Elot H. Raffety Farms, Inc. v. United States

GIBSON, Chief Judge

(dissenting).

I respectfully dissent. While this case presents a close question, to me the Mexican entity, El Sombrero, was not a cor*1240poration and should not be treated as a corporation for tax purposes because it served no business function other than to enable the taxpayer to operate in Mexico. The taxpayer and its associates sought to carry on a profit-making venture as a partnership1 and were advised by Mexican counsel that formal creation of a “limited liability company” would be legally required for conducting business in Mexico. Even after counsel created the entity, however, it was operated as a partnership in every respect. The sole purpose of the Mexican entity was to provide an assumed name to enable the Missouri partnership to operate lawfully in Mexico. Tax avoidance played no part in the taxpayer’s decision to create it.

The majority’s decision in this case is another application of an anomalous principle under which the taxpayer always loses. If the substance of the transaction favors the Government, we look to substance (which we should); if it favors the taxpayer, we ignore it and look to form. It is improper in this case to impute corporate characteristics where there were none so as to deny the claimed operating loss of what was obviously a partnership venture. Whenever taxation is allowed to depend upon form rather than substance, “the door is opened wide to distortions of the tax laws.” Landa v. Commissioner, 93 U.S. App.D.C. 265, 269, 211 F.2d 46, 50 (1954). Here, as elsewhere, the decision should turn on substance regardless of the outcome. Estate of Smith v. Commissioner, 313 F.2d 724, 730 (8th Cir. 1963).

I believe the entity as it was actually formulated and used by the partners did not possess sufficient corporate characteristics, even viewed under the Treasury Regulations cited by the majority, to warrant limiting the taxpayer to capital loss deductions by labeling this nebulous entity a corporation. It was in reality no more than a sham. None of the Missouri partners subscribed to the Articles which created the entity; they couldn’t even read the Spanish language of the Articles, and were not informed of their specific contents until the IRS provided them a translation. They were issued no stock, notes, assignments, or other conveyance evidencing their interests in the entity. Nor did they receive any assurance of dividends, interest, security or a fixed dafe for repayment of their advancements of operating funds.

Moreover, none of the Mexican subscribers (fictional owners) made any actual investment in the partnership or Mexican entity and only one participated in its affairs. Indeed, they were practically unknown to the Missouri partners and no money was invested by the partners in their behalf. The figurehead administrator’s activities appear to have been limited to signing documents with which he was unfamiliar or uninterested. He did not conduct the 1968 liquidation of the entity as the Articles purported to require. Nor were any required annual meetings conducted or accountings rendered. In sum, the entity was never capitalized or managed according to the provisions of its organizational Articles.

Three of the four characteristics relevant under Treas.Reg. § 301.7701 — 2 *1241(1960), as amended by T.D. 6797 (1965), if present at all in the Mexican entity, existed in form only. First, while the entity purported to enjoy continuity of life by withstanding death or separation of any of the fictional members, the portion of the Articles treating the subject failed to provide for other contingencies such as bankruptcy or insanity of a member which might otherwise cause dissolution of a partnership. And, of course, the investing Missouri partners themselves were in no way affected by the entity’s Articles. They had no documented legal interest nor association with it and their partnership did not enjoy continuity of life. See Uniform Partnership Law, Mo.Rev.Stat. § 358.310 (1969, V.A.M.S.).

Second, while the general partners formally appeared to enjoy limited liability shielded by the Mexican entity, they all in fact did not. Because of the entity’s obvious fictional nature, the partners were apparently unable to borrow sufficient capital under its name alone without adding Mr. Raffety’s personal guaranty. As a result, Raffety himself was ultimately held personally liable .for some of the venture’s debts in litigation in a Mexican court.

The third characteristic, centralized management, was not present because the fictional administrator merely performed ministerial acts as an agent under the direction of his principal, the Missouri partnership. Treas.Reg. § 301.-7701-2(c)(3) and (4). Although the Articles purported to empower the administrator to transact any of the entity’s business, in fact he had no authority to make business decisions on its behalf independent of the Missouri partners. The partners agreed from the start .that they alone would share management and control of the venture equally with the understanding that Mr. Raffety would conduct the business and farming operations personally in Mexico, using the entity’s name rather than his own. And while the entity itself extended no actual authority to Raffety to act on its behalf, the Missouri partnership surely did. As an example, Raffety personally drew all checks in the entity’s name to pay the venture’s farming expenses.

The final corporate characteristic, free transferability of interests, was present neither in form nor in substance. No shares of stock or any other evidence of equity ownership was ever issued to the Missouri partners or their nominees. The Government conceded that the interests of even the fictional owners of the Mexican entity were not freely transferable because the Articles contained restrictions. And if in reality the Missouri partners’ interests in the entity were none other than their partnership interests, transfer of the interests was restricted under Missouri law. See Uniform Partnership Law, Mo.Rev.Stat. § 358.270 (1969). It thus appears that the association of El Sombrero had more noncorporate characteristics than corporate characteristics and should under Treas.Reg. § 301.7701 — 2 be characterized as a noncorporate entity.

It further appears that even if the concept of a taxable association is stretched to include the Mexican entity in this case, the District Court correctly concluded that the entity should be disregarded for tax purposes because it was altogether passive. While the practice of disregarding a corporate entity is not to be lightly applied in any context, this case presents the proper exceptional situation that warrants it.

The entity here performed no substantial business function and actually engaged in no business. Its purpose, as the District Court found, was solely to allow the Missouri partners to farm in Mexico without violating Mexican law. Such a purpose cannot be considered the equivalent of commercial or “business activity” as that term is used in Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-39, 63 S.Ct. 1132, 87 L.Ed. 1499 (1943), because it is inert. Moreover, following its organization the entity did not itself' carry on any business. Raffety’s personal Mexican farming activities on behalf of the partnership, with no more connection to the entity than the use of *1242its name, cannot be characterized as conduct of business by the entity. The test of conducting business under Jackson v. Commissioner, 233 F.2d 289, 290-91 (2d Cir. 1956), is the actual business functioning of the entity itself, if any, not the taxpayer’s aim to be accomplished by using it. The entity here should thus be disregarded for tax purposes just as it was for all others, and the partners’ operating loss recognized as their own, not merely as that of the Mexican entity. See Paymer v. Commissioner, 150 F.2d 334, 337 (2d Cir. 1945).

I would affirm the judgment of the District Court for the reasons stated by Judge Wangelin and would further hold that the Mexican entity was not an association taxable as a corporation.

. The “Missouri partnership” was formed in 1965 by oral agreement between three partners:

(1) the taxpayer, Elot H. Raffety Farms, Inc., a Missouri corporation engaged in farming in Missouri and Illinois, acting through its president and principal stockholder, Mr. Raffety Qh interest);
(2) Mr. L. D. Joslyn, a Missouri attorney Qh interest); and
(3) Rolwing-Moxley Company, a corporation which Joslyn partly owned, engaged in producing cotton and other farm products (’A interest).
The partnership was formed solely for the purpose of conducting farming operations in Mexico. The three partners agreed to share the profits and losses of their Mexican venture in proportion to their interests Qh, 'A, and ‘A respectively). They considered themselves to be general partners having equal shares in management and control but delegated authority to Mr. Raffety to administer the Mexican operations personally.
Of the three partners, only the taxpayer corporation, Elot H. Raffety Farms, Inc., is a party to this litigation.