Lesson From The Tax Court: Form Trumps Substance On Phantom S Corp Income

This past June, the Supreme Court issued an opinion in Moore v. United States, 144 S.Ct. 1680 (June 20, 2024).  There, the taxpayers were shareholders of an American-controlled foreign corporation called KisanKraft and were being taxed on a portion of the corporation’s income that had been earned long ago and far away but never actually passed on to them substantively.  The unhappy taxpayers protested that Congress could not constitutionally tax them on income they had not realized through actual receipt.  To them it was phantom income.  Form could not, constitutionally, trump substance.

In explaining why the taxpayers were wrong, Justice Kavanaugh reviewed how Congress has historically chosen to make the owners of certain business entities responsible for paying tax on the entity’s income, regardless of what the entity actually does with that income.  He also reviewed how courts have routinely upheld that Congressional choice.

Today’s lesson is an example of that routine application of Congressional choice.  It also carries a cautionary lesson for taxpayers: choose your business partners carefully!  You do not want to go into business with Gru and Dru.  In James J. Maggard and Szu-Yi Chang v. Commissioner, T.C. Memo. 2024-77 (Aug. 7, 2021) (Judge Holmes), Mr. Maggard was a 40% shareholder of an S Corporation controlled by two other shareholders who, over the course of several years “made unauthorized distributions to themselves in excess of their proportionate ownership shares.” Op. at 1.  Judge Holmes translates this into plain English: they looted the corporation.  While the looting gave the taxpayer an argument to avoid taxation, it was not a winning argument.

Sad details below the fold.

Law: Congress Can Assign Income Even if You Cannot
I find it useful to approach tax issues by making sure I’m asking the right questions. Most of the time we are concerned with the “whether” question: whether a taxpayer has an item of income or can deduct an item of expense.  Many times we must also ask the “what kind” question.  If a taxpayer does have an item of income, is it a capital gain or ordinary income?  Sometimes we ask the “when” question.  When must the taxpayer report the item of income or when may the taxpayer take the deduction?

Today’s lesson involves the “who” question: we learn how Congress creates different structures for who should pay tax on a business entity’s income.

When only individuals are involved, the “who” question for income items is resolved by case-law.  Called the assignment of income doctrine, it dates back to a grumpy 89 year old Justice Oliver Wendell Holmes’ pronouncement that the tax statutes should not be read as permitting arrangements “by which the fruits are attributed to a different tree from that on which they grew.” Lucas v. Earl, 281 U.S. 111, 115 (1930).  Since then, the Supreme Court has called this “the first principle of income taxation: that income must be taxed to him who earns it.” Commissioner v. Culbertson, 337 U.S. 733, 739 (1949).  Substance basically trumps form.

When applied to business entities, however, Congress has exercised its power to change up that first principle. Thus for partnerships, corporations and trusts, Congress has created statutory rules to assign responsibility for who is generally responsible for paying tax on the income earned by the business entity.  At the same time, Congress gives taxpayers the ability to choose what entity they want to use to conduct their business activities.  Let’s take a closer look.

For partnerships, Congress says the entity, the partnership, does not pay tax on the income it earns. §701.  Instead, a partnership assigns its income to each of its partners, generally in proportion to each partner’s ownership interest in the partnership.  Thus we say that partnerships “pass through” their partnership income by allocating an appropriate “distributive share” to each partner.  They are pass-through entities.

For corporations, in contrast, the general rule is that they report and pay tax on the income they earn, just like an individual.  §11(a).  The shareholders don’t pay tax, the corporation does.  However, if and when the corporation later distributes its profits to its shareholders, it does so on an after-tax basis.  And the shareholders must then include those distribution as gross income. §61(a)(7).

A widely perceived downside of making corporations responsible for paying tax on their income, and then taxing shareholders on subsequent distribution of profits is that it creates a kind of double taxation and puts a drag on capital.  Thus, on this view, an important upside of the partnership pass-through structure is that it avoids this seeming double taxation.

But the benefits of the pass-through structure are not without cost. The pass-through structure has a downside as well.  While the entity itself pays no income tax on its gross income, each partner must report and pay tax on their distributive share, regardless of what happens to that distributive share.  That means they might pay tax on what, to them, is phantom income.  Their formal right to income is what Congress says makes them responsible for tax, not their substantive receipt.

That rule dates back at least to the Revenue Act of 1918’s statutory command that “there shall be included in computing the net income of each partner his distributive share, whether distributed or not, of the net income of the partnership for the taxable year.” §218(a), 405 Stat. 1057 at 1070.  You now find that rule in Treas. Reg. 1.702-1.  As the Supreme Court wrote: it “is axiomatic that each partner must pay taxes on his distributive share of the partnership's income without regard to whether that amount is actually distributed to him.” United States v. Basye, 410 U.S. 441 (1973).

We saw how that “distributive share” rule can bite individual taxpayers in partnerships in Lesson From The Tax Court: Of Distributive Shares And The CDP Mashup, TaxProf Blog (Oct. 25, 2021).  Today we’re going to see something similar for shareholders in S corporations.

In 1958 Congress created rules in Subchapter S to permit certain small business corporations to elect to be taxed on a pass-through basis like partnerships and not on an entity basis like regular corporations.  Treasury has written an accommodating regulation—called “check the box”—that makes the initial election pretty painless. Treas. Reg. 301.7701-3.  So it is no surprise that, at least according to Justice Kavanaugh in Moore, a “majority of the corporations in the United States are S corporations, so the taxation of individual shareholders of S corporations is widespread.” 144 S.Ct. at 1694.

S Corporation status may be easy to elect but there are still various requirements to be met.  §1361(b).  For example, there must be 100 or fewer shareholders, they generally must be individuals, and the corporation can’t be an insurance company subject to subchapter L.

The requirement important to today’s lesson is the one class of stock rule.  There must be only one class of stock. §1361(b)(1)(D).  The regulations explain that “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.”  Treas. Reg. 1.1361-1(l)(1) (emphasis added).  Other differences will not invalidate the one class of stock requirements.  The regulation explains that different voting rights do not matter: “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.”  Id.

The key requirement to have one class of stock is the “identical rights to distribution” requirement.  Yeah, I added emphasis again.  The regulation explains that whether all outstanding shares of stock have identical rights is to be determined “based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).”  Treas. Reg. 1.1561-1(l)(2).

Thus, an S corporation is generally treated for federal income tax purposes just like a partnership in the sense it is simply a conduit for income: income flows through it to its shareholders. See Gitlitz v. Commissioner, 531 U.S. 206, 209 (2001). Shareholders of an S corporation are required to report and pay taxes on their pro rata shares of the S corporation's taxable income. §1366(a)(1)(A).  And, just as with partnerships, that is true whether or not the shareholders actually receive any distribution from the S Corporation. Form controls.

And that is true even if your business partners are Gru and Dru and steal from you.  Let’s look at our case.

Facts
The tax years at issue are 2014, 2015, and 2016.  During those years Mr. Maggard held 40% of the shares of a company, Schricker Engineering, that he had co-founded in 2003.  The other 60% of the shares were held by two individuals that Judge Holmes identifies only as LL and WJ.  Judge Holmes drops a footnote explaining that he is reluctant to use their actual names “because Maggard’s allegations of their misconduct could seriously harm their reputations if believed, and the truth of his allegations turns out not to be important in ruling on his tax issue.”  Well, if we are going to make up names, let’s just call them Gru and Dru.

Schricker Engineering was a profitable company at all times.  However, starting in 2005 Gru and Dru apparently took control the company and started channeling those profits disproportionately to themselves and stiffing Mr. Maggard.  Mr. Maggard eventually caught on and confronted them about it in 2012.  It did not go well.

In 2013 he sued.  After that, Gru and Dru apparently totally froze him out of operations and meetings.  In 2016 the state court issued a judgment in Mr. Maggard’s favor, finding that Schricker Engineering had indeed overdistributed company profits to Gru and Dru and under-distributed to Maggard.  Op. at 5.  The state court also found that Maggard had not authorized these disproportionate distributions. Judge Holmes adds that “Maggard wasn’t aware of any formal board or shareholder agreements which authorized disproportionate distributions.”  Op. at 5.  The state court ordered Schricker Engineering to make a corrective distribution of almost $165,000.  Instead, Gru and Dru settled the litigation by buying Mr. Maggard out for about $1.26 million in October 2018.

Meanwhile, on the tax side, Schricker Engineering had not filed income tax returns nor had it issued any K-1s to Maggard between 2012 and 2018.  So Maggard—attempting to comply with his tax reporting obligations—had basically just made up numbers for those years, which included the three years at issue (2014-2016).  Only in November 2018 did Schricker Engineering send Mr. Maggard the K-1’s, which showed his proportionate share of Schricker’s earnings.  Again, note that those amounts had not actually been distributed to him.

And that was Mr. Maggard’s tax problem: once the IRS got the K-1’s, it saw there was no match to what Mr. Maggard had reported.  For example, the K-1 for 2014 showed his share of earnings to be $18,000.  That year he had reported instead a $300,000 loss.  Similarly, the K-1 for 2015 showed his earnings to be $324k but he reported a $50,000 loss.  Similarly, the K-1 for 2106 showed his earnings to be $160k but he had reported no gains (and no losses).

So the IRS sent Mr. Maggard an NOD and he petitioned Tax Court.  His basic argument was that the disproportionate distributions violated the one class of stock rule for S Corporations.  If true, that meant Schricker Engineering must be treated as a regular corporation and not a pass-through entity.

Lesson: Looting Does not Violate One Class of Stock Rule
In Tax Court Mr. Maggard argued that Gru and Dru’s actual behaviors—over years and years—effectively rendered the S Corporation’s governing documents void.  Those behaviors were more than the disproportionate distributions. They included all the other bad acts of Gru and Dru: denying him his shareholder and board member rights, denying him access to information. These facts distinguished Mr. Maggard's situation from past precedents.

Judge Holmes rejected that argument.  Remember that emphasized language in the regulation?  That the one class of stock rule is about whether the documents governing the entity create identical rights to equal distributions?  Judge Holmes shows how that focus on the formal rights set out in governing documents is what controls, regardless of how the corporation actually operates.

First, Judge Holmes reviews the regulations I set out above, Second, Judge Holmes reviews the caselaw.  Particularly on point was Mowry v. Commissioner, T.C. Memo. 2018-105, because it had very similar situation to Mr. Maggard’s. I cannot do better than to give you how Judge Holmes’ explains it:

“the taxpayer and his brother incorporated a rebar company as an S corporation. The taxpayer [a 49% shareholder] later discovered that his brother had taken substantial withdrawals from the corporation’s accounts without his knowledge or authorization. The company failed to file Forms 1120S and issue Schedules K–1 for the years at issue, and as a result the Commissioner determined that 49 percent of the corporation’s net income was the taxpayer’s even though he’d received nowhere near that amount in distributions. The taxpayer argued that his brother’s withdrawals effectively changed the company’s articles of incorporation and bylaws by majority action. But he could not point to a change in the articles or bylaws that redefined shareholders’ rights or authorized a new class of stock. We held against him.”  Op. at 10.

From this review Judge Holmes concludes that formal rights trump any actual denials of those rights:

“The regulation’s language and this caselaw force us to hold that disproportionate distributions by themselves do not change a company’s S corporation status. The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by WJ and LL by formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only one class of stock.”  Op. at 10.

Bottom Line: Form controls over substance.  In other words, what determines the rights are the governing provisions, not what actually happens.

Oh yeah, and choose your business partners carefully. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return on the first Monday of each month (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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