We are often contacted by clients, other attorneys, CPA’s, or others, looking to deal with unjust tax outcomes. Often, we are able to assist in avoiding those results. Sometimes, however, tax law simply allows what many see as injustices to occur. This can be the case, for example, when owners of a pass-through entity, S corporation or partnership, are allocated income reported on a Schedule K-1 but receive no distribution with which to pay the associated tax liability. Tax professionals often refer to this as “phantom income.[1]”
In reviewing governing documents for clients holding non-controlling interests in pass-through entities, it is very important to understand the potential for phantom income and ensure that the relevant documents require distributions sufficient to avoid that outcome. Beyond avoiding phantom income, owners of S corporations must follow strict rules that limit S corporations in several ways.[2] One of those limitations is that there can be no “second class of stock” meaning that all S corp. owners must have identical rights to distributions and liquidation proceeds.[3] This too is something that we typically must review in analyzing governing documents.
What happens, however, when the governing documents are drafted to cover these, and other, concerns but the controlling owners simply do not follow the agreements? That issue was addressed in a recent Tax Court case.[4]
Facts
James Maggard is a chemical engineer living in the Silicon Valley. In 2000, Maggard was co-founder of an engineering consulting partnership with his friend and business partner, Todd Schricker. The name of the firm was Schricker Engineering Group. The firm was incorporated in 2002 and made an election to be taxed as an S corporation, with the corporation’s governing documents complying with the requirements applicable to S corps. In 2003, Todd Schricker sold his interests in the firm to Maggard. Afterwards, Maggard sold a 60% interest in the corporation to two new shareholders, L and W.[5]
Although Maggard remained the firm’s principal engineer, L and W took on important roles in the firm. L, an old family friend of Maggard, had an accounting background and handled Schricker’s accounting and bookkeeping. W oversaw day-to-day operations. The board of directors consisted of the three shareholders, Maggard, L, and W.
By 2005, L and W began misappropriating company funds. They accomplished this by inflating expense reimbursement and making disproportionate distributions to themselves at the expense of Maggard. Around the same time, L ceased filing income tax returns for Schricker and issuing K-1’s to the three shareholders.
Sometime in 2012, Maggard had recognized this pattern of abuse and confronted L who denied any wrongdoing. However, after this confrontation, L and W cut Maggard off from company books and meetings. They engaged in other conduct that froze Maggard out of the corporation. They increased their own salaries, vacation time, and benefits, even retroactively going back to 2003. The parties ended up in litigation that was resolved in Maggard’s favor. After L and W refused to comply with the court ordered payments to Maggard, the parties ultimately settled with L and W buying Maggard out of the company.
In attempting to comply with his return filing obligations during these periods, Maggard requested his share of the firm’s income or loss to report.[6] For most years, he was given a single number written on a napkin and told it represented his loss. He reported losses consistent with that information. However, when Schricker eventually filed returns and issued K-1’s, they showed Maggard as being allocated profits during those years (profits that he never received as distributions). Due to the differences in Maggard’s individual income tax returns and Schricker’s informational returns, the IRS asserted a tax deficiency with the matter ultimately ending up before the Tax Court.
Analysis
Maggard argued that the failure of Schricker to make equal distributions constituted a violation of the requirements applicable to S corporations. As such, the corporation ceased to be taxed as an S corporation and reverted to a C corporation, which would render the corporation liable for any unpaid tax liability rather than the shareholders. In taking this position, Maggard agreed there had been no change to the corporation’s governing documents to allow disproportionate distributions.
The court started by citing to authorities finding that disproportionate distributions alone do not constitute a “second class of stock” as long as the entity’s governing documents require distributions to be equal.[7] Consistent with this, the IRS recently issued a Revenue Procedure allowing relief from certain failures to comply with the limitations applicable to S corporations. In that Rev. Proc., the IRS stated that distributions violating the one class of stock requirement will not cause termination of the entity’s S election as long as the govern documents for identical rights to distributions.[8]
Maggard attempted to distinguish his situation from these other authorities. Here, not only were there unauthorized disproportionate distributions, but his rights as a shareholder were removed, he had insufficient information to report his share of the firm’s income, etc. However, in spite of these factors, the court found against Maggard stating that “the law is ironclad on this issue, though. We find that Schricker as an entity neither authorized nor created a second class of shares by way of formal corporation action. That means we must hold that Schricker continued to maintain its S corporation status for the years at issue.”
Once it was concluded that Schricker maintained its status as an S corporation, the matter was over for Maggard. He was required to pay income tax on his proportionate share of Schricker income for the years at issue, even though he did not receive distributions representing that taxable income. This is consistent with S corporation treatment and preexisting authorities addressing similar circumstances.
Conclusion
As indicated above, tax law sometimes allows what may be seen as unjust results prevail. Maggard suffered from abusive business partners who collectively held controlling interests in the business entity, a state law corporation electing to be taxed as an S corporation. His business partners raided the corporation’s profits for their own benefit, did not distribute to Maggard his share of corporate profits, and froze Magard out of corporate governance. In addition, these business partners failed to properly file income tax returns, properly provide Maggard with the amount of his allocable share of the corporation’s taxable income, and comply with the state court’s order that they satisfy these previous unpaid amounts to Maggard.
In spite of all of these inequities, Maggard was still held to owe income tax on his allocable share of the S corporation’s income. Owners in pass-through entities need to carefully review governing documents to be sure they create the intended tax result. However, as seen here, that may also generate unintended consequences when the entity is operated differently than the governing documents indicate. As such, care cannot stop once the entity is formed or governing documents are agreed upon. Rather, vigilance must be maintained. Otherwise, business owners could find themselves in a similar situation as Maggard. Sometimes seemingly unjust results are supported by tax law. It is important that business owners and their advisors are aware of this potential and lookout for situations where they may find themselves on the wrong side of these outcomes.
[1] See, e.g., U.S. v. Basye, 410 U.S. 441 (1973) which stated that “each partner must pay taxes on his distributive share of the partnership’s income without regard to whether that amount is actually distributed to him.” With respect to S corporations, see also IRC § 1366. For a discussion particular to the potential effects of phantom income on non-grantor trusts, see Edmondson, Gray, “Estate Planning with Partnership Interests: Income Tax Considerations,” March 26, 2024, https://www.esapllc.com/estate-planning-with-partnership-interests-income-tax-considerations-2024/#_ftn22.
[2] In this regard, I am referring to entities having elected to be taxed under Subchapter S of the Internal Revenue Code under IRC § 1362(a) by filing a Form 2553. This election may be made by non-corporate entities such as LLC’s. See Edmondson, Gray, “LLC v. S Corp.: Is that Really the Question?,” July 16, 2021, https://www.esapllc.com/llc-v-s-corp-is-that-really-the-question/.
[3] IRC § 1361(b)(1)(D) and Treas. Reg. § 1.1361-1(l)(1).
[4] Maggard, T.C. Memo 2024-77.
[5] The Tax Court opinion refers to these two individuals as “LL” and “WJ.” For purposes of this writing, I will refer to them as L and W.
[6] Magard filed jointly with his wife, Szu-Yi Chang. However, in order to simplify this writing , I will refer to Maggard as the sole taxpayer at issue.
[7] Treas. Reg. § 1.1361-1(l)(2), Mowery, T.C. Memo 2018-105, and Minton, T.C. Memo 2007-372.
[8] Rev. Proc. 2022-19. See also, Edmondson, Gray, “Fixing S Corporation Problems Just Got a Lot Easier,” Oct. 19, 2022, https://www.esapllc.com/rev-proc-2022-19/.
