S corporation’s sole owner had unreported income but not constructive dividend

The Tax Court determined that an S corporation’s sole owner had enough basis in an S corporation to deduct the losses passed through to him from it. In addition, the court did not require the taxpayer to report the discharge of a loan from the S corporation as a constructive dividend, due to a lack of earnings and profits to support dividend treatment.

Facts: Philip Joseph Franklin was the sole shareholder of Franklin Drywall Inc. (FDI), a construction company. FDI was formed in 1989 and properly elected S corporation status three days after its formation. Franklin filed late personal tax returns for 2007 and 2008. He did not file returns for 2009 and 2010, so the IRS prepared substitutes for returns for those years.

FDI reported an ordinary business loss of $501,448 on its 2007 tax return, which also showed a loan to shareholder beginning balance of $218,342 but an ending balance of zero. FDI’s 2007 tax return indicated that it was the corporation’s final year.

During 2007, FDI owed ACRO Business Finance Corp. over $1.7 million. Franklin guaranteed the loan, and in 2007 ACRO seized and sold $496,000 of Franklin’s assets in partial satisfaction of the debt, which, according to Franklin, left him owing $500,000 to ACRO. Franklin reported passthrough losses from FDI of $343,939 and $107,298, respectively, on his 2007 and 2008 personal tax returns.

Franklin was also the sole shareholder of Franklin Construction Services (FCS), an S corporation. In 2008, FCS reported a loss of $187,503, which Franklin reported on his 2008 personal tax return as a passthrough loss.

Issues: The issues before the Tax Court included whether Franklin omitted dividends of $218,342 in 2007 and overstated passthrough S corporation losses by $343,939 in 2007 and $294,801 in 2008.

Holding: The court determined that Franklin had not received a constructive dividend as a result of the discharge of his debt to FDI. It further determined he was entitled to deduct the losses passed through from FDI because the satisfaction of the $496,000 owed to ACRO increased Franklin’s basis in FDI.

As to the dividends the IRS claimed Franklin constructively received when his debt to FDI of $218,342 was relieved, the court determined that Franklin could not have a constructive dividend because FDI did not have earnings and profits. S corporation status was elected for FDI almost immediately after the corporation was formed, so there were never any earnings and profits. Distributions from an S corporation are excluded from the shareholder’s income to the extent they do not exceed the shareholder’s basis in the stock. Any excess is treated as a gain from the sale or exchange of property, the court noted (Sec. 1368(b)).

With regard to losses, the IRS claimed Franklin could not deduct them because he did not have sufficient basis in FDI. Losses passed through from an S corporation to a taxpayer who is a shareholder can be deducted only to the extent of the taxpayer’s basis in the S corporation stock (Sec. 1366(d)(1)). The court found that Franklin had no basis in the stock at the beginning of 2007 because FDI had a negative accumulated adjustments account, and Franklin would have used any basis in deducting losses equal to basis because of prior-year losses. However, it also found that the sale of Franklin’s property to satisfy FDI’s obligations to ACRO increased Franklin’s basis by $496,000. Thus, Franklin’s basis in FDI was large enough to allow him to deduct the $343,939 loss passed through to him from the corporation in 2007.

However, the Tax Court denied the 2008 passthrough loss of $107,298 from FDI that Franklin claimed because the corporation’s 2007 return indicated that it was FDI’s final tax return, and there was no evidence of a 2008 return or loss for the corporation. The 2008 passthrough loss of $187,503 from FCS was denied because Franklin failed to show evidence of any basis in FCS.

Along with other penalties that the court sustained, the IRS assessed a penalty under Sec. 6651(a)(2) for failure to timely pay tax. However, the court determined that this penalty did not apply because the IRS did not introduce substitute returns for the years in question into evidence and the parties did not stipulate that the IRS had made the returns. While the IRS introduced transcripts that showed it had made the substitutes for returns, the court found that the transcripts did not establish that the returns met the requirements of Sec. 6020(b).

• Franklin, T.C. Memo. 2016-207

—By Karyn Bybee Friske, CPA, Ph.D., Schaeffer Professor of Business Ethics and professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.