Equitable and collateral estoppel fail to shield S corporation distribution

The Tax Court held that the surviving shareholder of an S corporation was still a shareholder at the time of the S corporation’s bankruptcy and liable for her share of a distribution and additions to tax for failure to timely file and pay.

Facts: In 1990, Karen Veeraswamy married her husband, Velappan. Ten years later, the couple started Ashand Enterprises Inc., which was organized as an S corporation. At the time of incorporation, Karen and Velappan each owned 100 shares of Ashand. The evidence of this ownership structure was derived from several sources. First, Karen testified that she remembered accompanying her husband in 2000 to an attorney’s office to sign the corporate formation documents. Second, the list of Ashand’s shareholders, which was memorialized in the first board meeting and in the articles of incorporation for Ashand, reflected the same 50%/50% ownership structure. Finally, Ashand’s 2010 Form 1120-S, U.S. Income Tax Return for an S Corporation, identified Karen and Velappan as 50% shareholders.

In 2005, Ashand purchased an apartment building on Ward Avenue in the Bronx, New York City, which was Ashand’s primary asset. Both Karen and Velappan participated in the business and served on Ashand’s board of directors. Velappan ran the business as its president, and Karen acted as Ashand’s secretary and treasurer.

Around 2004, the couple’s marriage began to break down, and in 2011 Karen moved out of the family home and filed for divorce. Despite the failing marriage, Karen continued to participate in Ashand’s business activities. Velappan, however, started to isolate her from the business by removing her from Ashand’s bank accounts and by trying to limit her access to the office. In their divorce, Velappan argued that Karen’s lack of involvement precluded Ashand from being a marital asset. Karen interpreted this to mean that she was no longer a shareholder in Ashand.

By 2013, Ashand was behind on its mortgage payments, and Velappan filed for Chapter 11 bankruptcy protection for Ashand. In the bankruptcy proceedings, Velappan claimed he was Ashand’s president and sole owner. Although it was denied by the bankruptcy court, Karen filed a proof of claim in Ashand’s bankruptcy for the domestic support order she had won in the divorce proceedings. As noted by the Tax Court, in filing her claim, she “did not represent to the bankruptcy court that she was co-owner of Ashand — only that she was entitled to domestic support by way of her marriage to Ashand’s purported sole owner, Velappan.” The bankruptcy court allowed her to continue to participate in the case.

In 2014, the trustee assigned to the Ashand bankruptcy sold the apartment building for $7.6 million, which covered Ashand’s debts and left close to a $2 million surplus after expenses. As Karen remained a party to Ashand’s bankruptcy, the bankruptcy court ordered that the surplus from the apartment building’s sale be put into an escrow account controlled by Karen’s attorney until the divorce proceedings were resolved.

Facing large family-support and federal tax debts, Velappan filed for Chapter 13 bankruptcy in 2018; the case was later converted to a Chapter 7 bankruptcy on Karen’s motion that same year. The IRS filed a proof of claim in Velappan’s bankruptcy for his income tax liabilities, and Karen filed a proof of claim for domestic support she was owed by Velappen.

In 2019, before his bankruptcy was adjudicated, Velappan died from a heart attack. The divorce case was deemed moot, and Karen was appointed as the administrator of Velappan’s estate. In sorting out his estate, Karen discovered corporate documents that showed she remained a 50% shareholder in Ashand. Following this discovery, Karen filed an amended proof of claim in Velappan’s bankruptcy, seeking the original claim for domestic support plus $950,000 as an equity distribution from the sale of the Ashand apartment building. In her amended proof of claim, which she signed under penalty of perjury, she asserted that she was a 50% shareholder of Ashand, attaching to the claim Ashand’s corporate-formation documents as proof. Also, Karen moved to reopen Ashand’s bankruptcy, arguing that she was a 50% shareholder of Ashand. In 2022, a final settlement in Velappan’s bankruptcy was approved and provided Karen with a $486,038 payment to satisfy her equity claim and $480,000 in domestic support. She did not, however, report either amount on her 2022 tax return or file a return for the 2014 tax year.

In 2022, the IRS reopened an audit of Ashand after it received the bankruptcy court filings in which Karen claimed that she owned half of the company. This quickly turned the IRS’s attention toward Karen and her unfiled 2014 tax return. The IRS prepared a substitute return under Sec. 6020(b) that incorporated the calculations and assumptions derived from Ashand’s bankruptcy filings. This included assigning half of Ashand’s rental income and capital gain to Karen because of Ashand’s S corporation status. The IRS also assessed penalties for failure to timely file and failure to timely pay in the notice of deficiency. In response, Karen timely petitioned the Tax Court to review the IRS’s determinations.

Issues: Sec. 1362(a) allows an S election that, once approved, remains effective for all succeeding years (Sec. 1362(c); even bankruptcy petitions do not terminate this status for tax purposes (Mourad, 121 T.C. 1 (2003), aff’d, 387 F.3d 27 (1st Cir. 2004))). The primary issue before the court was whether Karen was a 50% shareholder in Ashand in 2014.

The court first considered whether it was more likely than not that Karen was a shareholder in Ashand in 2014. Although neither Ashand nor Karen filed any tax forms for 2014, several other factors indicated that she was still a shareholder. For example, as the court observed, “the corporate records, tax returns, bankruptcy exhibits, and family-court exhibits” never showed a change in Ashand’s ownership from its inception to 2014. Citing Hightower, T.C. Memo. 2005-274, aff’d, 266 F. App’x 646 (9th Cir. 2008), the court emphasized, “Our S corporation law doesn’t permit the income of an S corporation to evade passthrough or ownership treatment because of a poor relationship between the shareholders.” Based on this analysis, the court concluded that it was more likely than not that Karen was a 50% shareholder in 2014.

The Tax Court also considered whether Karen had abandoned her ownership interest, which the court has previously held is possible for tax purposes of passthrough entities (Penland, T.C. Memo. 2011-274). To prove abandonment, Karen needed to show she had the intent to abandon her ownership interest and had taken an affirmative step to abandon it (Milton, T.C. Memo. 2009-246). The court determined that she had failed to prove that she had abandoned the interest because she not only had not made an affirmative act of abandonment, but she had also actively pursued her ownership interest in the bankruptcy proceedings. In addition, the court found that her amended proof of claim represented her final, considered position in those proceedings and that it showed that it was more likely than not that Karen owned 50% of Ashand in 2014.

Having concluded that Karen was a 50% owner in Ashand, the Tax Court considered her alternative argument that the doctrine of equitable or collateral estoppel applied to prevent the IRS from making the argument that she was an owner of Ashand. The court first addressed equitable estoppel. Quoting from its opinion in Howe, T.C. Memo. 2020- 78 (citing Hofstetter, 98 T.C. 695, 700 (1992)), the court explained that “[e]quitable estoppel precludes a party from ‘denying his own acts or representations which induced another to act to his detriment.’”

Karen needed to meet five basic requirements of equitable estoppel to preclude the IRS from arguing that she was a shareholder in 2014 (a false representation or misleading silence by the opposing party, an error in a statement of fact and not an opinion or statement of law, that she was ignorant of the true facts, that she reasonably relied on a false or misleading statement by the opposing party, and that she incurred a detriment as a result (Telesmanich, T.C. Memo. 2011-181)). In addition, under the higher standard that applies when asserting equitable estoppel against the government, Karen also needed to show that the IRS engaged in affirmative misconduct going beyond mere negligence, that its wrongful acts would cause a serious injustice, and that the public interest would not suffer undue damage if the court estopped the IRS (Howe, slip op. at 15).

The Tax Court, however, did not find any bad faith or misconduct on the IRS’s part in Velappan’s bankruptcy proceedings, noting that the IRS did not learn about Karen’s claim that she was a 50% owner of Ashand until 2019, when Karen submitted an amended proof of claim making that assertion. Similarly, the court found that the five basic elements of equitable estoppel were not present. Thus, the court concluded that the IRS was not equitably estopped from asserting Karen’s ownership interest.

Regarding collateral estoppel, the court explained that when an issue of fact or law is actually and necessarily determined by a court, that issue is deemed “conclusive in subsequent suits based on a different cause of action involving a party to the prior litigation” (Monahan, 109 T.C. 235 (1997), quoting Montana, 440 U.S. 147 (1979)). To establish that collateral estoppel applied, the court found that Karen would need to demonstrate five facts, one of which was that the bankruptcy court was of competent jurisdiction and rendered a final judgment on the issue. This element was not met because the bankruptcy court in Ashand’s bankruptcy case did not issue a final judgment on the ownership issue, and Velappan’s bankruptcy case also ended without a final judgment on the issue of ownership.

Holding: The Tax Court held that the IRS was not equitably or collaterally estopped from arguing that Karen was a 50% shareholder in Ashand and found it more likely than not that she was a 50% shareholder. Thus, it concluded that Karen must include her pro rata share of Ashand’s 2014 rental income and its capital gain on the sale of the apartment building, less her pro rata share of the company’s expenses, in her 2014 income. Further, the court held that Karen was liable for additions to tax for failure to timely file a return and failure to timely pay the amount shown on a return because she had not argued that she had reasonable cause for her failure to file or pay and had not been advised she did not have a 2014 filing obligation.

■ Veeraswamy, T.C. Memo. 2024-83

— Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy, and 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, both at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA’s tax editor.