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.

 

Embezzlement And A Payroll Tax Penalty

It has been about a month since I last posted.

To (re)introduce myself, I am a practicing tax CPA. I like to think practice allows a certain reality check on topics we discuss here. I am hesitant to discuss topics I do not work with or have not worked with for a long time. On the other hand, I can be acerbic while bloviating within my wheelhouse. I have strong opinions, for example, with IRS administration of “reasonable cause” relief for certain penalties. Here is one: work someone 80, 90 or more hours per week, deprive him/her of adequate rest, maintain the stress meter at redline, and ... stuff ... just ... happens. Maybe - if we had a government union to drag high achievers down to the level of the common spongers - then stuff would stop happening.

The downside is that this blog is maintained by a practicing CPA, and we just finished busy season.

Let’s ease back into it.

Let’s talk about the big boy penalty - the BBP.

There are penalties when someone fails to remit withheld payroll taxes to the IRS. It makes sense when you think about it. Your employer withholds 6.2% of your gross paycheck for social security and another 1.45% for Medicare. Your employer is also withholding federal income tax. All that is your money - your employer is acting only as a go-between - and not remitting the tax to the IRS is tantamount to stealing from you. And from the IRS.

I have seen it many times over the years. Sometimes still do. Not grievous stuff like Madoff, but nonetheless happening when a business is laboring.

I get it: the business is doing the best it can. I am not saying it is right, but growing up includes acknowledging that a lot of things are not right.

The BBP is a 100% penalty on the withheld employee taxes.

You read that right: 100 percent.

It applies if you are a “responsible person.” That makes sense to me if you are the big cheese at the Provolone factory, but the IRS has been known to consider ordinary Joe’s – somebody stuck at a miserable job for a needed paycheck before another job allows an escape – to be responsible persons. A common thread is that someone has the authority to write checks, meaning the person can decide where the money (however limited) goes. Sounds great in a classroom, but it can lead to stupid in the real world.

Let’s look at Rodney Taylor.

He has degrees in political science, speech, and theater. He is multilingual. He has worked domestically and internationally. He now owns a management company called Taylor & Co.

He says that he suffers from a limited learning disability, one involving mathematics.

Couldn’t tell, but I believe him.

Over the years he delegated much of his financial stuff to professionals such as Robert Gard, his CPA.

OK.

Gard embezzled between one and two million dollars from Taylor. Some of those monies were earmarked as payroll tax deposits.

Gard had a heart attack during a meeting when his fraud was unearthed. It appears that Taylor is a good sort, as Gard survived and attributed his survival to actions Taylor immediately took in response to the heart attack.

And next we read about the lawsuits. And the insurance companies. And banks. And insurance reimbursements. You know the storyline.

While all of this was happening, Taylor paid himself a $77 thousand bonus.

STOP! Pay it back. Immediately. Not Kidding.

Taylor transferred funds from the company’s bank account to a new something he was launching.

DID YOU NOT HEAR STOP???

You know the IRS had a BBP issue here.

Taylor argued that he could not be a responsible person, as he was embezzled. He had difficulties with mathematical concepts. He hired people to do stuff.

I do not know who was advising Taylor - if anyone - but he lost the plot.

• Taylor owed the IRS.
• Taylor was CEO, hired and fired, controlled the financial affairs of the company, and made the decision to sue Gard. He couldn’t be any more responsible if he tried.
• Meanwhile, Taylor diverted money to himself while still owing the IRS.

The IRS gets snarky when you prioritize yourself when you still owe back payroll taxes.

Bam! Big boy penalty.

Yeah, and rain is wet.

Sometimes it … is … just … obvious.

Our case this time was Taylor v Commissioner, T.C. Memo 2024-33.