The Tax Court (court) in Maggard v. Commissioner (T.C. Memo 2024-77, Aug. 7, 2024) held that the founder of an S corporation is liable for taxes on income that was never distributed to him because the corporation's S corporation election was not terminated when the S corporation made disproportionate distributions to its other shareholders.

Facts

James Maggard was one of the founders of an engineering consultant partnership that was incorporated into an S corporation. The bylaws provided for 10,000 shares of one class of common stock, which entitled each owner under the relevant state law to a pro-rata share of any dividends as well as any distribution of the corporation's assets on liquidation. Maggard maintained a 40% interest in the corporation and sold a 60% interest to two individuals (40% to one and 20% to the other).

According to the court, the two individuals proceeded to misappropriate funds and make disproportionate distributions to themselves. In addition, they did not file Forms 1120S, U.S. Income Tax Return for an S Corporation, with the IRS or send Maggard Schedules K-1 showing his share of distributions.

Maggard accused the individuals of embezzling more than $1 million from 2012–2015. The individuals then cut Maggard off from the corporation's books and out of meetings, voted to increase their salaries and benefits, and authorized payouts to themselves based on retroactively increasing their paid time off.

The individuals then sued Maggard in California Superior Court alleging breach of contract and fraud and Maggard filed a countersuit in 2013. The California Superior Court found that the corporation had overdistributed to one of the individuals and underdistributed to Maggard and ordered the company to make corrective distributions to Maggard, which the individuals refused to do. Maggard then agreed to an offer from one of the individuals to buy Maggard's entire stake in the corporation for about $1.26 million.

Maggard filed his taxes in 2018 for tax years 2011–2016. His attorney asked one of the individuals to give him Maggard's share of the corporation's income and expenses and the individual provided a napkin with the number $300,000 written on it, representing Maggard's pro rata portion of the corporation's losses for tax year 2014. The individual did the same for 2015 with a loss of $50,000. The corporation subsequently issued Schedules K-1 to Maggard for the 2011–2016 tax years showing his proportionate share of the earnings as profits, not losses.

The IRS audited Maggard and determined that he and his wife did not correctly report income from the corporation for the years 2014–2016.

Relevant law

Included among the various statutory requirements that must be satisfied for a taxpayer to be treated as an S corporation is Section 1361(b)(1)(D), which requires the corporation to have only a single class of stock. Treas. Reg. Section 1.1361-1(l)(1) treats a corporation as having only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. For these purposes, any differences in voting rights are disregarded.

In turn, Treas. Reg. Section 1.1361-1(l)(2) bases the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds on the corporate charter, articles of incorporation, bylaws, applicable state law and binding agreements around distribution and liquidation proceeds (collectively, the "governing provisions"); it further states that a " … corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights." In applying these regulations, the IRS has said that it will not treat any disproportionate distributions made by a corporation as violating the single-class-of-stock requirement if the corporation's governing provisions provide for identical rights (Revenue Procedure 2022-19, Section 3.02, 2022-41).

Court analysis

Because an S corporation is a pass-through entity, the IRS argued, Maggard must pay tax on his share of the corporation's income for the years at issue, regardless of whether the income was distributed to him. Maggard, however, argued that the corporation's S election terminated before the years at issue by virtue of the repeated disproportionate distributions made by the corporation, which, Maggard maintained, violated IRC Section 1361(b)(1)(D)'s requirement for an S corporation to have only a single class of stock. As a result, Maggard asserted, the corporation was no longer a pass-through entity from 2014–2016, and Maggard should not be required to pay tax on his share of the corporation's income.

In concluding that the disproportionate distributions made before the years at issue did not terminate the corporation's S election, the court cited the relevant regulations and emphasized that, despite the history of disproportionate distributions, the corporation did not formally change its governing documents or authorize or create a second class of shares. Thus, the governing provisions continued to provide for identical rights to distributions and liquidation proceeds.

Citing case law and the regulations, the court said that "[o]ne cannot help but sympathize with a taxpayer caught in this situation. But it is a situation that we've seen before."

Implications

Of all the statutory requirements that must be satisfied for a taxpayer to be eligible to be an S corporation, perhaps the most misunderstood is IRC Section 1361(b)(1)(D)'s requirement for a corporation to have only a single class of stock. Many taxpayers and tax advisers alike interpret this rule to mean that an S corporation must make every distribution precisely pro-rata, and that even a single disproportionate distribution will result in an immediate, cataclysmic termination of the corporation's S election.

As the Tax Court reminded everyone in Maggard, however, that is not how the regulations at Treas. Reg. Section 1.1361-1(l) work. Instead, those regulations look not to what a corporation actually does in making its distributions, but rather to what the corporation's governing provisions say. This rule creates a fascinating and often-confusing dichotomy: as evidenced in Maggard, a corporation may make years of disproportionate distributions, but those distributions should not create a second class of stock as long as the governing provisions provide for identical rights to distribution and liquidation proceeds. Conversely, if an S corporation makes every distribution pro-rata to the penny but confers non-identical rights to distribution and liquidation proceeds in its governing provisions, the election will terminate (See, for example, PLR 202247004).

A common concern for practitioners has been the fear that the IRS would treat a pattern of repeated disproportionate distributions as creating a deemed, implied, governing provision. But it is difficult to imagine a longer — or more egregious — pattern of disproportionate distributions than the one found in Maggard, and yet the IRS and Tax Court refused to terminate the corporation's S election.

Of course, all S corporations should make each distribution pro-rata. After all, an S corporation must allocate all income pro-rata on a per-share, per-day basis; as a result, if distributions are made disproportionately, at least one shareholder will be burdened with paying tax on his or her pro-rata share of income without a corresponding pro-rata distribution of cash.