Disproportionate distributions did not terminate corporation’s S status

Unauthorized distributions to a corporation’s shareholders did not terminate an entity’s S status since the shareholders did not authorize or create a second class of stock in the entity’s governing documents, the Tax Court held.

Facts: James J. Maggard, along with his wife, Szu-Yi Chang, lived in the Silicon Valley, Calif., community of Saratoga. Maggard was an innovator and inventor in chemical engineering, particularly in designing manufacturing facilities and structures. He founded Schricker Engineering Group (SEG) with a friend, Todd Schricker, to consult on mechanical, electrical, and structural engineering matters for commercial and industrial clients.

In 2002, Maggard and Schricker incorporated SEG in California. They also elected for the company to be treated as an S corporation when they filed its 2002 Form 1120-S, U.S. Income Tax Return for an S Corporation. SEG’s S status remained in effect for the years at issue, 2014 through 2016.

Maggard and Schricker each owned half of the corporation’s shares, which were all classified as common. The number of shares, their class, and the percentages of ownership were all set out in SEG’s governing documents. The bylaws made no mention of a second class of stock and did not refer to any allowance for disproportionate liquidation rights of its shareholders.

In July 2003, Schricker sold his interest in the company to Maggard. Maggard then sold a 60% interest in the corporation to two friends, identified by the Tax Court only as LL and WJ. Both individuals joined Maggard on the board of directors while taking on executive roles, and they oversaw the corporation’s day-to-day operations. LL, having an accounting background, handled SEG’s accounting and books while serving as CEO and CFO for the years at issue. Maggard remained the company’s lead engineer while helping with sales and business development.

By 2005, Maggard owned 40% of SEG’s shares, while LL and WJ owned 40% and 20%, respectively. According to the corporation’s governing documents, each was entitled to a proportionate share of SEG’s distributions. These documents were never changed to allow for disproportionate distributions or liquidation rights.

What did change were the company’s cultural dynamics. LL began to misappropriate funds, while both LL and WJ made disproportionate distributions of earnings to themselves to Maggard’s detriment. Upon becoming CFO, LL also failed to file Form 1120-S and stopped sending Schedules K-1, Shareholder’s Share of Income, Deductions, Credits, etc., to Maggard.

Maggard eventually caught on to LL and WJ’s scheme and in 2012 hired a CPA to reconcile SEG’s accounts. The CPA determined that LL overdistributed $160,800 to himself and failed to distribute $165,000 to Maggard. Maggard eventually accused LL and WJ of embezzling more than $1 million from the company from 2012 through 2015.

When Maggard confronted LL and WJ, they began cutting him off from the company’s books and meetings while preventing him from fully participating as a director or shareholder. Also, using their majority position, LL and WJ voted to increase their salaries, vacation time, and other employee benefits. They also authorized at least $325,000 in payouts to themselves retroactively to 2003 by increasing their amount of paid time off.

LL and WJ then sued Maggard in California Superior Court for breach of contract and fraud. Maggard countersued, seeking rescission based on fraud and failure of consideration, conversion, breach of contract, and embezzlement. He also sought declaratory relief to invalidate LL’s shares and to order an accounting of SEG’s books.

In August 2016, the court filed its proposed judgment finding that SEG overdistributed profits to LL and underdistributed them to Maggard. Distributions also were not made to Maggard during the litigation, while they were still being made to LL and WJ. Finding that Maggard had not authorized or been aware of the disproportionate distributions to LL and WJ, the court ordered SEG to make a corrective distribution of $164,783 to Maggard, which LL and WJ refused to pay. However, LL and WJ offered to buy Maggard’s shares in the company for $1,262,500, which he accepted, signing a settlement agreement in 2018.

In addition to the state court litigation, Maggard contacted the IRS Whistleblower Office, claiming that SEG had made disproportionate distributions and failed to issue him a Schedule K-1 for 2011. He also reported that LL used company funds to pay a portion of the litigation expenses against him. Maggard was told that he would need to file Form 3949-A, Information Referral.

Doing so, Maggard was told, could revoke the company’s S status, making it taxable at the entity level as a C corporation. This would preclude Maggard from having to include in his own taxable income the “money that he was entitled to, but had not received, from the firm.” Maggard completed and filed the whistleblower form.

SEG eventually filed Forms 1120-S for the years in issue in April 2018. Knowing he needed to complete Form 1040, U.S. Individual Income Tax Return, to include his share of SEG’s income and expenses, Maggard had his attorney contact LL to obtain that information. LL provided “a single number written on a napkin,” $300,000, which purportedly represented Maggard’s pro rata share of SEG’s 2014 losses. This loss was claimed by Maggard and his wife on their 2014 Form 1040 filed on Aug. 16, 2016. For tax year 2015, he again received a single number, $50,000, supposedly representing Maggard’s share of loss for that year, which he and his wife included on their Form 1040 filed in July 2017. They reported no income or loss from SEG on their 2016 return.

“Napkin accounting is bound to attract the [IRS’s] attention,” the Tax Court observed. The Service determined that the losses the couple reported were incorrect. Forms K-1 SEG filed in November 2018 for the years at issue showed Maggard’s proportionate share of income, not losses.

Issues: Shareholders must elect to be taxed as an S corporation by filing Form 2553, Election by a Small Business Corporation (Regs. Sec. 1.1362-6(a) (2)(i)). Once approved by the IRS, the election remains in effect indefinitely (Sec. 1362(c)). The Code lists several other requirements, including that the entity hold no more than one class of stock (Sec. 1361(b)(1)(D)). The Code does not define a second class of stock, but Regs. Sec. 1.1361-1(l)(1) provides that a corporation will have only one class of stock if “all outstanding shares … confer identical rights to distribution and liquidation proceeds.” To determine whether the stock confers these rights, one must look to the corporation’s governing documents, including its articles of incorporation, corporate charter, and bylaws.

Maggard argued that LL and WJ “were looting the company” by making “unauthorized and grossly unequal distributions to themselves.” However, the court observed that Regs. Sec. 1.1361-1(l) (2) plainly states that uneven distributions do not mean that the corporation has more than one class of stock. Thus, the court found, as the IRS argued, that the regulation “tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what shareholders actually do.”

Even though the court was sympathetic to Maggard, it determined it was bound by precedent. In Minton, T.C. Memo. 2007-372, aff’d, 562 F.3d 730 (5th Cir. 2009), the court held that, pursuant to Regs. Sec. 1.1361-1(l)(2), the absence of a binding agreement between an S corporation and its shareholders did not give disproportionate distribution rights to shareholders who in fact received unequal distributions. The court also found that such an agreement was necessary under Regs. Sec. 1.1361-1(l)(2) to disqualify the company from remaining an S corporation.

The Tax Court relied on Minton in Mowry, T.C. Memo. 2018-105. In that case, a minority shareholder argued that the majority shareholder, by taking disproportionate distributions, had effectively changed the company’s articles of incorporation and bylaws by majority action. However, the minority shareholder “could not point to a change in the articles or bylaws that redefined shareholders’ rights or authorized a new class of stock,” so the court held that a second class of stock had not been created.

Relying on the regulations and case law, the court held that disproportionate distributions by themselves do not change a company’s S status, even if they are unauthorized and hidden from one of the shareholders, as long as the distributions are not memorialized by formal amendments to the corporation’s governing documents. Lacking any such memorialization, SEG only had one class of stock. Therefore, its S status could not be revoked for disproportionate distributions under Regs. Sec. 1.1361-1(l)(2).

Maggard argued that the case was also about “deferred income, removal of shareholder and board member rights, and lack of sufficient information,” which together with the disproportionate distributions should result in the revocation of the corporation’s S status. The court held, however, that “the law is ironclad on this issue.” SEG did not authorize or create a second class of stock by any formal corporate action.

Holding: The court consequently held that SEG’s S status was not revoked and it was not a C corporation subject to entity-level taxation for 2014 to 2016. Rather, its income flowed through to Maggard and his wife, resulting in their having to report it on their joint income tax returns for those years.

■ Maggard, T.C. Memo. 2024-77

— John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business, and Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy, both at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA’s tax editor.