Can a North Carolina city buy 100% of the stock of a private water/sewer company and then keep the company alive as a shell so the seller pays less tax?

Plain-English summary

Charlotte was in the middle of phasing in a uniform water and sewer rate across Mecklenburg County. A 1991 annexation pulled in a subdivision that was already being served by a private water/sewer company, and the City had a duty under Chapter 160A to extend service to the annexed area. The private company's shareholders wanted out, and the City wanted control of the company's pipes. The cheapest way to do the deal, from the seller's tax perspective, was a stock sale rather than an asset sale: a stock deal saved the company itself a Section 311(b) federal corporate-level tax on the gain, which the City quantified at roughly half a million dollars on a roughly $4 million transaction.

To preserve that tax savings, the City proposed buying 100% of the shares and then keeping the corporation alive as a shell. City employees would sit as the corporation's directors and officers. Their only real job would be to sign a master agreement letting the City operate the company's water and sewer system under the City's own policies and rates and collect all the revenue. The corporation would basically be a paper entity with the City running its underlying business.

The AG's Special Deputy Charles J. Murray said the structure failed for two independent reasons.

First, there was no statutory grant of authority for a North Carolina city to own and operate a for-profit Chapter 55 corporation. The City pointed to N.C.G.S. § 160A-11, the general "authority to hold property" provision, and to § 160A-4's command that municipal powers be construed broadly. The AG agreed that the authority to "hold" personal property reached the purchase of shares where the corporation's only asset was a water and sewer system. But the AG drew a line at operating the corporation: holding shares as a step toward dissolution was within the city's traditional public-enterprise functions; running a private for-profit corporation as an ongoing concern was not. Reading § 160A-11 to authorize that would not be a broad construction; it would be the addition of a power the Legislature had not granted. Part 1 of Article 16 of Chapter 160A contemplated only two postures for a city in a public enterprise: operate it directly, or franchise it out to a private entity. Owning and operating a Chapter 55 corporation was neither.

Second, even if the authority existed, the structure would destroy the corporation's separate identity. North Carolina corporate law treats a corporation as a distinct juridical person only when it has officers and directors who can act on behalf of the corporation, not solely on behalf of someone else. Under Charlotte's plan, the directors and officers were City employees whose duties to the City would dominate any duty to the corporation. There was no independent private business purpose for the corporation to pursue. The AG concluded that, if challenged, a court would treat the corporation as having merged into the City and ceased to exist, which would defeat the very tax structure the plan was designed to preserve.

The AG closed with an opening: the City could buy the shares and convert the corporation to a Chapter 55A nonprofit. § 160A-312 expressly authorized a city to contract with a nonprofit corporation to provide a public enterprise service, and the Court of Appeals had upheld that structure in the Publishing Co. and Sides hospital cases. Whether converting the for-profit shell to a nonprofit would still yield the desired federal tax treatment was, in the AG's words, "not addressed in this opinion," which was a polite way of saying that was the City's problem to work out with its tax advisors.

Currency note

This opinion was issued in 1992. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here. North Carolina's municipal-powers statutes in Chapter 160A have been amended several times since 1992, and the federal tax treatment of stock-versus-asset sales (Section 311(b) and related provisions) has shifted as well. The Dillon Rule analysis here remains the starting point, but later decisions like Lanvale Properties v. County of Cabarrus refined the standard for implied powers in important ways.

Background and statutory framework

Two doctrines collide in this opinion. The first is the Dillon Rule, which (as North Carolina applied it) presumes that a municipality has only those powers expressly conferred by statute, plus those necessarily or fairly implied. The 1971 enactment of N.C.G.S. § 160A-4 was an attempt to soften the Dillon Rule by requiring courts to construe grants of municipal power broadly. The Supreme Court's 1990 River Birch Associates decision confirmed that broad construction was the rule of decision. But Section 160A-4 was not a free-pass: it told courts to interpret grants generously; it did not let courts manufacture grants that were not there at all.

The second doctrine is corporate separateness. A Chapter 55 for-profit corporation is a creature of statute whose existence depends on having shareholders, directors, and officers who play those roles in a meaningful sense. The "piercing the corporate veil" cases run the other direction (creditor going through the corporate fiction to reach a shareholder), but the underlying premise is the same: if the corporation has no independent existence, the law does not pretend it does. Robinson, North Carolina Corporation Law §§ 2.8 through 2.10, set out the doctrinal framework the AG cited.

The two out-of-state cases the AG quoted (Dade County from Florida and Springfield from Missouri) both involved cities buying all the stock of a utility company, and both expressly contemplated immediate dissolution of the acquired corporation. The AG used them to show that even the cases the City relied on for general stock-purchase authority assumed dissolution. None of the cases approved keeping the acquired corporation alive as a shell.

The federal tax angle is what made the case interesting. Section 311(b) of the Internal Revenue Code generally treats a corporation's distribution of appreciated property to its shareholders as a sale at fair market value, triggering corporate-level gain. By keeping the corporation alive and not having it distribute its assets, the City and the shareholders thought they could avoid that corporate-level tax and have the shareholders pay only their own gain on the stock sale. The AG's opinion meant the shareholders had to swallow the extra tax or the parties had to find a different structure (the nonprofit conversion was the suggested path forward).

Common questions

Could the City buy the company's stock at all under this opinion?

Yes, but only as a step toward dissolution. The AG agreed that § 160A-11 supported the share purchase where the corporation's only asset was a water and sewer system. The problem was the post-closing plan to keep the corporation operating.

What was the difference between a Chapter 55 for-profit corporation and a Chapter 55A nonprofit?

Chapter 55 governed private profit-seeking corporations. Chapter 55A governed nonprofit corporations. A city had no statutory authority to operate a Chapter 55 entity, but § 160A-312 expressly let it contract with and operate a Chapter 55A nonprofit to provide a public enterprise service. The Publishing Co. v. Hospital Systems and Sides v. Cabarrus Memorial Hospital cases approved that structure for hospital systems.

Did the AG say anything about whether converting the corporation to a nonprofit after the share purchase would still get the federal tax benefit?

No, the AG punted that question. The opinion said the tax consequences of a Chapter 55-to-55A conversion were not addressed.

What did "corporate separateness" mean in this context?

It meant the corporation had to have a real independent business purpose and decisionmakers whose duty ran to the corporation, not exclusively to some outside entity. The proposed plan had every corporate officer and director acting solely as a City employee, with the corporation's only function being to hold the City's water/sewer assets on paper. The AG said that if challenged, a court would find the corporation had merged into the City and ceased to exist.

Did Charlotte ultimately complete the transaction?

The opinion does not say. The opinion's effect was to force Charlotte either to swallow the extra tax (by structuring as an asset sale), to convert the company to a nonprofit, or to abandon the deal. Subsequent municipal water/sewer consolidation in Mecklenburg County did happen, but the specific path is outside the scope of this opinion.

Citations

• N.C.G.S. § 160A-4 (broad construction of municipal powers)
• N.C.G.S. § 160A-11 (authority to hold property)
• N.C.G.S. § 160A-311, 312 (public enterprise authority and nonprofit contracting)
• Chapter 55, General Statutes (for-profit corporations)
• Chapter 55A, General Statutes (nonprofit corporations)
• Madison Cablevision v. City of Morganton, 325 N.C. 634, 386 S.E.2d 200 (1989)
• River Birch Associates v. City of Raleigh, 326 N.C. 100, 388 S.E.2d 538 (1990)
• State v. Dade County, 142 So.2d 79 (Fla. 1962)
• Springfield v. Monday, 353 Mo. 981, 185 S.W.2d 788 (1945)
• Publishing Co. v. Hospital Systems, Inc., 55 N.C. App. 1, 284 S.E.2d 542 (1981)
• Sides v. Cabarrus Memorial Hospital, Inc., 287 N.C. 14, 213 S.E.2d 297 (1975)

Source

• Landing page: https://ncdoj.gov/opinions/municipalities-water-and-sewer-systems-corporations-purchase-of-property/

Original opinion text

November 24, 1992

SUBJECT: Municipalities; Water and Sewer Systems; Corporations; Purchase of Property

REQUESTED BY: H. Michael Boyd, Deputy City Attorney

QUESTION: Under the conditions and circumstances set forth below, is the City of Charlotte ("City") authorized to purchase with non-bond funds all of the stock of a private corporation engaged solely in the business of providing residential water and sewer service ("Corporation") and thereafter continue the Corporation in existence with the City agreeing to operate and maintain the Corporation's water and sewer system under the same policies and rates as apply to the City's own water and sewer system?

CONCLUSION: No.

I. FACTS AND ANALYSIS IN THE REQUEST FOR OPINION.

The facts as set out in the request for an opinion are as follows. The City operates and maintains a consolidated water and sewer system throughout Mecklenburg County pursuant to interlocal agreements with Mecklenburg County and the Towns of Cornelius, Davidson, Huntersville, Matthews, Mint Hill and Pineville. Under these agreements, the City owns the consolidated water and sewer system and is obligated to provide water and sewer service throughout the County (including within the Towns) under uniform policies. The City is phasing in a uniform rate structure. Effective July 1, 1993, water and sewer rates for City customers will be the same throughout Mecklenburg County, without regard to whether the customers reside within the corporate limits of the City. Under these agreements, the City is required to use all water and sewer revenues for water and sewer purposes and may not use any portion of those revenues to subsidize another operation.

Effective June 30, 1991 the City involuntarily annexed an area, which includes a residential subdivision receiving water and sewer service from the Corporation which is a private utility. The City is required to make water and sewer service available to the annexed area, including this subdivision, in accordance with Part 3 of Article 4A of Chapter 160A of the General Statutes.

The Corporation and its shareholders desire to get out of the business of providing water and sewer service and are willing to sell all of the Corporation's water distribution and sewage collection systems to the City on or before June 30, 1993. Those systems are located wholly within Mecklenburg County and a portion is located within the annexed area described above. By selling all of its systems, the Corporation will be entitled to retain the full economic benefit of the sale. If only a portion of its systems were sold, the Utilities Commission would require that any gain on that sale be shared with the Corporation's remaining customers. In the Matter of Application of Carolina Water Service, Inc. of North Carolina, Docket Nos. W-354, Sub 86, 87, 88. Therefore, under any transaction with the City, the goal of the Corporation and its shareholders is for the net proceeds of any sale to end up in the hands of the shareholders. The Corporation must secure the Utilities Commission's approval of any sale.

The Corporation and its shareholders have offered to sell these water and sewer systems to the City for approximately $4 million or, alternatively, to sell all of the stock in the Corporation to the City for approximately $3.5 million. The sole reason for the approximate difference of $.5 million arises from the application of Federal tax law. If the Corporation sells the water and sewer systems directly to the City and distributes the net proceeds of the sale to its shareholders, tax liability will be incurred both at the corporate and the shareholder levels. If the City purchases all of the stock of the Corporation and causes the Corporation to transfer the Corporation's water and sewer systems to the City, the Corporation would incur a tax on the gain under Section 311(b) of the Internal Revenue Code, just as if the Corporation had sold the systems to the City for full, fair market value. If the City purchases all of the stock in the Corporation and the Corporation continues in existence with its facilities, only the former shareholders incur a tax. As a result, the difference in the sales prices accounts for the additional tax liability incurred by the Corporation, if the City elects to purchase the Corporation's assets, rather than its stock. Under either approach, the net proceeds of the transaction in the hands of the shareholders remain the same.

The City desires to acquire effective control over the Corporation's water and sewer systems in the most economical manner within the limits of its authority. Funds for the stock purchase would come from revenues from water and sewer operation and not from bonds or other debt.

In order to preserve the economic benefit from purchasing the Corporation's stock, the City would not cause the Corporation to transfer its water and sewer systems to the City but would continue the Corporation under strictly limited conditions. City employees who discharge duties that are generally similar to their counterparts in the corporate world would be given the responsibility, as City employees, to perform limited duties for the Corporation as directors or officers. The duty of a director or officer of the Corporation would be to approve and execute an agreement with the City under which the City would: connect the Corporation's water and sewer systems to the City's own water and sewer system; maintain and operate the Corporation's water and sewer systems under the same policies as apply to the City's own water and sewer system; bill all persons receiving water and sewer service from the Corporation's water and sewer systems according to the same rates that apply to the City's own water and sewer system; and collect and retain all revenue received from such persons in consideration for the City's services to the Corporation under the agreement. The only other duty of a director or officer would be to prepare and maintain such records, reports, tax returns, etc., as may be necessary for the Corporation to satisfy applicable law and maintain its corporate existence. Necessary changes to the Corporation's Charter, bylaws or any other corporate documents would be made to insure that the Corporation would not undertake any activity which the City is not authorized to undertake.

The contract by which the City would acquire the stock of the Corporation is being negotiated. That contract will assure that the transaction is undertaken in a prudent and business-like manner. Binding and enforceable representations will be made by the shareholders concerning the absence of adverse claims against the Corporation, e.g., litigation, tax liability, governmental investigation, etc. The shareholders will indemnify the City against any loss arising from a breach of such representation. A substantial portion of the purchase price will not be paid immediately to the shareholders but will be retained or otherwise escrowed for a reasonable time to serve as a source of funds to stand behind the indemnification responsibilities of the shareholders.

II. DISCUSSION.

Water and sewer systems are public enterprises which the General Assembly has authorized a city to acquire, construct, establish, enlarge, improve, maintain, own, operate and contract for and which the Supreme Court has held to be public purposes. N.C.G.S. §§ 160A-311, 312; Madison Cablevision v. City of Morganton 325 N.C. 634, 386 S.E.2d 200 (1989). While the statutes do not specifically authorize the purchase of stock of a private corporation owning a water and sewer system, the authority of a city generally to acquire and hold personal property under the provisions of N.C.G.S. § 160A-11 should be sufficient to authorize the purchase of all of the stock of a corporation where the corporation's sole asset is a water and sewer system.

However, there are two problems with that part of the plan that calls for the City to continue the existence of the Corporation. The first problem is the lack of any express or implied authority for a city to own or operate a private for-profit corporation which was created under the provisions of Chapter 55 of the General Statutes. It is the opinion of this office that the authority to "hold" property granted by N.C.G.S. 160A-11 should not be interpreted to authorize a city to act as a shareholder of such a corporation, and to appoint city officials and employees as corporate directors or officers.

The language of N.C.G.S. 160A-4 requires that the provisions of Chapter 160A "be broadly construed". While River Birch Associates v. City of Raleigh, 326 NC 100, 388 S.E.2d 538 (1990), reaffirms the broad construction to be given to statutory grants of power, there must be language granting the power. The language of N.C.G.S. § 160A-11 granting in very general terms the authority to own property does not address the issue at hand, i.e., the operation of a for-profit corporation by a city. The operating of a private for-profit corporation does not appear to be either necessary or expedient to the general power to hold or own property. To determine that the authority to "hold" property is a grant of authority to operate a for-profit corporation would not be merely a broad interpretation of the statutory language, but, rather, it would constitute the addition of a power. A review of Part 1 of Article 16 of Chapter 160A of the General Statutes reveals a legislative intent that a city either operate a public enterprise itself or that it grant a franchise to one or more private entities to operate the enterprise. The proposed plan for operating the Corporation set out in the request for an opinion does not fall within either category contemplated by that legislation.

The cases from other jurisdictions cited by the City in its memorandum of law are relevant on the issue of the purchase of all of the stock of the private corporation, but they do not address the issue of the continued operation or existence of the corporation. In fact, the judicially approved plans for purchase of stock in those cases called for the dissolution of the corporations shortly after purchase by the municipalities.

[T]he agreement of sale and purchase provides that the companies shall be delivered to the County free and clear of all encumbrances and provides for indemnity by Pawley for any undisclosed obligations of the companies prior to the hour of sale. It is further conceded and the agreement provides that the purchase of all of the common stock of these companies by the County is made for the purpose of acquiring said companies in their entirety including all of assets, and that promptly upon the closing of the transaction the companies will be dissolved. The County will then become the owner of the transportation system and all of its physical properties. (Emphasis added)

State v. Dade County, 142 So.2d 79, 88 (Fla. 1962).

Respondents further contend that the City cannot purchase the common stock of Gas & Electric, citing Section 6, Article 9, of the Constitution, prohibiting a city from becoming a subscriber to the capital stock of any corporation. However, it is clear that the City is not subscribing to the stock of Gas & Electric and becoming a part owner therein, but has contracted with Federal to buy all of its stock in order to become the owner of its physical utility properties and is purchasing this stock solely to acquire them. The ordinance provides for the immediate dissolution of Gas & Electric and is using this means of acquiring its properties because it can do so at much less cost in this way. (Emphasis added)

Springfield v. Monday, 353 Mo. 981, 185 S.W.2d 788, 792 (1945).

Therefore, while there may be authority for the City to purchase all of the stock of the Corporation, there is no authority to operate a private for-profit corporation which is outside of the traditional functions of a municipality and for which there is no judicial or legislative approval.

A second and independent problem is that the proposed plan of operation of the Corporation by the City eliminates the "corporate separateness" necessary for the Corporation's continued existence. An integral part of the proposed operation has municipal officials and employees in corporate offices and positions. Chapter 55 of the General Statutes lists statutory duties and responsibilities of directors, officers and agents of a for-profit corporation; however, under the proposed plan of operation municipal officers and employees could act only on behalf of the City and there could be no thought of acting on behalf of the private for-profit Corporation. In other words the proposed plan of operation would result in the merger of the corporate entity into the municipal entity and the dissolution of the Corporation. The concept of corporate separateness usually arises in attempts to "pierce the corporate veil" so that assets of the corporate shareholder may be made available for payment to a creditor. Generally speaking, the courts will look to find fraud before allowing such a recovery. Robinson, North Carolina Corporation Law §§ 2.8 through 2.10. While the fact situation under consideration clearly has no fraud involved, the complete dominance of the public purpose, and complete lack of a separate private corporate purpose, leads to the conclusion that the Corporation would become an instrumentality of the City and there would no longer be a separate corporate existence. Under such circumstances there would not be any independent identity of the private for-profit Corporation and, if challenged, it is the opinion of this office that the existence of the Corporation would be declared to have ceased.

However, on the other hand, if after purchasing all of the shares of the Corporation, the City is able to transform the Corporation into a nonprofit corporation there is clear authority for the City to contract with and operate the Corporation. N.C.G.S. § 160A-312; Publishing Co. v. Hospital Systems, Inc., 55 N.C. App. 1, 284 S.E.2d 542, rev. denied 305 N.C. 302, 291 S.E.2d 151, cert. denied, appeal dismissed 103 S. Ct. 26, 459 U.S. 803, 74 L. Ed. 2d 42 (1981); Sides v. Cabarrus Memorial Hospital, Inc., 287 N.C. 14, 213 S.E.2d 297 (1975). Whether the transformation of the Corporation to a nonprofit corporation under Chapter 55A can be accomplished with the beneficial tax consequences is not addressed in this opinion.

III. CONCLUSION.

In light of the above, it is concluded that the City does not have the authority to continue the existence of the private for-profit Corporation.

LACY H. THORNBURG, Attorney General
Charles J. Murray, Special Deputy Attorney General