The United States Tax Court has held that the corporation’s net income was the taxpayer’s even though he’d received nowhere near that amount in distributions.
The court relied on Minton in Mowry v. Commissioner, 116 T.C.M. (CCH) 55 (2008), where the taxpayer and his brother incorporated a rebar company as an S corporation. The taxpayer later discovered that his brother had taken substantial withdrawals from the corporation’s accounts without his knowledge or authorization. The company failed to file Forms 1120S and issue Schedules K–1 for the years at issue, and as a result the Commissioner determined that 49 percent of the corporation’s net income was the taxpayer’s even though he’d received nowhere near that amount in distributions.
The court ruled that disproportionate distributions by themselves do not change a company’s S corporation status. The unauthorised distributions were hidden from Maggard, but they were certainly not memorialized by WJ and LL by formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only one class of stock. And this means that we cannot revoke Schricker’s election to be an S corporation for disproportionate distributions under Treasury Regulation § 1.1361-1(l)(2).
“Schricker as an entity neither authorized nor created a second class of shares by way of a formal corporate action. That means that we must hold that Schricker continued to maintain its S corporation status for the years at issue,” the court said.
Facts
James Maggard is an entrepreneur who co-founded an engineering firm. When his original partner left, Maggard took on two friends as co-owners. They proceeded to loot the firm or, as one says in taxspeak, made unauthorised distributions to themselves in excess of their proportionate ownership shares. Maggard says these actions effectively terminated the firm’s status as an S corporation under the Code. The Commissioner disagrees and wants Maggard and his wife to pay tax on income that they never received, as owners of S corporations must sometimes do.
The taxpayer argued that his brother’s withdrawals effectively changed the company’s articles of incorporation and bylaws by majority action. But he could not point to a change in the articles or bylaws that redefined shareholders’ rights or authorized a new class of stock.
Conclusion
Schricker’s income from 2014–16 flowed through to Maggard and Chang, and Schricker isn’t subject to taxation as a C corporation. The couple must include in their income for these years Maggard’s proportionate share of Schricker’s income despite the disproportionate distributions made to LL and WJ at Maggard’s expense. The parties settled other issues, so.
Case Details
Case Title: James J. Maggard And Szu-Yi Chang V/S Commissioner Of Internal Revenue
Citation: T.C. Memo. 2024-77
Judges: Holmes Judge
Date of Order / Judgment: 07/08/2024
