Cracking Walnuts with a Sledgehammer: The Uncertainty of the Reallocation Doctrine in Stewart v. Commissioner
In Stewart v. Commissioner, the Tax Court held that the individual taxpayer could not deduct payments made by him as a sole proprietor to his wholly-owned corporation under a contract for management services, where he alone performed the services connected with those payments. The court concluded that the payments could not be considered deductible business expenses under section 162(a) where there was no evidence to indicate that the taxpayer was acting as an employee of the corporation rather than in his individual capacity. This Note analyzes the overall issues raised by taxpayers shifting income to wholly-owned corporations. It illustrates how the Service has sometimes been conflicted by its promise to uphold a corporation’s independent status, while also maintaining the fundamental rule that income be taxed to the true earner. More specifically, this Note suggests that the Tax Court’s decision in Stewart effectively disregarded the legitimate corporate form of business organization in order to disallow a deduction to the individual taxpayer. The court’s holding can be read to penalize taxpayers who act in good faith, and to thwart congressional objectives.Part I of this Note explains the facts and holding of the Stewart case, while also identifying a gap in the court’s reasoning. Part II examines how the conflict between viable corporations and the assignment of income among related tax-payers has generated two distinct legal theories for reallocating income. Part III argues that while the court’s decision in Stewart appears to conform to the assignment of income doctrine, a more equitable resolution could have been achieved by applying an alternative section 482 analysis. Part IV examines the steps a taxpayer should undertake, in light of the Stewart decision, in order to properly conduct business transactions between related entities. Part V concludes that confusion in this area of the law continues to undermine confidence among taxpayers who seek to utilize the tax advantages of the corporate form, while still complying with the Service’s standards.