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Understanding alter ego liability

On Behalf of | Jan 26, 2022 | Tax Law |

Partnerships and sole proprietorships are not separate legal entities from their owners. Therefore, the IRS treats the business and the owner as the same person for tax purposes. On the other hand, corporations are separate entities from their owners. However, the IRS may treat an LLC or corporation just like a sole proprietorship or partnership if the owners do not separate themselves from their establishments as provided by the law. This situation is called alter ego liability.

Corporations as alter egos

The term “alter ego” refers to a person with an alternate identity. Business law uses a similar concept to mean that the corporation is another owner’s face and not a separate entity.

If the owner wants to enjoy the benefits of being separate from the business, they must abide by all the corporate rules and principles in running business affairs. However, this is not always the case. Here are some examples of when an alter ego may come into play:

  • Running a corporation without capitalizing it properly
  • Failure to separate corporate and personal funds
  • The owner accesses corporate funds and uses them to pay personal debts.
  • Owners assume corporate debts and pay them from their personal funds.
  • Creating companies to transfer personal debts
  • Failure to follow other corporation guidelines, such as maintaining books of account, holding meetings or taking stock

Alter egos and the IRS

The IRS may seek to assert that the corporation and the owner are the same person and attempt to collect taxes. If the court allows it, the IRS may seek to acquire the owner’s personal assets to clear any outstanding taxes. In many cases, the case does not go to court. Instead, the IRS seeks the approval of the area counsel to collect accrued taxes from the business owner. This act of transfer of responsibility is also called “piercing the corporate veil” if it involves other debts.

There are other cases where the corporation may be held liable for individual debts. This is called reverse alter ego. However, it follows the same principle as alter ego, where corporate and personal assets are indistinguishable. In such a case, tax and liability defaults by the owner may be demanded from the corporation.