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.
