Oregon Tax Court Holds Non-Resident Corporate Partners Of Law Firm Are Legitimate Taxable Corporate Entities

On August 6, the Oregon Tax Court held that non-resident professional service corporations serving as partners of a multistate law firm were legitimate "taxable corporate entities."¹ Finding that the corporations were not sham corporations primarily created to avoid the payment of Oregon income tax, the Court found that there were a number of legitimate business reasons for the business model. Because the out-of-state partners were recognized as legitimate corporations, they could not be required to pay state income tax on their partnership income sourced to Oregon.

Background

The taxpayer, Stoel Rives, was a multistate law firm that was formed as a partnership owned by out-of-state corporate partners. Individual lawyers were the principals and shareholders in these professional service corporations. For the 1995 tax year, the Oregon Department of Revenue sought to impose assessments of Oregon income tax upon individuals as partners of the law firm instead of recognizing the partners as corporate entities. As individuals, the partners would be required to pay Oregon state income tax on their share of the partnership income sourced to Oregon.

Stoel Rives disputed the assessments, asserting that the out-of-state partners were taxable corporate entities and not the related individuals. The individuals had legally formed professional service corporations in their respective jurisdictions and according to Stoel Rives, these corporations, and not the individuals, became the partners of the law firm. The Magistrate Division of the Oregon Tax Court agreed with Stoel Rives and granted its motion for summary judgment. In response, the Department appealed the matter to the Regular Division of the Oregon Tax Court. The parties subsequently filed motions for summary judgment and stipulated to an extensive set of facts. The issue before the Court was whether the out-of-state partners were, in fact, taxable corporate entities.

Legitimate Business Model

The Court began its analysis by asserting that the two-part test espoused by the U.S. Supreme Court in Moline Properties² was appropriate to this case. The Moline test determined whether a corporation was a viable taxable entity versus a shareholder who created a "sham" corporation. Under Moline, courts consider whether: (i) the corporation was created for business purposes; and (ii) the corporation actually conducted business activity in a corporate form.

The Court summarily concluded that the corporations were created for business purposes. According to the affidavit of a partner and member of the management committee of the law firm, there were legitimate business reasons for developing the partnership under the current model of having non-resident professional service corporations serve as the technical partners. To illustrate, the model was initially developed to assimilate a separate law firm into Stoel Rives. In addition, as was the case for most individuals who incorporated, the firm wished to limit potential personal liability. Therefore, the first prong of the Moline test was satisfied because business reasons drove the decision to set up the model of corporate partners rather than the avoidance of Oregon state income tax. With respect to the second prong of the Moline test, the business activity test, the Court noted that the evidence showed that the partners "conducted their day to day business activity with great attention to compliance with corporate business requirements." Thus, the partners conducted business activity in a corporate form as required by the second part of the Moline test.

While passing the Moline test, by itself, determined the outcome of the case in favor of Stoel Rives, the Court also noted that the Department had previously lost on this issue. The Department had initially argued for the treatment of the partners of the firm as individual partners when a separate law firm joined the Stoel Rives partnership. The Magistrate Division hearing the case ruled in favor of the law firm and the Department never appealed that decision. To the Court, there was a "strong argument" that this prior Magistrate Division decision was precedential to this case.

Commentary

This decision illustrates a state's failed efforts to reach out-of-state residents' income by repeatedly attacking a business arrangement that is relatively common in the professional service fields. Although the Department lost on this issue in the past when it litigated against the law firm that assimilated into Stoel Rives, the Department nonetheless attempted to tax the 1995 income again by issuing an assessment against Stoel Rives. Moreover, historically, a corporation has been recognized where it engages in some, even minimal, income-producing business activity.³ Therefore, the Department's assessment on the non-resident partners appears to have disregarded historical legal precedent in preference for a new potential revenue stream from out-of-state residents.

Robert Manicke, the attorney for Stoel Rives in this matter, commented to us about the case. He emphasized the importance of documenting the non-tax business purposes of the formation of an entity. For Stoel Rives, there were a number of business purposes, including the benefit of withholding on the wages of the shareholder-employee partners versus the filing of quarterly tax returns by the individual partners.⁴ In addition, among other business reasons for creating its business model, health insurance premiums were excludable from the income of the shareholder-employee partners whereas such exclusion was unavailable to the individual partners.⁵

Manicke also stated the importance of following through on the corporate formalities after the formation of the entity. For instance, the entity should conduct board meetings, record meeting minutes and establish its own bank account. Stoel Rives' professional service corporations had approved written partnership agreements.⁶ Thus, the decision reaffirms the rule that as long as the evidence shows that there is substance to the formation of a corporation, a court will likely honor the corporation as such.

Footnotes

1 Department of Revenue v. Stoel Rives PC, Oregon Tax Court, No. TC 4832, Aug. 6, 2012.

2 Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943).

3 For example, see Britt v. United States, 431 F.2d 227, 237 (5th Cir. 1970).

4 Defendants' Reply to Plaintiff's Response to Defendants' Cross-Motion for Summary Judgment filed on July 31, 2009, Department of Revenue v. Stoel Rives PC, Oregon Tax Court, No. TC 4832.

5 Id.

6 Id.

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