Whose Job Is It Anyway?

One of our accountants asked me recently:

R:      Do you think [so and so] qualifies as a real estate professional?

CTG: I do not know [so and so]. Tell me a little.

R:      Husband pulls a W-2.

CTG: How much and how many hours?

R:      Blah blah dollars.

CTG: Works in real estate?

R:      Nah.

CTG: Hours?

R:      Maybe 2,000.

CTG: Is the wife in real estate?

R:      No.

I have told you (almost) everything you need to answer the question.

Let’s look at the Warren case.

James Warren organized Warren Assisted Living, LLC in 2015.

He purchased a group home in 2016.

He started repairing the home almost immediately.

In 2017 he worked at Lockheed Martin for 1,913 hours as an engineer.

On his 2017 tax return he claimed a $41 thousand-plus loss from the group home. He claimed he was a real estate professional.

Warren did not keep time logs.

What sets this up are the passive activity rules under Section 469. As initially passed, that Section considered rental activities (with minimal exceptions) to be “per se” passive.

The passive activity rules would then stifle your ability to claim losses. You – for the most part – had to wait until you had income from the activity. You could then use the losses against the income. 

Well, that caught real estate landlords and others around the country by surprise. When you do one thing, it is difficult to have a Congressional staffer decide that your thing is not a regular thing like the next thing across the street.

Congress made a change.

(c)(7)  Special rules for taxpayers in real property business.

 

(A)  In general. If this paragraph applies to any taxpayer for a taxable year-

 

(i)  paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

(ii)  this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

 

Notwithstanding clause (ii) , a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

 

(B)   Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if-

 

(i)  more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

(ii)  such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

 

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

The above is called the real estate professional exception. It is a mercy release from the per se rule that would otherwise inaccurately (and unfairly) consider people who work in real estate all day to not be working at all.

It has two main parts:

(1) You have to spend at least 750 hours working in real estate, and

(2)  You have to spend more than 50% of your “working at something” total hours actually “working in real estate.”

If you are a real estate professional, you avoid the “per se” label. You have not yet escaped the passive activity rules – you still have to show that you worked - but at least you have the opportunity to present your case.

The Court looked at Warren’s 1,913 hours at Lockheed. That means he would need 3,827 total hours for real estate to be more than ½ of his total work hours. (1,913 times 2 plus 1).

First of all, 3,827 total hours means he was working at least 74 hours a week, every week, without fail, for the entire year.

Maybe. Doubt it.

Warren is going to need really good records to prove it.

Here is the Court:

Mr Warren did not keep contemporaneous logs of his time renovating the group home.”

Not good, but not necessarily fatal. I represented a client who kept Outlook and other records. She created her log after the fact but from records which themselves were contemporaneous. Mind you, we had to go to Appeals, but she won.

In preparation for trial, Mr Warren created – and presented – two time logs.”

Good grief.

The first log maintained that he worked 1,421 hours at the group home; it was created one week before trial.”

End it. That is less than his 1,913 hours at Lockheed.

The second log maintained that Mr. Warren worked 1,628 at the group home; it was created the night before trial.”

Why bother?

This was a slam dunk for the Court. They did not have to dwell on contemporaneous or competing logs or believability or whether the Bengals will turn their season around. Whether 1,421 or 1,628, he could not get to more-than-50%.

Warren lost.

As a rule of thumb, if you have a full-time W-2, it will be almost impossible to qualify as a real estate professional. The exception is when your full-time W-2 is in real estate, maybe with an employer such as CBRE or Cushman & Wakefield.  At 1,900-plus Lockheed hours, I have no idea what Warren was thinking, although I see that it was a per se case. That means he represented himself, and it shows.

I suppose one could have a W-2 and work crazy hours and meet the more-than-50% requirement, but your records should be much tighter. And skip the night before thing.

BTW another way to meet this test is by being married.

Look at (B)(ii) again:

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

If your spouse can meet the test (both parts), then you will qualify by riding on the shoulders of your spouse.

Our case this time was Warren v Commissioner, T.C. Summary Opinion 2024-20.

Some Thoughts After The Tax Filing Deadline(s)

 

There is something happening in the public accounting profession. The profession itself is aging. The AICPA expected 75% of practicing CPAs to reach retirement age by 2020 – which was four years ago. Many smaller firms do not have succession plans, meaning that an owner’s retirement plan likely involves being acquired by another firm. Fewer college students are pursuing accounting majors, placing stress on recruiting and retaining accountants in the early years of their career. We see firms releasing clients and sometimes entire lines of practice. I know of one which released its trust work, which surprised me. I contributed to this several years ago when we released our inbound (that is, international) work. These clients still need professional advice, but fewer CPAs are providing these services.

On the flip side, it is a great time for someone to start (or grow) an accounting practice. A challenge here is step growth – that is, growth that requires hiring. One circles back to the issue of the talent shortage. A bad hire is damaging, perhaps even more so in a small firm.

Even the IRS is not immune to the talent shortage. In 2019 the IRS employed approximately 75,000 people. The Inflation Reduction Act supposedly provided funds to hire an additional 87,000 people through the year 2031. It hasn’t, of course, as the IRS is competing with every other employer in the market.

I suspect the profession has done much of the damage to itself. One can easily point to the 150-hour requirement for a CPA license. That may have made sense years ago, but with today’s exorbitant college costs that additional year of class, books and housing might be difficult to justify.

And then we have the toxicity of the profession itself. I cannot recall the last time that a CPA my age has not shared his/her “horror” stories: the stress, hours, near-impossible deadlines, psychopathic personalities, power dynamics and whatnot. I remember a managing partner bringing cigars so we could “talk”; we sat outside, and he explained how infeasible it was for me to visit my ailing grandmother in Florida. My grandmother died that year. I also left the firm that year. I suspect Gen Z will not tolerate this behavior as passively, and rightfully so.   

Congress has greatly exacerbated the problem with its never-ending and wildly metastasizing tax changes. It used to be that accountants would spread their tax work over the course of the year by placing their business clients on a fiscal year – that is, a tax year ending other than December 31. This allowed work to be distributed more sanely over the year. Congress changed this in 1986 by requiring almost everyone to use the calendar year. Yes, there was an “out,” and the out was for the business to pay a “deposit” for taxes it would have paid had it changed to a calendar year. I suspect that – even if not a CPA – you can guess how well those client conversations went. Combine that with Congress’ recent-enough 1099 reporting fetish and you have a crippling steamroller than begins in January and ends … well, who know when.  

I think we overstretched ourselves here at Galactic Command this year. Potential clients are calling for appointments, and it can be hard (for some of us) to say no. After the just-concluded September and October extension deadlines, however, we must learn to say no. We do not have the resources, and we are burning the resources – including me – that we do have.    

Then there is AI – will artificial intelligence replace any/some/much of what a CPA does? Depending on what the accountant does, I suppose it is possible. First year audit work, for example, scarcely requires a 150-hour degree. That might be a viable onramp for AI. Then again, I remember when QuickBooks was going to put accounting services departments out of business. It didn’t, and accounting services is one of the most sought-after practice areas in accounting firms today. Will AI take away much of my 1040 workload? 

I hope so.

A Real Estate Course – And Dave

 

The case made me think of Dave, a friend from long ago – one of those relationships that sometimes surrenders to time, moving and distance.

Dave was going to become a real investor.

That was not his day job, of course. By day he was a sales rep for a medical technology company. And he was good at sales. He almost persuaded me to join his incipient real estate empire.

He had come across one of those real estate gurus – I cannot remember which one – who lectured about making money with other people’s money.

There was even a  3-ring binder or two which Dave gave me to read.

I was looking over a recent case decided by the Tax Court.

The case involved an engineer (Eason) and a nurse (Leisner).

At the start of 2016 they owned two residential properties. One was held for rent; the other was sold during 2016.

COMMENT: Seems to me they were already in the real estate business. It was not a primary gig, but it was a gig.

Eason lost his job during 2016.

A real estate course came to his attention, and he signed up – for the tidy amount of $41,934.

COMMENT: Say what?

In July 2016 the two formed Ashley & Makai Homes (Homes), an S corporation. Homes was formed to provide advice and guidance to real estate owners and investors.  They had business cards and stationary made and started attending some of those $40 grand-plus courses. Not too many, though, as the outfit that sponsored the courses went out of business.

COMMENT: This is my shocked face.

By 2018 Eason and Leisner abandoned whatever hopes they had for Homes. They never made a dime of income.

You know that $40 grand-plus showed up on the S corporation tax return.

The IRS disallowed the deduction.

And tacked on penalties for the affront.

This is the way, said the IRS.

And so we have a pro se case in the Tax Court.

Respondent advances various reasons why petitioners are not entitled to any deductions …”

The respondent will almost always be the IRS in these cases, as the it is the taxpayer who petitions the Court.

And we have discussed “pro se” many times. It generally means that a taxpayer is representing himself/herself, but that is not fully accurate. A taxpayer can be advised by a professional, but if that professional has not taken and passed the exam to practice before the Tax Court the matter is still considered pro se.

Back to the Court:

          … we need to focus on only one [reason].”

That reason is whether a business had started.

Neither Homes nor petitioners reported any income from a business activity related to the disputed deductions, presumably because none was earned.”

This is not necessarily fatal, though.

The absence of income, in and of itself, does not compel a finding that a business has not yet started if other activities show that it has.”

This seems a reasonably low bar to me: take steps to market the business, whatever those words mean in context. If the context is to acquire clients, then perhaps a website or targeted advertising in the local real estate association newsletter.

Here, however, the absence of income coupled with the absence of any activity that shows that services were offered or provided to clients or customers […] supports respondent’s position that the business had not yet started by the close of the year.”

Yeah, no. The Court noted that a business deduction requires a business. Since a business had not started, no business deduction was available.

The Court disagreed with any penalties, though. There was enough there that a reasonable person could have decided either way.

I agree with the Court, but I also think that just a slight change could have changed the outcome in the taxpayers’ favor.

How?

Here’s one:  remember that Eason and Leisner owned a rental property together?

What if they had broadened Homes’ principal activity to include real estate rental and transferred the property to the S corporation? Homes would have been in business at that point. The tax issue then would have been expansion of the business, not the start of one.

Our case this time was Eason and Leisner v Commissioner, T.C. Summary Opinion 2024-17.

Caleb William’s NFL Contract

 It may be that the NFL saved him from bad tax advice.

We are talking about Caleb Williams, the 2024 NFL number one overall draft pick by the Chicago Bears. He signed a four-year fully guaranteed contract for $39.5 million.

I can only wish.

But it was two additional negotiating positions that caught my eye.

(1)  He wanted to be paid via an LLC.

(2)  He wanted some/all of his contract to be structured as a forgivable loan.

I read that he was represented by his father, who has experience in commercial real estate but is not a registered agent.

But it helps to explain the LLC. The use of LLCs for real estate is extremely common, so his father would have seen their use repetitively. Still, what is the point of an LLC with an NFL contract?

It might be the expenses that an NFL player might incur: agent fees, union dues, specialized training and related travel, certain therapies and so forth. As those receiving a W-2 know, employee business expenses are presently nondeductible. If Caleb could run his NFL earnings through an LLC, perhaps he could avoid employee business expense classification and deduct them instead as regular business expenses.

There is a hitch, though. None of the four major team sports will pay compensation to an entity rather than directly to the athlete. In contrast, non-team athletes – like golfers – can route their earnings through a business entity. A key difference is that the PGA considers its golfers to be independent contractors, whereas the NFL (or MLB, NBA, or NHL) considers its players to be employees.

There is speculation that Caleb may have preferred an LLC because LLCs – ahem – “do not file tax returns.”   

Not quite. The tax treatment of LLCs is quite straightforward:

(1)  If the LLC has partners, then it will file a partnership return.

(2)  If the LLC elects to be taxed as a corporation, then it will file a corporate return. If an S election in place, it will file an S corporation return.

(3)  If the LLC has a single member, then the LLC is disregarded and does not file a tax return.

Do not misunderstand that last one: it does not say that income belonging to the LLC does not land on a tax return.

Let’s say that Caleb created a single member LLC (SMLLC). SMLLCs are also referred to as disregarded entities. The tax  Code instead considers Caleb and his SMLLC to be the same taxpayer. That is why there is no separate LLC return: all the income would be reportable on Caleb’s personal return.

Could someone have read the above and thought that income routed through an SMLLC is not taxed at all?

If so, Caleb really needs to hire a tax professional yesterday.

What about the loan forgiveness proposal?

I get it: loans are normally not considered income, as any increase in wealth is immediately offset by an obligation to repay the loan.

OK, Caleb receives contract monies, but he is liable for their repayment to the NFL. This potential liability means no immediate income to him. He would have income when the loan is forgiven, and (hopefully) he has some control when that happens.

But the NFL can call his loan, meaning he then must repay.

Oh puhleeeze.

Not to worry, says whoever. The NFL has no intention of calling the loan.

I am a huge NFL fan, but I am not an NFL team owner fan. There is no way I am trusting my money to owners who are monetizing their sport to such a degree that many fans cannot even see the games. Seriously, how many streaming services do they think an average person can afford?

What if Caleb includes conditions and guarantees and collateral and puts and ….?

Listen to yourself. You are leaving loan-land and whatever tax idea you started with. The IRS will come to the same conclusion. You have accomplished nothing, and you may even be exposing yourself to fraud charges.

I suppose Caleb could structure it as deferred compensation, the way Shohei Ohtani did with the Los Angeles Dodgers. Deferred compensation can get into crazy tax tripwires, but at least we are no longer talking about loans. If this is what he wants, then drop the loan talk and negotiate deferred compensation.

That is BTW what I would do. There is enough money here to make Caleb rich both now and later.

The NFL did Caleb Williams a favor by shooting down both proposals. 

Taxing A 5-Hour Energy Drink

 

I am skimming a decision from the Appeals Court for the District of Columbia. I am surprised that it is only 15 pages long, as it involves a gnarly intersection of partnership tax and the taxation of nonresident aliens.

Let’s talk about it.

In general, partnerships are not treated as a taxable entity. A partnership is a reporting entity; it reports income and expenses and then allocates the same to its partners for reporting on their tax returns. Mind you, this can get mind-numbing, as a partner in a partnership can itself be another partnership. Keep this going a few iterations and being a tax professional begins to lose its charm.

A partner will - again, in general - report the income as if the partner received the income directly rather than through the partnership. If it was ordinary income or capital gain to the partnership, it will likewise be ordinary income or capital gain to the partner.

Let’s introduce a nonresident alien partner.

We have another tranche of tax law to wade through.

A nonresident alien is fancy talk for someone who does not live in the United States. That person could still have U.S. income and U.S. tax, though.

How?

Well, through a partnership, for example.

Say the partnership operates exclusively in the United States. A nonresident alien generally pays tax on income received from sources within the United States. Let’s look at one type of income: business income. We will get to nonbusiness income in a moment.

The tax Code wants to know if that business income is “effectively connected” with a U.S. trade or business.

The business income in our example is effectively connected, as the partnership operates exclusively in the United States. One cannot be any more connected than that.

The partnership will issue Schedules K-1 to its partners, including its nonresident alien partner who will file a U.S. nonresident tax return (Form 1040-NR).

Question: Will any nonbusiness income on the K-1 be reportable on the nonresident?

The tax Code separates business and nonbusiness income because they might be taxed differently for nonresidents. Nonbusiness income can go from having 30% withholding at the source (think dividends) to not being taxed at all (think most types of interest income).

What if the Schedule K-1 reports capital gains?

I normally think of capital gains as nonbusiness income.

But they do not have to be.

There is a test:

If the income is derived from assets used or held for use in the conduct of an effectively connected business – and business activities were a material factor in generating the income  – then the income will taxable to a nonresident alien.

Think capital gain from the sale of farm assets. Held for use in farming? Check. Material factor in generating farm income? Check. This capital gain will be taxable to a nonresident.

Forget the K-1. Say that the nonresident alien sold his/her partnership interest altogether.

On first impression, I am not seeing capital gain from the sale of the partnership interest (rather than assets inside the partnership) as meeting the “held for use/material factor” test.

Problem: partnership taxation has something called the “hot asset” rule. The purpose is to disallow capital gains treatment to the extent any gain is attributable to certain no-no assets – that is, the “hot assets.”

An example of a hot asset is inventory.

The Code does not want the partnership to load up on inventory with substantial markup and then have a partner sell his/her partnership interest rather than wait for the partnership to sell the inventory. This would be a flip between ordinary and capital gain income, and the IRS is having none of it.

Question: have you ever had a 5-hour Energy drink?

That is the company we are talking about today.

Indu Rawat was a 29.2% partner in a Michigan partnership which sells 5-hour Energy. She sold her stake in 2008 for $438 million.

I can only wish.

At the time of sale, the company had inventory with a cost of $6.4 million and a sales price of $22.4 million. Her slice of the profit pending in that inventory was $6.5 million.

A hot asset.

The IRS wanted tax on the $6.5 million.

Mind you, Indu Rawat did not sell inventory. She sold a partnership interest in a business that owned inventory. That would be enough to catch you or me, but could the hot asset rule catch a nonresident alien?

The Tax Court agreed with the IRS that the hot asset gain was taxable to her.

That decision was appealed.

The Appeals Court reversed the Tax Court.

The Appeals Court noted that there had to be a taxable gain before the hot asset rule could kick in. The rule recharacterizes – but does not create – capital gain.

This capital gain does not appear to meet the “held for use/material factor test” we talked about above. You can recharacterize all you want, but when you start at zero, the amount recharacterized cannot be more than zero.

Indu Rawat won on Appeal.

By the way, tax law in this area has changed since Rawat’s sale. New law would tax Rawat on her share of effectively connected gain as if the partnership had sold all its assets at fair market value. Congress made a statement, and that statement was “no more.”

Our case this time was  Indu Rawat v Commissioner, No 23-1142 (D.C. Cir. July 23, 2024).

Renting Real Estate And Self-Employment Tax

 

I was looking at a tax return recently. There was an issue there that I did not immediately recognize.

Let’s go over it.

The client is a new venue for cocktail parties, formal dinners, corporate meetings, bridal showers, wedding rehearsals and receptions, and other such occasions.

The client will configure the space as you wish, but you will have to use a preselected list of caterers should you want food. There is a bar, but you will have to provide your own bartender. You can decorate, but there are strict rules on affixing decorations to walls, fixtures, and such. Nonroutine decorations must be approved in advance. You will have to bring your own sound system should you want music, as no system exists. The client will clean the space at the end of the event, but you must first remove all personal items from the property.

Somewhat specialized and not a business I would pursue, but I gave it no further thought.

The question came up: is this ordinary business income or rental income?

Another way to phrase the question is whether the income would or would not be subject to self-employment tax.

Let’s say you have a duplex. One would be hard pressed to think of a reasonable scenario where you would be paying self-employment tax, as rental income from real estate is generally excepted from self-employment income.

Let’s change the facts. You own a Hyatt Hotel. Yes, it is real estate. Yes, there is rental income. This income, however, will be subject to self-employment tax.

What is the difference? Well, the scale of the activity is one, obviously. Another is the provision of additional services. You may bring in a repairman if there were a problem at the duplex, but you are not going into the unit to wash dishes, vacuum carpets, change bed linens or provide fresh towels. There is a limit. On the other hand, who knows what concierge services at a high-end hotel might be able to provide or arrange.

We are on a spectrum, it appears. It would help to have some clarification on which services are innocuous and which are taunting the bull.

IRS Chief Counsel Advice 202151005 addressed the spectrum in the context of residential rental property.

First a warning. A CCA provides insight into IRS thinking on a topic, but that thinking is not considered precedent, nor does it constitute substantial authority in case of litigation. That is fine for us, as we have no intention of litigating anything or having a tax doctrine named after us.

Here is scenario one from the CCA:

·       You are not a real estate dealer.

·       You rent beachfront property via online marketplaces (think Airbnb).

·       You provide kitchen items, Wi-Fi, recreational equipment, prepaid ride-share vouchers to the business district and daily maid service.

Here is scenario two:

·       You are not a real estate dealer.

·       You rent out a bedroom and bathroom in your home via online marketplaces.

·       A renter has access to common areas only to enter and exit.

·       You clean the bedroom and bathroom after each renter’s stay.

I am not overwhelmed by either scenario. Scenario one offers a little more than scenario two, but neither is a stay at the Hotel Jerome.

Here is the CCA walkthrough:

·       Tax law considers rental income collected by a non-dealer to be non-self- employment income.

·       However, the law says nothing about providing services.

·       Allowable services include:

o   Those clearly required to maintain the property in condition for occupancy, and

o   Are a sufficiently insubstantial portion of the rent.

·       Nonallowable services include:

o   Those not clearly required to maintain the property in condition for occupancy, and

o   Are so substantial as to comprise a material portion of the rent.

The CCA considered scenario two to be fine.

COMMENT: I would think so. The services are minimal unless you consider ingress and egress to be substantial services.

The CCA considered scenario one not to be fine.

Why not?

·       The services are for the convenience of the occupants.

·       The services are beyond those necessary to maintain the space for occupancy.

·       The services are sufficient to constitute a material portion of the rent.       

I get the big picture: the closer you get to hotel accommodations the more likely you are to be subject to self-employment tax. I am instead having trouble with the smaller picture – the details a tax practitioner is looking for – and which signal one’s location on the spectrum.

·       Is the IRS saying that services beyond the mere availability of a bed and bathroom are the path to the dark side?

·       IRS Regulations refer to services customarily provided.

o   How is one to test customarily: with reference to nearby full-service hotels or only with other nearby online rentals?

o   In truth, did the IRS look at any nearby services in scenario one?

·       What does material portion mean?

o   Would the provision of services at a lower rent situs (say Athens, Georgia) result in a different answer from the provision of comparable services at a higher rent situs (say Aspen, Colorado)?

o   What about a different time of year? Can one provide more services during a peak rental period (say the NCAA Tournament) and not run afoul of the material portion requirement??

One wonders how much this CCA has reinforced online rental policies such as running-the-dishwasher and take-out-the-trash-when-you-leave. There is no question that I would advise an Airbnb client not to provide daily services, whatever they may be.

I also suspect why our client set up their venue the way they did.

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.