Not So Happy Law

If given their druthers, most transactional corporate attorneys would prefer to spend their day practicing “happy law,” by which they typically mean transactions that involve capital formation, mergers and acquisitions, joint ventures, business restructurings, and other collaborative-type projects in which the parties have clearly delineated goals, there are definite beginning and end points to the project, and the project is expected to be completed within a relatively short time frame.

The odds are pretty good, however, that a transactional lawyer in the so-called “middle market” will, over the course of their career, become involved in several disputes among the shareholders of a closely held corporation.

What’s more, there is a very good chance that the corporation in question will have elected to be treated as an S corporation for tax purposes,[i] which may present some very challenging issues, as was illustrated in the case of an individual taxpayer (“Taxpayer”)[ii] (described below), and some difficult choices.

In the Beginning

Taxpayer founded an engineering firm (“Corp”) that was organized as a corporation under state law, and which elected to be treated as an S corporation for tax purposes.[iii]

According to its articles of incorporation, all the authorized shares of Corp stock were of one class of voting common stock. Neither Corp’s articles nor its bylaws mentioned more than one class of stock or made any allowance for disproportionate distribution or liquidation rights for any of its shareholders.

Just prior to the tax periods in question (the “Exam Years”), Taxpayer owned all of the issued and outstanding shares of Corp stock.

New Shareholders

Taxpayer sold a 60 percent interest in Corp to two individuals, Tom and Jerry.[iv] It appears that no shareholders’ agreement was entered into in connection these transactions.

These individuals joined Taxpayer on Corp’s board of directors and took on executive roles. Specifically, Jerry assumed responsibility for Corp’s accounting and books, and also served as its secretary, while Tom served as Corp’s CEO and CFO. Although Taxpayer served as Corp’s chief engineer, Tom and Jerry oversaw the corporation’s day-to-day operations.

During the Exam Years, Taxpayer owned 40 percent of Corp, as did Tom, while Jerry owned the remaining 20 percent. In accordance with state law and with Corp’s governing documents, each individual shareholder was entitled to a share of corporate dividends and liquidating distributions that was proportionate to their respective Corp stock holdings. The three shareholders never changed Corp’s articles of incorporation or its bylaws to allow for disproportionate distributions or liquidation rights.

Something’s Rotten

It was not long after the foregoing arrangements were implemented that Tom began to misappropriate funds by inflating reimbursements for his expense accounts.

Tom and Jerry also began making disproportionate distributions of Corp’s earnings to themselves, at the expense of Taxpayer.

And if that wasn’t bad enough, as soon as Tom became CFO he stopped filing Corp’s annual federal income tax return.[v] Tom also stopped sending Schedules K-1[vi] to Taxpayer.

Eventually, Taxpayer caught on to his fellow shareholders’ shenanigans. He hired CPA to assist him with reconciling Corp’s accounts and discovered that Tom had overdistributed to himself an amount of Corp’s profits that, instead, should have been distributed to Taxpayer.

Taxpayer subsequently accused Tom and Jerry of embezzling more than $1 million from Corp during the Exam Years. He also confronted Tom about the unauthorized distributions, but Tom denied any wrongdoing.

From Bad to Worse

From that point on, however, Tom and Jerry froze out Taxpayer. They cut off his access to Corp’s books, left him out of board and shareholder meetings, and otherwise made Taxpayer’s position with the business altogether untenable.

Using their majority positions on the board, Tom and Jerry also voted to increase their own salaries, vacation time, and other benefits provided to them as employees of Corp. They authorized payouts to themselves based on retroactively increasing the amount of paid time off they had accumulated going back several years.

Taxpayer received no such benefits.

State Court Litigation

The dastardly duo then sued Taxpayer in state court, claiming breach of contract and fraud. They also sought injunctive relief in the form of specific performance of Taxpayer’s employment contract, as well as declaratory relief to assert Tom’s and Jerry’s combined 60 percent ownership of Corp.

Taxpayer filed a countersuit in which he asked for rescission based on fraud and failure of consideration, conversion, breach of contract, and embezzlement. He also sought declaratory relief to invalidate Tom’s shares, as well as an accounting of Corp’s books.

State Court Findings

The state court found that Corp had overdistributed to Tom and under-distributed to Taxpayer. In fact, Corp had not distributed any of its profits to Taxpayer during the course of the litigation, although cash continued to flow to Tom and Jerry.

The court also found that Taxpayer had not authorized Corp’s disproportionate distributions to Tom and Jerry, nor was Taxpayer aware of any formal board or shareholder agreements which authorized such distributions.[vii] The state court, therefore, ordered Corp to make a corrective distribution to Taxpayer.

However, Tom and Jerry refused to pay. Instead, Tom offered to buy Taxpayer’s entire stake in Corp, and Taxpayer agreed.

The settlement agreement in which the agreed-upon purchase and sale of Taxpayer’s shares was memorialized also included a covenant that Corp would not make any changes to the Schedules K-1 after it got around to issuing them to Taxpayer in respect of the Exam Years.

From that point on, Taxpayer had no role in the company.

Whistleblower Attempt

In addition to litigating in state court, Taxpayer contacted the IRS’s Whistleblower Office. He spoke with a customer service representative to explain that Corp had made disproportionate distributions among its shareholders and had failed to issue Schedules K-1. Taxpayer also explained that Tom had used company funds to pay for a portion of the litigation expenses incurred by Tom personally in connection with the state court litigation.

The IRS representative told Taxpayer how to submit a whistleblower claim. This representative also mentioned to Taxpayer that the submission of such a claim, based upon the facts provided, may cause the termination of Corp’s S corporation status, following which Corp would be taxed as a C corporation. In that case, Corp would owe corporate income tax to which it was not previously subject, but Taxpayer would no longer have to report on his own tax return any Corp profits that were not distributed to him.

Taxpayer submitted the whistleblower form[viii] to the IRS after the state court issued its decision. On the form, Taxpayer alleged that Corp had claimed false deductions, underreported income, failed to pay tax, and provided kickbacks to Tom and Jerry.[ix]

Tax Preparation

Against the backdrop of the foregoing activity, Taxpayer took on the task of compiling the information required for preparing his federal income tax returns for the Exam Years. Not surprisingly, he did not receive much help from Corp. However, Taxpayer knew he had to include his share of Corp’s income and expenses on his individual return, so he had his attorney contact Tom to get these figures.

Tom provided[x] Taxpayer with a single number for each of the Exam Years which purported to be Taxpayer’s share of Corp’s loss for each such year. Taxpayer filed his tax returns for the Exam Years and claimed the losses of which Tom had “informed” him, without the benefit of Schedules K-1.[xi]

Unfortunately for Taxpayer, when Corp subsequently filed its delinquent federal S corporation tax returns for the Exam Years, the Schedules K-1 issued to Taxpayer for each year showed only his proportionate share of Corp’s profits – there were no losses during such years.[xii]

Notice of Deficiency

The IRS audited Taxpayer’s returns for the Exam Years. The agency determined that Taxpayer did not correctly report his share of Corp’s income. It also disallowed the losses claimed by Taxpayer on the returns.[xiii]

The IRS issue a notice of deficiency[xiv] in which it asserted an income tax deficiency against Taxpayer (including penalties and interest), in response to which Taxpayer timely[xv] petitioned the U.S. Tax Court.

The only issue before the Court was whether the disproportionate distributions described above resulted in the loss of Corp’s status as an S corporation status because they caused Corp to fail the “one class of stock” rule.[xvi]

S Corporation Requirements

The Court began its analysis of this issue by describing the pass-through treatment[xvii] of S corporations and the taxation of their shareholders; specifically, a shareholder of an S corporation is required to take into account in the shareholder’s tax return, their pro rata share, whether or not distributed, of the S corporation’s items of income, loss, deduction, or credit.[xviii]

Next, the Court considered the criteria[xix] that a corporation must satisfy in order to be treated as a “small business corporation” eligible to elect “S” status.[xx]

With one exception, the IRS and Taxpayer agreed that Corp satisfied the definition of a small business corporation.

Single Class of Stock

The one requirement in dispute was the prohibition against having more than one class of stock.[xxi] A corporation that has more than one class of stock does not qualify as a small business corporation.

In general, a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.[xxii] (Differences in voting rights are disregarded.) For example, one class of stock may not be preferred over another as to any corporate distributions.

Although 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, any distributions – including actual, constructive, or deemed distributions[xxiii] – that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.[xxiv]

The determination of whether all the outstanding shares of stock of a corporation confer identical rights to distribution and liquidation proceeds is made based on the corporation’s articles of incorporation, its bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds (collectively, the “governing provisions”).

A commercial contractual agreement, such as a lease, employment agreement, or loan agreement, is not a binding agreement relating to distribution and liquidation proceeds and thus is not a governing provision unless a principal purpose of the agreement is to circumvent the one class of stock requirement.[xxv]

Court’s Analysis

Consistent with the foregoing discussion, the IRS explained that it would not treat a corporation’s disproportionate distributions among its shareholders as violating the one-class-of-stock requirement if the corporation’s governing provisions provided for identical distribution rights.

The Court observed that this was “where the parties diverge,” with Taxpayer asserting that Tom and Jerry were “looting the company when they made unauthorized and grossly unequal distributions to themselves,” and with the IRS responding that such behavior was irrelevant because the proper focus was “on shareholder rights under a corporation’s governing documents, not what shareholders actually do.”

On this point, the Court sided with the IRS. According to the Court, the Regulation “plainly states that uneven distributions don’t mean that the corporation has more than one class of stock.”[xxvi]

The Court recognized that this outcome may create a serious problem for a shareholder who remains liable for the income tax imposed upon their share of an S corporation’s income notwithstanding the shareholder’s never having received their share of corporate distributions. This may be especially problematic, the Court continued, when the shareholder-taxpayer relies on distributions by the S corporation to pay these taxes.

Such a shareholder’s situation becomes worse yet, the Court stated, when the corporation also fails to provide the information needed for the shareholder to accurately report their share of the corporation’s income on a tax return.

The Court observed that the foregoing described the exact circumstances in which Taxpayer found himself, before adding “it is a situation that we’ve seen before.”[xxvii]

It then described several cases in which a group of shareholders agreed among themselves to exclude another shareholder from corporate distributions. The Court explained that, in the absence of a binding agreement among all the shareholders, such arrangements did not give disproportionate distribution rights to those shareholders who in fact received unequal distributions. Further, the Court rejected the argument made by the deprived shareholders in those cases that the disproportionate distributions had effectively changed their corporation’s articles of incorporation by majority action.

The Court stated that a binding agreement that disproportionally affected the shareholders’ economic rights was necessary under the Regulation to disqualify a corporation from remaining an S corporation.

Court’s Conclusion

The unauthorized distributions from Corp to Tom and Jerry in the present case were hidden from Taxpayer, but they were not memorialized by formal amendments to Corp’s governing provisions.

In light of the Regulation’s language and the caselaw, the Court stated it was compelled to hold that the disproportionate distributions, by themselves, did not violate the one class of stock requirement and, so, did not change Corp’s “S” status.[xxviii]

Thus, Corp was not subject to taxation as a C corporation, it remained a passthrough, and its income for the Exam Years properly flowed through to Taxpayer, who had to include it in his income.

Oppressed Shareholder

Taxpayer tried to “convert” Corp from an S into a C corporation into to terminate its treatment as a passthrough for tax purposes. You can’t blame him. After all, Taxpayer was being taxed on his share of Corp’s income but was not receiving any distributions from Corp.[xxix] In order to satisfy the resulting income tax liability, Taxpayer may have had to withdraw money from elsewhere, sell another asset to generate the necessary liquidity, or borrow the funds.[xxx]

If Taxpayer had succeeded in “erasing” the S election, Corp would have been treated as a taxable corporation during the Exam Years, and its taxable income would have been subject to federal income tax at the rate of 21 percent.[xxxi]

Because Corp would thereby have ceased to be treated as a passthrough entity, Taxpayer would no longer have been subject to federal income tax (at a top rate of 37 percent) on his undistributed share of Corp’s taxable income.[xxxii]

Unfortunately for Taxpayer, he was unable to convince the IRS and the Court that the one class of stock rule had been violated as a result of Tom and Jerry’s misdeeds.

Was there anything else Taxpayer could have done to avoid the allocation of S corporation income to him during the Exam Years? Perhaps.

Redemption?

For example, considering the failure to invite Taxpayer to shareholders’ and board meetings, the denial of access to corporate books and records, and the failure to include him in dividend distributions, might Taxpayer have reasonably argued that his shares of Corp stock had effectively been redeemed as a matter of state law?[xxxiii]

Dissolution?

Did Taxpayer threaten to bring an action for dissolution under state law, on the basis of shareholder oppression, as a means of bringing Tom and Jerry to the negotiating table? It does not appear that Taxpayer actually pursued such a course; if he had, his status as a shareholder could have been converted into that of a creditor awaiting payment of the purchase price for his shares of Corp stock.

Stock Transfer?

Alternatively, what if Taxpayer had transferred[xxxiv] just one share of Corp stock to a person not eligible to own shares of S corporation stock; say to a C corporation of which he or a family member was the only shareholder? In the absence of a shareholders’ or other agreement restricting one’s ability to dispose of their Corp shares, such a transfer would have terminated Corp’s status as an S corporation.[xxxv]

Of course, the transfer would have had to be real and bona fide, had economic reality, and represented a real transfer of beneficial (as well as legal) ownership.

It could not have been a mere formal device; if it was, the IRS would have disregarded it as a sham. Furthermore, a state court would not respect the transfer, perhaps treating it instead as a breach of the transferor-shareholder’s fiduciary duty.

Regardless, one may expect the other shareholders to refuse to recognize the transfer. For example, they would not file a final S corporation return and would continue to issue K-1s to the transferor-shareholder, though the latter may notify the IRS that they are treating the corporation’s income in a manner that is inconsistent with the Sch. K-1 issued to the shareholder.[xxxvi]

What to do?

There is a lot to digest here, and there are a number of strategic decisions for the oppressed shareholder to consider.

The better, and ultimately less expensive, course would have been for the shareholders to have entered into a well-drafted shareholders’ agreement[xxxvii] at the inception of their relationship. An agreement that addresses voting rights and management, distributions, rights of first refusal, put rights, stock valuation, and mechanisms for dispute resolution is priceless.

The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Within the meaning of IRC Sec. 1361. According to the Bureau of Economic Analysis, of the U.S. Dept. of Commerce, S corporations account for almost 77% of corporations with fewer than 500 employees.

[ii] Maggard v. Comm’r, T.C. Memo. 2024-77 (2024).

[iii] An S corporation is a small business corporation within the meaning of IRC Sec. 1361(b), whose shareholders make an election under section 1362(a).

[iv] Not necessarily the cat and mouse characters, respectively, from the eponymously named “Tom and Jerry” cartoons created by Hanna and Barbera.

[v] IRS Form 1120S, U.S. Income Tax Return for an S Corporation. S corporations are required to file information returns to report their income and deductions to their owners. IRC Sec. 6037.

[vi] Schedule K-1 (Shareholder’s Share of Income, Deductions, Credits, etc.) is the IRS form used by S corporations to report a shareholder’s share of the corporation’s income, as well as any deductions, credits, etc. The information included on a shareholder’s K-1 is used by the shareholder to prepare their own federal income tax returns.

[vii] Corp had only one class of stock. The board’s declaration of a dividend would not have been specific to a particular shareholder – every person owning shares of the same class of stock on which the dividend is declared is entitled to receive the same amount of dividend per share.

[viii] The issue of whether Taxpayer was entitled to an award for his claim under IRC Sec. 7623(b) wasn’t before the Court, but the suggestion made by the Whistleblower Office – that unequal distributions might terminate Corp’s status as an S corporation – definitely was.

[ix] The IRS received the whistleblower form but did not act on the information.

[x][x] According to the Court, Tom provided the numbers on a paper napkin. You can’t make this up. A business divorce can be every bit as nasty as one involving a married couple.

[xi] Schedule E, Supplemental Income and Loss. As we’ll see, there were no such losses.

[xii] Like I said, a business divorce can be very nasty.

[xiii] In addition, the IRS concluded that Taxpayer’s income from Corp during those years was passive because Taxpayer had not been actively participating in the corporation’s business.

[xiv] IRC Sec. 6212.

[xv] Within 90 days after the notice of deficiency was mailed. IRC Sec. 6213. See Tax Court Rule 34 regarding the contents of the petition.

[xvi] If Corp’s S corporation election had been lost, the Court would also have had to determine the adjustments to be made to Taxpayer’s income for the years affected thereby.

[xvii] The S corporation is generally not subject to income tax. IRC Sec. 1363(a). A key exception is the tax on built-in gain. IRC Sec. 1374.

[xviii] IRC Sec. 1366; Reg. Sec. 1.1366-1. These items are reflected on the Schedule K-1, and are generally reported by an individual shareholder on Part II of Schedule E of Form 1040.

[xix] IRC Sec. 1361(b): not more than 100 shareholders; a nonresident alien may not be a shareholder; only individuals and certain estates and trusts may be shareholders; not more than one class of stock.

[xx] IRC Sec. 1362(a).

[xxi] IRC Sec. 1361(b)(1)(D).

[xxii] Reg. Sec. 1.1361-1(l)(2). The “Regulation.”

Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock. Thus, if all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.

[xxiii] For example, the foregone interest on a loan from a corporation to a shareholder, or that portion of the compensation paid by a corporation to a shareholder-employee in excess of what is reasonable compensation for the services rendered by the shareholder-employee.

[xxiv] Reg. Sec. 1.1361-1(l)(2)(i). See the examples at Reg. Sec. 1.1361-1(l)(2)(vi).

[xxv] Reg. Sec. 1.1361-1(l)(2)(i). The Regulation provides that buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights unless a principal purpose of the agreement is to circumvent the one class of stock requirement, and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock. Reg. Sec. 1.1361-1(l)(2)(iii).

[xxvi] Reg. Sec. 1.1361-1(l)(2) (“[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 ….”).

[xxvii] Small comfort to Taxpayer.

[xxviii] Taxpayer tried arguing that his case was about more than just disproportionate distributions, that it was also about deferred income, removal of shareholder and board member rights, and lack of sufficient information. “Surely, he says, all of this warrants the removal of [Corp’s] S corporation status, so that he doesn’t get taxed on income he didn’t receive and didn’t for some time even know about.”

The Court rejected Taxpayer’s argument, stating that the law was “ironclad on this issue.” We find that Schricker as an entity neither authorized nor created a second class of shares by way of a formal corporate action. That means that we must hold that Schricker continued to maintain its S corporation status for the years at issue.

[xxix] There was no indication that his employment with Corp had been terminated.

[xxx] Each of these options would have generated additional costs.

[xxxi] For our purposes, I’m ignoring the shareholder-level federal income tax (IRC Sec. 1(h)) and surtax (IRC Sec. 1411) on dividend distributions, as well as the corporate-level accumulated earnings tax (IRC Sec. 531 et seq.).

[xxxii] Not to mention the resulting economic loss from having to come up with the means to pay the tax.

[xxxiii] Query whether this point was raised during the state court litigation.

[xxxiv] We won’t consider the nature of the transfer as a gift or sale.

[xxxv] Of course, Taxpayer would also be hurting himself. (For example, the double taxation that accompanies status as a C corporation.) There may be times however, where “rational” behavior is not to be expected; viewed differently, the course taken may actually be rational under the circumstances – the shareholder is using the potential loss of S status and the consequences arising therefrom as leverage in their negotiations with the corporation and the other shareholders.

[xxxvi] IRS Form 8082, “Notice of Inconsistent Treatment.”

[xxxvii] An aspect of happy law.