President of not-for-profit organization denied passthrough losses

The Tax Court held that a taxpayer who was the president and a director of a not-for-profit organization could not deduct losses from the organization, which had applied for S corporation status. According to the court, the taxpayer was neither a shareholder of record nor a beneficial owner because “there is no interest in a nonprofit corporation equivalent to that of a stockholder in a for-profit corporation who stands to profit from the success of the enterprise.”

Facts: Waterfront Fashion Week Inc. was organized in May 2012, in Kentucky as a nonstock, not-for-profit corporation but never applied for federal tax-exempt status. According to its articles of incorporation, its primary mission was to raise money for the conservation and maintenance of the Waterfront Park in Louisville, Ky. The organization could not distribute any part of its earnings to its directors, officers, or other private individuals. Clinton Deckard was Waterfront’s president and one of its three directors during the years at issue.

In October 2012, Waterfront produced an event at the Louisville Waterfront Park that failed to break even after Deckard had contributed $275,000. Waterfront failed to submit its 2013 annual report to the state and was dissolved by Kentucky’s secretary of state but was subsequently reinstated; however, after Waterfront failed to file its 2014 annual report, Kentucky’s secretary of state again dissolved it on Sept. 30, 2014. Waterfront did not apply for reinstatement; however, on Oct. 28, 2014, it did apply to the IRS to be retroactively treated as an S corporation for federal income tax purposes as of May 8, 2012.

Waterfront filed untimely 2012 and 2013 Forms 1120S, U.S. Income Tax Return for an S Corporation, on Jan. 13, 2015, reporting losses of $277,967 and $3,239, respectively. All of the losses passed through to Deckard, listed as Waterfront’s sole owner, who reported those losses on his respective 2012 and 2013 individual tax returns. The IRS issued a deficiency notice for 2012 and 2013 disallowing Deckard’s losses on the basis that Waterfront’s S corporation election was invalid and that Deckard was not a shareholder of it. Deckard petitioned the Tax Court for relief.

Issues: A corporation, with the consent of all of its shareholders, may elect to be an S corporation for federal income tax purposes, which allows income and losses to be passed through to its shareholders, who report those items on their individual income tax returns. In determining whether someone is a shareholder of an S corporation, courts have examined whether that person is a beneficial owner of the corporation’s stock under state law. The IRS argued that Deckard was not a shareholder or a beneficial owner of Waterfront, while Deckard argued that he was the exclusive beneficial owner.

Holding: In a case of first impression addressing a beneficial ownership interest in a nonstock, not-for-profit corporation for purposes of Subchapter S, the Tax Court held that the taxpayer did not have an ownership interest in Waterfront similar to an ownership interest in an S corporation and could not deduct any passthrough losses.

According to the court, under the Kentucky Nonprofit Corporation Acts, Waterfront could not issue stock. Therefore, Deckard was not an S corporation shareholder under Regs. Sec. 1.1361-1(e)(1), which ordinarily treats as an S corporation shareholder “the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation).”

Furthermore, Waterfront’s articles of incorporation prohibited Waterfront from distributing any part of its profits to Deckard, so treating Deckard as a shareholder in the not-for-profit organization would be “fundamentally incompatible with the purpose and operation” of S corporations. Also, the Kentucky Nonprofit Corporation Acts and Waterfront’s articles of incorporation prohibited the distribution of any of Waterfront’s assets to Deckard in the event it was dissolved, a right typical of a shareholder.

The court also rejected the taxpayer’s argument that he meant to operate Waterfront as a for-profit corporation, so it should be treated as such despite its legal form as a not-for-profit corporation. The court stated, “Nothing in the record suggests that Waterfront’s form did not respect its substance.” Deckard also argued that Waterfront should be a for-profit corporation because it never became a tax-exempt organization. However, the court rejected that argument, stating that Waterfront’s federal tax-exempt status or lack of it had no impact on its not-for-profit status under state law. Finally, because the court determined that Deckard was not a shareholder, it found it unnecessary to address whether Waterfront’s S corporation election was valid.

• Deckard, 155 T.C. No. 8 (2020)

— By Charles J. Reichert, CPA.