock returning to the shareholder, the corporation continued in existence and
engaged in business activities such as the sale of the real estate, and the rental of the
parking lot property. In acknowledgment, the Court decided, “The facts … compel the
conclusion that the taxpayer had a tax identity distinct from its shareholder.” 319 U.S.
440.

DuPont involved a taxpayer who was the largest individual shareholder of a C
corporation. In 1919, the corporation created a new executive committee; it was
thought desirable for the executive committee members to have a financial interest in
the corporation, but for several reasons, it was legally problematic for the corporation to
issue shares directly to them. Therefore, the individual shareholder agreed to sell
shares to the members, but as he did not have enough shares in his own account to
satisfy the obligation, the shareholder instead borrowed additional shares from a related
third party, under an agreement to return the shares in ten years and in the interim to
pay the lender all dividends paid on the loaned shares. After obtaining the shares, the
shareholder then sold the borrowed shares to the executive committee members, the
purchase price being furnished by the corporation.

In 1929, near the end of the ten year period, the shareholder did not have enough
shares to repay the first lender. In response the shareholder borrowed more shares
from a second lender, also a third party, to repay the first lender. The second lending
agreement had similar terms to the first borrowing, but added a term whereby the
shareholder would reimburse the second lender for all taxes due. These terms resulted
in the shareholder paying the second lender approximately $650,000 in 1931,
POSTU-119530-17                                    4

representing the dividend equivalent and tax reimbursements. The shareholder claimed
this $650,000 as a “trade or business” expense deduction under § 23(a), the
predecessor to § 162.

The District Court found that the individual shareholder was in the “business” of
conserving and enhancing his estate, but that the payments to the lender were not
ordinary and necessary expenses of that business because they were not proximately
connected with the enhancement of the stock value. The court suggested that even if
the shareholder paid the salaries of the corporation’s employees directly in hopes of
increasing the value of the stock, such costs would not be deductible as business
expenses. The opinion also holds that the extraordinary and unusual nature of the
payments caused them to fail to be “ordinary,” and rejected the taxpayer’s alternative
characterization of the payments as deductible losses or interest. 22 F.Supp. 589. On
appeal, the Third Circuit reversed, agreeing the shareholder was in the business of
conserving his estate, but concluding the expenses necessary for him to sell stock to
the committee members were in furtherance of that business, even if the sale itself was
not specifically for the purpose of profit. 103 F.2d 257.

The Supreme Court reversed the Third Circuit, affirming the decision of the District
Court, though without opining on whether the shareholder’s activities in conserving and
enhancing his estate rose to the level of a business. Instead, the Court concluded that
even if the shareholder’s payments were in furtherance of his business, it was a
business different than that of the corporation. The transactions giving rise to the
expenses “proximately result not from the taxpayer’s business but from the business of
the [corporation] ... The well established decisions of this Court do not permit any such
blending of the corporation’s business with the business of its stockholders.” 308 U.S.
494.

The “separate identity” or “separate entity” principles of Moline and DuPont are
regarded as foundational by the courts, the Service, and commentators. See Bittker &
Eustice, Fed. Inc. Tax’n of Corps. & Shareholders, at 1.05[1][b] (“In general… the courts
follow the principles enunciated in [Moline].”) and McKee, et al., Fed. Tax’n Partnerships
& Partners, at 3.03 (“In general, the U.S. Supreme Court’s seminal decision in [Moline]
set the historical substance standard for recognition of corporate entities.”)1

2. Morton

Peter Morton (Morton) was a co-founder of the Hard Rock Cafe restaurant chain.
Morton also established the Hard Rock Hotel, Inc. (HRH), a C corporation, which owned
and operated the Hard Rock Hotel and Casino in Las Vegas. Morton owned all or most
of several S corporations, including Red, White, and Blue Pictures (RWB), Lily Pond

1
 For specific descriptions of Moline or DuPont as “landmark,” “seminal,” or establishing a general legal
                                                                                                     th
principle, see Love v. U.S., 96 F.Supp. 919 (Ct. Cl. 1951), Hagist Ranch v. Comm., 295 F.2d 351 (7 Cir.
1961), Grossman v. Comm., T.C. Memo 1974-269, and In re Homelands of DeLeon Springs, 190 B.R.
666 (U.S. Bankruptcy Ct, M.D. Fla. 1995).
POSTU-119530-17                                      5

Investments (LP), and 510 Development Corporation (510). RWB owned the real
estate underlying some of the Hard Rock Cafe sites and acted as landlord. LP was a
holding company with all the voting shares and 94% of the total shares of HRH. 510
performed various other services for the Hard Rock Hotel, such as marketing and public
relations, design, management, and accounting, and was also the employment vehicle
for Morton’s staff.

RWB bought a Gulfstream-III (G-III) aircraft. Morton stated that he purchased the plane
through RWB to take advantage of the corporation’s limited liability protection. He
advanced to RWB all funds used to operate the plane and advanced to 510 all funds
used to pay the salaries of its crew. Morton used the plane both for personal travel and
for uses which he maintains were related to the business of HRH or more generally “to
promote the Hard Rock brand.” Morton personally claimed deductions for business use
of the G-III for 1999 through 2001 under § 162, as well as depreciation deductions
under §§ 167 and 168.2 The Service challenged these deductions as attributable to an
activity not engaged in for profit under § 183 (“hobby losses”). The parties filed
cross-motions for summary judgment.

The court summarizes Morton’s argument as follows:

        Plaintiff argues that the aircrafts were used to facilitate multiple business
        activities engaged in by Plaintiff, RWB, and his other business entities,
        and that such uses are deductible business expenses. In other words, he
        argues that he is permitted to apply the expenses of an asset owned by
        one entity towards other entities because Plaintiff and the entities all
        worked towards a common business purpose, and therefore were all
        engaged in a common activity for profit. He sets forth a theory that he and
        his entities operated as a ‘unified business enterprise.’

The court accepted Morton’s unified business enterprise argument:

        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 relied primarily on two cases to support its conclusion. The first case was
Campbell v. Commissioner, 868 F.2d 833 (6th Cir. 1989). In Campbell, substantially all
the shareholders of a corporation created a partnership to purchase and lease an

2
 For the later part of this period, he actually claimed deductions for its replacement, a Gulfstream-IV
(G-IV). A second issue in the case, which we do not discuss, involves the claimed § 1031 like-kind
exchange treatment of the sale of the G-III and purchase of the G-IV.
POSTU-119530-17                              6

airplane. The partnership leased the airplane to the corporation for, according to the
court, the purpose of generating a profit in the corporation. The airplane was primarily
used for the corporation’s business, and generated significant tax losses relative to the
partner’s capital contribution. The 6th Circuit overturned the Tax Court’s decision by
holding a partner, Dr. Campbell, was allowed to take deductions for the partnership’s
losses because the partnership was engaged in an activity for profit under § 183. The
6th Circuit allowed Dr. Campbell’s deduction based on the “relationship between the
partnership and the corporation establish[ing] the requisite profit motive ... The profit
motive in these cases need not be isolated and attributed to just the individual or to just
the corporation. The entire economic relationship and its consequences are what
determine profit motive” (emphasis added by the Morton court). 868 F.2d 836-37. The
Service did not acquiesce in Campbell. AOD 1993-001, 1993-2 C.B. 1.

The second case is Kuhn v. Commissioner, 64 T.C.M. 488 (1992). In Kuhn, an
individual bought land and rented it to his wholly-owned corporation at below-market
rates. The corporation had substantial benefit from the land while the individual
reported losses from it on his individual returns. The Tax Court found that the individual
had a profit motive under § 183 because it was irrelevant whether he intended to
“benefit directly (individually) or indirectly (through the corporation).” The Morton court
acknowledges that in Kuhn, the taxpayer owned the asset in his own name rather than
in that of an entity,

       that difference does not make a distinction. If Plaintiff had titled the
       aircraft in his name, he would have lost the advantage of limited liability.
       And since the income, losses, deductions, and credit of S Corporations
       are passed on to the individual taxpayer, the outcome would have been
       the same regardless of whether he titled the aircraft in his or RWB’s name.

Countering these two cases, the Service argued both DuPont and Moline Properties
should apply and the corporation’s existence and business purpose must be kept
separate from that of the individual taxpayer With regard to DuPont, the court
distinguished it from Morton’s facts, noting,

       [DuPont] was decided in 1940 and the entity at question was a C
       corporation with many stockholders. The development of S corporations
       and other newer types of business entities has changed individuals’
       relationships with corporations; in an S corporation, the corporation is
       essentially the individual owner(s). The taxpayer in [DuPont] owned 16%
       of the stock in the company whereas Plaintiff wholly owns or is a large
       majority holder of all the entities at issue. The purported business
       purpose in [DuPont] of ‘conserving and enhancing [Plaintiff’s] estate is
       unrelated to [DuPont Corporation’s] activity in investment and realty, while
       Plaintiff’s business purpose in traveling to promote the Hard Rock and
       Morton brands is directly related to the business purposes of all his
       entities- to further the Hard Rock and Morton brands.
POSTU-119530-17                                     7

Regarding Moline Properties, just like DuPont, the court made a point of the timing of
Moline Properties and the creation of subchapter S: “[a]gain, there are important
distinctions between Moline Properties and the facts in our case. Moline Properties was
decided in 1943, before the formation of S Corporations.”

The court then distinguished Moline Properties from Morton’s facts by focusing on the
corporate-level tax owned by C corporations, but not (typically) by S corporations,

        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.3 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.

Although the court found that the facts supported the treatment of Morton’s entities as a
“unified business enterprise,” they did not find enough information in the record to
determine which aircraft expenses were for business rather than personal purposes,
and therefore deferred judgment on the ultimate allowance of the § 162 and
depreciation deductions.

Since the Morton decision, Steinberger v. Commissioner, TC Memo 2016-104, is the
only case that cited and discussed Morton. In so doing, the Tax Court distinguished
and, thereby limited, Morton’s holding. In Steinberger, the Tax Court rejected a
taxpayer’s argument he should be able to combine the activities conducted by separate
entities, an airplane leasing business and medical practice, as a single activity to
overcome the § 183 limitation. The Tax Court declined to apply Morton’s holding for
two reasons. First, the taxpayer in Steinberger and the taxpayer in Morton had
significantly different ownership in the entities that each attempted to combine.
Specifically, in Steinberger the taxpayer owned approximately 14% of the professional
association (i.e., the professional practice) and, with his spouse, 100% of the LLC (i.e.,
the airplane leasing business). In Morton the taxpayer owned the majority or all of the
interest in the corporations he sought to combine. Second, unlike Morton, the taxpayer
in Steinberger failed to show the two businesses were a unified business enterprise.
Supporting this conclusion the Steinberger court noted that in Morton “the entity that
owned the airplane … did more than just own the airplane—it also owned the real
property on which several of the Hard Rock Cafes were built and served as landlord of
those cafes.”

3
  The court does not mention that an S corporation can have liability for corporate level income taxes in
several situations, under §§ 1371(d)(2) (recapture of investment credits under §§ 49(b) or 50(a)), 1374
(“built-in gains” tax on sale of certain corporate property), and 1375 (tax on excess “passive investment
income”). As all of these provisions require the S corporation to have had a previous existence as a C
corporation or to have previously merged with a C corporation, and do not otherwise appear applicable to
the Morton facts, it is unclear whether the court would have found Moline Properties applicable to an S
corporation to the extent one of these taxes was implicated.
POSTU-119530-17                            8

3. Historic application of Moline Properties & DuPont to S corporations

Although there are a number of sources discussing the general “unified business
enterprise” theory enunciated in Morton, very few of them specifically analyze the claim
that Moline Properties and DuPont do not apply to S corporations (or at least to S
corporations that are wholly or mostly owned by a single shareholder). The only
detailed discussion we located is “A Rock and a Hard Place: The ‘Unified Business
Enterprise’” by Professor John Gamino, Tax Notes Today, 8/30/11. Professor Gamino
criticizes the Morton decision on several grounds. With respect to the Moline Properties
aspect, he states:

      There is no question that Moline Properties remains strong as a general
      matter—so what is to be made of the view that an S election trumps it, at
      least in cases of a sole or dominant shareholder? It may seem
      counterintuitive to treat an S corporation and its shareholder as having
      separate tax lives, but take such an assumption only a half-step further
      and one would be left questioning why wholly owned S corporations file
      returns at all. Why not simply disregard them, the same default treatment
      applied to single-member LLCs? There is simply no precedent for
      excluding S corporations from the reach of Moline Properties, and none is
      cited by the Court of Claims here. The available authority points in the
      opposite direction—that S corporation status is perfectly congruent with
      the separation principle. Indeed, no other answer is thinkable in statutory
      terms—Congress has never limited the subchapter S reporting rigors to
      corporations having multiple shareholders. [Paragraph break and citations
      omitted.]

As Prof. Gamino states, prior to Morton, Moline Properties and DuPont had been
uniformly applied to S corporations by the courts. In some cases, an S corporation
separateness is assumed; in other cases courts consider, and ultimately reject, the
position that S corporations might not be treated as separate due to their pass-through
nature.

Howell v. Commissioner, 57 T.C. 546 (1972) and Buono v. Commissioner, 74 T.C. 187
(1980) were similar cases involving S corporation’s sale of property in which the Service
attempted to recharacterize capital gain as ordinary income. The Howell opinion notes
that “respondent has not questioned the validity of the corporation structure. Rather,
both parties agree that [the S corporation] was a viable corporation. Such an
understanding is appropriate in light of the Supreme Court’s determination in [Moline
Properties].” 57 T.C. 553. In both cases, one of the Service’s alternative arguments
was to apply the then-existing anti-abuse rule of Treas. Reg. § 1.1375-1(d) under which
property that would have produced ordinary income in the hands of the substantial
shareholders would do so as well in the hands of an S corporation if the corporation was
availed of to change the character. In both, the court found that the regulation was
inapplicable because the income would have produced capital gain in the hands of the
shareholders (i.e, the shareholders were not “dealers” in that kind of property in their
POSTU-119530-17                                   9

individual capacities). Because of this, both decisions explicitly avoid opining on the
validity of the anti-abuse regulation, but the Buono decision suggests doubt about the
regulation because “corporations are almost universally accorded recognition as
separate viable entities under the tax law. Moline Properties.” 74 T.C. 207.

Crook v. Commissioner, 80 T.C. 27 (1983), involved taxable years of an S corporation
governed by the original 1958 provisions of subchapter S, under which S corporation
income other than capital gains did not retain its separate character (as is the case for
post-1982 S corporations) but was taxable as either an actual or deemed dividend. The
shareholders of an S corporation had considerable “investment interest” expense, which
they could only deduct against “investment interest” income pursuant to the § 163(d)
limits. The Service argued that the S corporation income from the operation of
automobile dealerships should be treated as business rather than investment income,
and thus should not free up any suspended interest deductions. The court disagreed,
finding that the separate existence of the corporation should be respected under Moline
Properties and citing to Howell and Buono for the “separate and distinct” business of the
corporation from that of its shareholders. Because subchapter S described the income
as a “dividend,” one of the classic forms of investment income, the interest deductions
were allowable against it.4

In Allen v. Commissioner, T.C. Memo 1988-166, an individual owned stock in an S
corporation which held a partnership interest. The shareholder had insufficient basis in
the S corporation stock to claim all of the losses flowing through from the partnership,
but argued that his individual guarantees of partnership debts should increase his S
corporation basis. The court cited Moline Properties denying the basis and deductions.

Deductions were denied for expenses of an S corporation paid directly by its
shareholders in Russell v. Commissioner, T.C. Memo 1989-207. The Service argued
that DuPont, among other cases, holds “a taxpayer may not deduct expenses which
were incurred for the benefit of others.” The taxpayers in Russell argued that these
precedents should not apply:

       because, unlike the subchapter C corporations involved in those cases, [S
       corporation] was a subchapter S corporation. Thus, petitioners reason,
       even though [S corporation] never paid salaries or dividends the profits
       would eventually flow to petitioners by operation of law giving petitioners
       the requisite profit motive. Although all future profits will pass through to
       petitioners, their profit motive is no greater than that of any subchapter C
       shareholder. [S corporation] remains a separate taxable entity regardless
       of whether it is a subchapter S corporation or a subchapter C corporation.
       It is [S corporation] which ‘reaped the income from petitioners’ activities,
       and yet paid none of petitioners’ expenses and nothing for petitioners’

4
 Footnote 13 in the Crook decision notes the result would have been reversed under the 1982 revisions,
with the active business income retaining its character in the hands of the shareholders.
POSTU-119530-17                                     10

        efforts in producing the income.’ We do not agree with petitioners that a
        subchapter S corporation should be treated differently from a subchapter
        C corporation in this respect.5 [Citations and paragraph break omitted.]

In Amorient v. Commissioner, 103 T.C. 11 (1994), P, a C corporation with several
subsidiaries, acquired an S corporation, thereby terminating the S election. P’s
consolidated return included a net operating loss (NOL), part of which was attributable
to the former S corporation. The court found that this portion could not be carried back
to P’s prior consolidated year, even though such carryback would have been allowed
under the consolidated return regulations if the S corporation had instead previously
been a partnership, all of the interests in which were acquired by the consolidated
group. Despite the similarities between an S corporation and a partnership, the court
cited Moline Properties as requiring the former S corporation’s corporate status to be
respected. Under the relevant portion of Treas. Reg. § 1.1502-79, an acquired
corporate subsidiary’s post-acquisition NOL could not be carried back to the
consolidated group’s pre-acquisition return.

Ding v. Commissioner, T.C. Memo 1997-435, aff’d 200 F.3d 587 (9th Cir. 1999)
discusses whether the income that flow-through an S corporation is treated as
self-employment (SE) income for purposes of §§ 1401 and 1402. The taxpayers
calculated their SE tax taking into account not only profits and losses from their sole
proprietorships and a partnership, but also from several S corporations. For the years
in question, the S corporations generated sufficient losses to cause the taxpayers to
have negative SE earnings and thus no SE tax. Although the SE statute did not
explicitly address S corporations, the court held that the § 1366 income and loss was
not an SE item, citing Moline Properties for the separate existence of a legitimate
corporation from its shareholder and DuPont for the separate nature of a corporation’s
business from that of the shareholders. Although § 1366 preserves the nature of S
corporation items in the shareholders’ hands, this explicitly applies only to chapter 1 of
the Code, whereas SE tax is determined under chapter 2.6

In Catalano v. Commissioner, T.C. Memo 1998-447, the taxpayer owned several boats
which he leased to his wholly-owned S corporation. The court disallowed the
corporation’s claimed deductions for the lease payments as a § 274 entertainment
5
  A footnote acknowledges that “[i]f petitioners had allocated the expenses at issue to [S corporation] and
had deducted them on [S corporation’s] income tax return, the resulting loss would have ultimately
passed through to petitioners personally. However, this was not done and cannot help petitioners now.”
6                                      th
  Durando v. U.S., 70 F.3d 548 (9 Cir. 1995), similarly held that S corporation income was not treated as
SE earnings for purposes of calculating a “Keogh” retirement plan deduction. Both Ding and Durando
favorably cite Rev. Rul. 59-221, 1959-1 C.B. 225, in which the Service first opined that S corporation
income did not constitute SE earnings, although that ruling was under the substantially different
provisions of the original subchapter S in which there was no general pass-through of S corporation
items, even under chapter 1. In Grigoraci v. Commissioner, T.C. Memo 2002-202, the Service attempted
to disregard an S corporation which the individual taxpayer had interposed between himself and a general
partnership, and treat the S corporation wages as SE earnings. The court held that the taxpayer’s desire
to limit his liability was a sufficient business purpose that the S corporation should be respected under
Moline Properties.
POSTU-119530-17                                     11

expense. The taxpayer objected this effectively resulted in double taxation, with the
lease payments reportable as Schedule E rental income and the flow-through under
§ 1366 from the S corporation increased by the disallowance. The court found that this
result was compelled by Moline Properties and DuPont:

        In view of these fundamental principles, courts have consistently required
        shareholders to treat income received as passthroughs from their S
        corporations as distinct from income the same shareholders received for
        providing personal services to their corporations. This requirement
        applies even though the shareholders, and not their corporations, are
        liable for their pro rata shares of corporate income on their individual
        income tax returns.7

Nelson v. Commissioner, T.C. Memo 2000-212, involved losses of an S corporation
which the individual taxpayer had admittedly created as a “shill” for the former owners of
a legal gambling business who had been required to divest because of their criminal
convictions. The taxpayer did not have sufficient basis in the S corporation stock to
claim his losses, but made the argument that the corporation was a “sham” and the
losses should instead appear directly on his own return, not subject to basis limitations.
The court held that this argument could not be made on certain procedural grounds, but
also noted that it would fail under Moline Properties; even if the corporation had been
originally created as a sham, it in fact carried on business activities.8

One case that might suggest that Moline Properties is not applicable to S corporations
is Russon v. Commissioner, 107 T.C. 263 (1996). P was an employee of a C
corporation owned by his father and uncles. P and his brothers agreed to purchase the
stock of the C corporation from the older generation. P incurred debt to make the
purchase, and the issue was whether this was fully deductible as business debt or was
subject to the investment interest deduction limits of § 163(d). The Tax Court, citing
Moline Properties, concluded that the corporation and its shareholders were separate
taxpayers, and that the interest paid by the shareholders to acquire their interests was
as part of an investment, not arising out of the corporation’s own business. The opinion
notes, however,

7
 In TAM 200214007, IRS Examination unsuccessfully attempted to disregard the existence of S
corporations in a § 274 context. A married couple owned all or most of two S corporations, Taxpayer and
B. Taxpayer developed and operated Facility, which it rented to B, which deducted the allowable amount
of the rents under § 274. Examination questioned the bona fide nature of the payments because of the
common ownership of the S corporations, but CC:ITA concluded that given the lack of evidence that
either was a sham, Moline Properties and DuPont required that they be respected.
8
  More briefly, the following also apply Moline Properties and/or DuPont to respect the existence of an S
corporation: IRS Market Segment Specialization Program Guideline: Passive Activity Losses, Feb. ’96
(taxpayers attempting to deduct their payment of corporate expenses on individual returns); Weekend
Warrior v. Commissioner, TC Memo 2011-105 (validity of second S corporation formed to provide
personnel services to original S corporation); and PLR 201328035 (tax-exempt entity’s ownership in S
corporation does not cause for-profit activities of corporation to be attributed to owner, which would
threaten exemption).
POSTU-119530-17                                     12

        petitioners fail to consider the fact that [the entity involved here, ‘C Corp’]
        is a C corporation. If [C Corp] were an S corporation or a partnership, it
        appears that [this partnership], as an active manager, would be entitled to
        deduct the interest, without limitation, on the debt incurred to purchase the
        stock as a direct owner of the business. [Citation omitted.]

The distinction between an S corporation and a C corporation under § 163 arises
because § 163(d) applies to interest paid on indebtedness allocable to “property held for
investment,” which § 163(d)(5)(A)(i) defines to include “property which produces income
of a type described in § 469(e)(1).” Section 469(e)(1), part of the provision limiting the
deduction for losses incurred in “passive activities,” includes, in relevant part, “gross
income from interest, dividends, annuities, or royalties not derived in the ordinary course
of a trade or business.” As C corporation stock is property of a kind which produces
dividends, it is investment property, even though the actual stock at issue in Russon
had never paid dividends. An S corporation (under current law) usually does not pay
dividends but instead passes through the items of income earned by its assets and
activities. The published guidance under § 163 applies an aggregate approach to these
pass-through entities, allocating the interest among the entities’ assets, with that portion
belonging to the business assets fully deductible, subject to the passive activity loss
limitations under Treas. Reg. § 1.469-2T(d)(3), and that part belonging to the
investment assets subject to the § 163(d) limitations.9



9
  Although the similarity of an S corporation to a partnership in the §§ 469 and 163 contexts requires a
distinction between the treatment of S and C corporations under those sections, it should be noted that
Moline Properties has also been held applicable to partnerships, and therefore the quasi-partnership
treatment of subchapter S is not a reason for the non-application of Moline Properties. Briefly, the next
three cases extend the Moline Properties principles to partnerships:
                                             th
Denning v. Commissioner, 180 F.2d 288 (10 Cir. 1950). A corporation was engaged in the business of
buying and selling “broom corn” (variety of sorghum used in making brooms) and related products.
Several minority shareholders formed a partnership in the same business with their own capital, with no
contribution or loan from the corporation or the majority shareholder. Although there were shared
employees and facilities, the partnership paid its own share of the expenses and maintained separate
records. Citing Moline Properties, the court found that the partnership was valid and could not be
disregarded in determining liability for income and excess profits taxes, except with respect to a small
portion of its business which was found to be an attempt to evade government price controls (this
                                                                     th
decision being in the related Denning v. Fleming, 160 F.2d 697 (10 Cir. 1947)). With respect to this
small portion, the partnership was the alter ego of the corporation.

Campbell County State Bank v. Commissioner, 37 T.C. 430 (1961), acq. 1966-2 C.B. 3, reversed &
                                            th
remanded on another issue, 311 F.2d 374 (8 Cir. 1963). The shareholders of a bank formed a
partnership to engage in the insurance business because state law forbade banks from engaging in
anything other than the banking business. Despite the bank’s facilities being used for the insurance
business with the bank paying most or all expenses, the Tax Court found that because the insurance
partnership did engage in the insurance business, it would be respected under Moline Properties and its
income would not be attributed to the bank. The Circuit Court accepted this finding, but held that the Tax
Court had not properly allocated expenses between the corporation and partnership under § 482.
POSTU-119530-17                                     13

There are two narrow exceptions to the general rule that a taxpayer may not deduct an
expense paid on behalf of another. The first exception is taxpayers are allowed a
deduction for paying another’s expense if their primary motive was to protect their
reputation or promote their business.10 The second exception is taxpayers are allowed
a deduction if there is a genuine agency relationship between the parties.11 Although
we acknowledge these exceptions, we emphasize the exceptions are narrow and
neither attempts to negate Moline Properties.

DISCUSSION & CONCLUSION

As discussed above, 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



Bertoli v. Commissioner, 103 T.C. 501 (1994). The taxpayer was the general partner of a partnership to
which his brother transferred assets in an attempt to defraud creditors. A state court found that the
transfers were fraudulent conveyances and the partnership’s assets were placed in receivership. Based
on this, the partnership wrote down the value of its assets to zero and the taxpayer claimed losses. The
Tax Court found that the state court adjudication could bind the parties in a federal action, and that the
taxpayer was estopped from asserting that the partnership was created for a business purpose.
However, the taxpayer was not estopped from showing the validity of the partnership under Moline
Properties by proving that the partnership actually engaged in any business activities.
10
   See, e.g., Lohrke v. Commissioner, 48 T.C. 679 (1967)(establishing a two-prong test for a shareholder
to deduct payment of a corporation’s expense: (1) the purpose was to protect or promote the
shareholder’s own business, and (2) the expenses paid were ordinary and necessary to that business);
Capital Video Corp v. Commissioner, 311 F3d 458 (CA1 2002)(a corporation failed to meet the second
prong of the Lohrke test because its payment for shareholder’s criminal defense were not an ordinary and
necessary business expense).
11
  See, Commissioner v. Bollinger, 485 U.S. 340 (1988) (an agency relationship existed and an individual
shareholder was allowed to deduct construction and operation expenses despite his corporation holding
record title to the improved property).
POSTU-119530-17                              14

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.

For the reasons above, we conclude that the Service should reject the Morton holding
and continue to assert that Moline Properties is applicable to S corporations, regardless
of whether the S corporation is wholly or majority owned. If, despite clear law to the
contrary, to the extent a court supported Morton’s holding, we would also argue
Steinberger significantly limits Morton to its facts. Those facts include a shareholder
owning at least a majority, if not substantially more, of the entities sought to be
combined and that those same entities must have significant business integration.

If you have any questions, please call (202) 317-5279.

                                         JOHN P. MORIARTY
                                         Acting Associate Chief Counsel
                                         (Passthroughs and Special Industries)


                                         By:
                                               Bradford R. Poston
                                               Senior Counsel, Branch 3
                                               Associate Chief Counsel
                                               (Passthroughs and Special Industries)