Content by Ivan H. Golden (Chicago)

Many businesses operate as S corporations because of the tax benefits they offer – namely, the ability to avoid corporate tax on the business’ earnings.

Unlike C corporations, S corporations do not pay income tax; instead, profits (and losses) are passed through to owners, who pay tax on the corporation’s earnings on their individual income tax returns. The ability to lawfully avoid corporate income tax often results in a lower overall tax burden for business owners.

But S corporation benefits come with a set of rigid rules: S corporations cannot have more than 100 shareholders; cannot have as a shareholder a person other than an individual (and certain estates and trusts); cannot have a foreign shareholder; and cannot have more than one class of stock. It was this last requirement that was at issue in Maggard v. Commissioner, a recent Tax Court case.

The facts in Maggard were outrageous: the taxpayer, James Maggard, sold a 60% interest in his S corporation to two individuals, who promptly looted the company by making large, unauthorized distributions to themselves. Over a three-year period, Maggard estimated the two new shareholders distributed more than $1 million to themselves, while Maggard – still a 40% shareholder – received nothing. The new shareholders also froze Maggard out of corporate meetings and information, including even the basic information he needed to prepare his income tax returns.

Beginning in 2014, Maggard reported no income or losses from his interest in the corporation. The IRS determined, however, that he had income from the corporation despite receiving no distributions. When the dispute reached the Tax Court, Maggard argued the other shareholders’ unequal distributions amounted to a second class of stock that terminated the corporation’s S election.

The Tax Court disagreed. While expressing sympathy for Maggard, the Court observed that whether an S corporation has more than one class of stock is determined by the corporation’s governing documents, such as its charter, articles of incorporation, bylaws, and the like. According to the Tax Court, the fact an S corporation actually makes unequal distributions does not necessarily create a second class of stock.

Bottom Line: Although the Tax Court’s decision was unfortunate for Maggard, who was forced to pay income tax on money he never received, the Court’s decision was, in many respects, a taxpayer-friendly result because it confirmed that an S corporation that makes unequal distributions, whether accidentally or on purpose, will not lose its subchapter S status, so long as the corporation’s governing documents do not create a second class of stock.

“Next to being shot at and missed, nothing is really quite as satisfying as an income tax refund.” – F.J. Raymond