No Second Class of Stock

The Fifth Circuit Court of Appeals rejected an S corporation owner’s argument that the corporation’s payments to her father, one of the company’s founders, had created a second class of stock that had terminated the S election. The daughter had unsuccessfully sought by that reasoning to exclude from her gross income a distributive share of the corporation’s income. The appeals court thus upheld a holding by the Tax Court that there was no proof of any binding agreement that gave the father rights that were not identical to those of other shareholders.

Long’s Preferred Products Inc. was incorporated in Louisiana by Julian and Alma Long in 1975 to sell janitorial and paper supplies. The company properly elected to be treated by the IRS as an S corporation. In 1986 the Longs, their daughter, Linda Minton, and their son, Julian “Dooksie” Long, agreed that the parents would receive distributions of $4,000 a month as the children took over the business. In 1990, following Alma’s death, the distribution was reduced to $2,000.

By 1996 Linda and Dooksie had acquired complete ownership of the corporation. A dispute arose between them that led to a question of ownership that Linda litigated in state court. As part of this litigation, Linda’s attorney determined that the monthly distributions were preferential distributions and not stock purchase payments. The attorney then concluded that the corporation had a second class of stock outstanding and under IRC § 1361(b)(1)(D) had ceased in 1986 to be an S corporation. On that basis, Linda did not report her share of the corporation’s income for 1998 and filed refund claims for the two prior years omitting it. The IRS determined the distributions did not create a second class of stock and assessed tax against Linda. The Tax Court sided with the IRS.

In the Fifth Circuit, Linda again based her argument on Treas. Reg. § 1.1361-1(l), which provides that outstanding stock differs in class if it confers different rights to distributions or liquidation proceeds. The right to these distributions or proceeds can be contained in the articles of incorporation, bylaws, applicable state law or binding agreements. Although Linda argued that the $4,000 monthly payments to her parents were paid under a binding agreement, the Tax Court noted that she testified it was an oral, informal understanding not attested to by any formal corporate action.

The Fifth Circuit agreed with the Tax Court that there was insufficient evidence of a binding agreement. However, the Fifth Circuit said that if the burden of proof had been on the government, the outcome might have been different.

 Linda K. Minton v. Commissioner, TC Memo 2007-372 (5th Cir., aff’d, 3/18/09)

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.