An S Corporation Nightmare

Over my career the preferred entities for small and entrepreneurial businesses have been either an S corporation or a limited liability company (LLC). The C corporation has become a rarity in this space. A principal reason is the double taxation of a C corporation. The C pays its own taxes, but there is a second tax when those profits are returned to its shareholders. A common example is dividends. The corporation has already paid taxes on its profits, but when it shares its profits via dividends (with some exception if the shareholder is another corporation) there is another round of taxation for its shareholders. This might make sense if the corporation is a Fortune 500 with broad ownership and itself near immortal, but it makes less sense with a corporation founded, funded, and  grown by the efforts of a select few individuals – or perhaps just one person.

The advantage to an S corporation or LLC is one (usually - this is tax, after all) level of tax. The shareholder/owner can withdraw accumulated profits without being taxed again.

Today let’s talk about the S corporation.

Not every corporation can be an S. There are requirements, such as:

·       It cannot be a foreign corporation.

·       Only certain types of shareholders are allowed.

·       Even then, there can be no more than 100 shareholders.

·       There can be only one class of stock.

Practitioners used to be spooked about that last one.

Here is an example:

The S corporation has two 50% shareholders. One shareholder has a life event coming up and receives a distribution to help with expenses. The other shareholder is not in that situation and does not take a distribution.

Question: does this create a second class of stock?

It is not an academic question. A stock is a bundle of rights, one of which is the right to a distribution. If we own the same number of shares, do we each own the same class of stock if you receive $500 while I receive $10? If not, have we blown the S corporation election?

These situations happen repetitively in practice: maybe it is insurance premiums or a car or a personal tax. The issue was heightened when the states moved almost in concert to something called “passthrough taxes.” The states were frustrated in their tax collection efforts, so they mandated passthroughs (such as an S) to withhold state taxes on profits attributable to their state. It is common to exempt state residents from withholding, so the tax is withheld and remitted solely for nonresidents. This means that one shareholder might have passthrough withholding (because he/she is a nonresident) while another has no withholding (because he/she is a resident).

Yeah, unequal distributions by an S corporation were about to explode.

Let’s look at the Maggard case.

James Maggard was a 50% owner of a Silicon Valley company (Schricker). Schricker elected S corporation status in 2002 and maintained it up to the years in question.

Maggard bought out his 50% partner (making him 100%) and then sold 60% to two other individuals (leaving him at 40%). Maggard wanted to work primarily on the engineering side, and the other two owners would assume the executive and administrative functions.

The goodwill dissipated almost immediately.

One of the new owners started inflating his expense accounts. The two joined forces to take disproportionate distributions. Apparently emboldened and picking up momentum, the two also stopped filing S corporation tax returns with the IRS.

Maggard realized that something was up when he stopped receiving Schedules K-1 to prepare his personal taxes.

He hired a CPA. The CPA found stuff.

The two did not like this, and they froze out Maggard. They cut him off from the company’s books, left him out of meetings, and made his life miserable. To highlight their magnanimity, though, they increased their own salaries, expanded their vacation time, and authorized retroactive pay to themselves for being such swell people.

You know this went to state court.

The court noted that Maggard received no profit distributions for years, although the other two were treating the company as an ATM. The Court ordered the two to pay restitution to Maggard. The two refused. They instead offered to buy Maggard’s interest in Schricker for $1.26 million. Maggard accepted. He wanted out.

The two then filed S corporation returns for the 2011 – 2017 tax years.

They of course did not send Maggard Schedules K-1 so he could prepare his personal return.

Why would they?

Maggard’s attorney contacted the two. They verbally gave the attorney – piecemeal and over time – a single number for each year.

Which numbers had nothing to do with the return and its Schedules K-1 filed with the IRS.

The IRS took no time flagging Maggard’s personal returns.

Off to Tax Court Maggard and the IRS went.

Maggard’s argument was straightforward: Schricker had long ago ceased operating as an S corporation. The two had bent the concept of proportionate anything past the breaking point. You can forget the one class of stock matter; they had treated him as owning no class of  stock, a pariah in the company he himself had founded years before.

Let’s introduce the law of unintended consequences:

Reg 1.1361-1(l)(2):

Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Here is the Tax Court:

… the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what the shareholders actually do.”

That makes sense if we were talking about insurance premiums or a car, but here … really?

We recognize that thus can create a serious problem for a taxpayer who winds up on the hook for taxes owed on an S corporation’s income without actually receiving his just share of distributions.”

You think?

This especially problematic when the taxpayer relies on the S corporation distributions to pay these taxes.”

Most do, in my experience.

Worse yet is when a shareholder fails to receive information from the corporation to accurately report his income.”

The Court decided that Maggard was a shareholder in an S corporation and thereby taxable on his share of company profits.

Back to the Court:

The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by … formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only class of stock.”

I get it, but I don’t get it. This reasoning seems soap, smoke, and sophistry to me. Is the Court saying that – if you don’t write it down – you can get away with anything?      

Our case this time was Haggard and Szu-Yi Chang v Commissioner, T.C. Memo 2024-77.

 

Paying Tax On Borrowed Money

I am looking at a Tax Court case where the IRS was chasing almost two-thirds of a million dollars. It involves an attorney and something called “litigation support agreements.”

There is a term you do not hear every day.

The taxpayer is a class-action lawyer.

You see, in a class action, the law firm sues on behalf of a group – or class - of affected parties. Perhaps numerous people were affected by a negligent act, for example, but there is not enough there for any one person to pursue litigation individually. Combine them, however, and you have something.

Or the lawsuit can be total malarkey and the law firm is seeking a payday, with little to no regard to the “class” it allegedly represents.

Ultimately, a class action is a tool that can be used for good or ill, and its fate depends upon the intent and will of its wielder.

Let get’s back to our taxpayer.

It takes money to pursue these cases. One has to bring in experts. There can be depositions, travel, cross-examinations. This takes money, and we already mentioned that a reason for class action is that no one person has enough reason – including money – to litigate on his/her own power.

Did you know there are people out there who will play bank with these cases? That is what “litigation support agreements” are. Yep, somebody loans money to the law firm, and – if the case hits – they get a very nice payoff on their loan. If the case fails, however, they get nothing. High risk: high reward. It’s like going to Vegas.

The taxpayer received over $1.4 million of these loans over a couple of years.

Then IRS came in.

Why?

I see two reasons, but I flat-out believe that one reason was key.

The taxpayer left the $1.4 million off his tax return as taxable income. The taxpayer thought he had a good reason for doing so: the $1.4 million represented loan monies, and it is long-standing tax doctrine that one (generally) cannot have income by borrowing money. Why? Because one has to pay it back, that is why. You are not going to get rich by borrowing money.

There are variations, though. It is also tax doctrine that one can have income when a lender forgives one’s debt. That is why banks issue Forms 1099-C (Cancellation of Debt) when they write-off someone’s credit card. How is it income? Because one is ahead by not having to pay it back.

Our taxpayer had different loan deals and agreements going, but here is representative language for one litigation support agreement:

… shall be a litigation support payment to [XXX] made on a nonrecourse basis and is used to pay for all time and expenses incurred by [XXX} in pursuant [sic] of this litigation. Said payment shall be repaid to …. at the successful conclusion of this litigation with annual interest to be paid as simple interest at the rate of …. as of the date of concluding this litigation.”

Let’s see: there is reference to repayment and an interest rate.

Good: sounds like a loan.

So where is the problem?

Let’s look at the term “nonrecourse.” In general, nonrecourse means that – if the loan fails – the lender can pursue any collateral or security under the loan. What the lender cannot do, however, is go after the borrower personally. Say I borrow a million dollars nonrecourse on a California house that subsequently declines in value to $300 grand. I can just mail the keys back to the lender and walk away without the lender able to chase me down. I am trying to divine what the broader consequence to society could possibly be if numerous people did this, but of course that is silly and could never happen.

Still, nonrecourse loans happen all the time. They should not be fatal, as I am technically still obligated on the loan - at least until the time I mail back the keys.

Let’s look at the next phrase: “successful conclusion of this litigation.”

When are you on the hook for this loan?

I would argue that you are on the hook upon “successful conclusion of this litigation.”

When are you not on the hook?

I would say any time prior to then.

The loan becomes a loan – not at the time of lending – but in the future upon occurrence of a distinguishable event.

The IRS was arguing that the taxpayer received $1.4 million for which he was not liable. He might be liable at a later time - perhaps when the universe begins to cool or the Browns win a Super Bowl – but not when that cash hit his hand.

Granted, chances are good that whoever lent $1.4 would pursue tort action if the taxpayer skipped town and sequestered on an island for a few years, but that would be a different legal action. Whoever put up the money might sue for fraud, nonperformance or malfeasance, but not because the taxpayer was liable for the debt. 

Let’s go back: what keeps one from having income when he/she borrows money?

Right: the obligation to pay it back.

So who did not have an obligation to pay it back?

The taxpayer, that’s who.

The IRS won the case. Still, what bothered me is why the IRS would go after this guy so aggressively. After all, give this arrangement a few years and it will resolve itself. The law firm receives money; the law firm spends money. When it is all said and done, the law firm will burn through all the money, leaving no “net money” for the IRS to tax.

So what fired up the IRS?

The taxpayer filed for bankruptcy.

Before burning through the money.

Meaning there was “net money” left.

He was depriving the IRS of its cut.

There is the overwhelming reason I see.

Our case this time was Novoselsky v Commisioner.

Is There Any Point To Middle Class Entitlements?

I was reading a Bloomberg article last week titled “Those Pointless Upper-Middle-Class Entitlements.” It is - to be fair - an opinion piece, so let’s take it with a grain of salt.

The article begins:

Let’s talk about upper-middle-class entitlements, the subsidies that flow almost entirely to those in the upper fifth or even tenth of the income distribution. You know, the home mortgage interest deduction and the tax subsidies for 401(k)s, IRAs and other retirement plans.

Then we have a spiffy graph: 

I am confused with what is considered a “tax break.”

The true “tax break” here is the earned income credit. We know that this began as encouragement to transition one from nonworking to working status, and we also know that it is the font of massive tax fraud every year. The government just sends you a check, kind of like the tooth fairy. An entire tax-storefront industry has existed for decades just to churn-out EIC returns. Too often, their owners and practitioners are not as … uhh, scrupulous … as we would want.

And this is a surprise how? Give away free money to every red-headed Zoroastrian Pacific Islander and wait to be surprised by how many red-headed Zoroastrian Pacific Islanders line up at your door. Even those who are not red-headed, Zoroastrian or Pacific Islander in any way. 

Here is more:

Of course, we wouldn’t want to take away all of those tax expenditures, would we? The earned income tax credit and the Social Security exclusion, for example, are targeted at people with pretty low incomes.

Doesn’t one need to have income before receiving an INCOME TAX expenditure?

Then we have these bright shiny categories:

·       Defined contribution retirement plans

·       Defined benefit retirement plans

·       Traditional IRAs

·       Roth IRAs

Interesting. One would think that saving for retirement would be a social good, if only to lessen the stress on social security.

We read:

Wealthy people who would save for retirement in any case respond to subsidies by shifting assets into tax-sheltered accounts; the less wealthy don’t respond much at all.

It makes some sense, but don’t you feel like you are being conned? Step right up, folks; make enough money to save for retirement and you do not need a tax break to save for retirement.

When did we all become wealthy? Did someone send out letters to inform us?

Did you know that the majority of income tax breaks are claimed by people with the majority of the income?  

Think about that one for a second, folks.

This following is a pet peeve of mine:

·       Deferral of active income of controlled foreign corporations

We have discussed this issue before. Years ago, when the U.S. was predominant, it decided that U.S. corporations would pay tax on all their earnings, whether earned in the U.S. or not.

There is a problem with that: the U.S. is almost a solo act in taxing companies on their worldwide income. Almost everyone else taxes only the profit earned in their country (the nerd term is “territoriality”).

Let’s be frank: if you were the CEO of an international company, what would you do in response to this tax policy?

You would move the company – at least the headquarters - out of the U.S., that’s what you would do. And companies have been moving: that is what "inversions" are.

So, the U.S. had no choice but to carve-out exceptions, which is how we get to “deferral of active income of controlled foreign corporations.” This is not a tax break. It is a fundamental flaw in U.S. international taxation and the reason Congress is currently considering a territorial system.

By the way, how did these tax breaks come to be, Dudley?

Why do these subsidies continue nonetheless? Mainly, it seems, because they’ve been granted to a sizable, influential population who, it is feared, will fight any effort to take them away. 

Politicians giving away money. Gasp.

But mainly it’s the millions of upper-middle-class Americans who, like me and my family, are beneficiaries of tax subsidies for home mortgages, retirement accounts and/or college savings.

To state another way: It is unfair that people with more money can do more things with money than people with less money.

Profound.

What offends about this bella siracha is:

You train for a career.

You set an alarm clock daily, dress, fight traffic and do your job.

You get paid money.

You take some of this money and save for nefarious causes such as your kids’ college and your eventual retirement.

Yet you keeping your own money is the equivalent of receiving a welfare check euphemistically described as an “earned income credit.”

No, no it is not.

And the false equivalence is offensive.

I get the issue. I really do. The theory begins with all income being taxable. When it is not, or when a deduction is allowed against income, there is – arguably - a “tax break.” The criticism I have is equating one-keeping-one’s-money (for example, a 401(k)) with flat-out welfare (the earned income credit). Another example would be equating a deeply-flawed statutory tax scheme (multinational corporations) with the state income tax deduction (where approximately 30% of this tax break goes to two states: California and New York). 

And somebody please tell me what “wealthy” means anymore. It has become one of the most abused words in the English language.

Bloomberg