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Shareholder in S Corporation Must Pay Tax Despite Exclusion from Management

Form_2553,_2005.pngThe minority shareholder in an S corporation argued that he was not liable for federal tax on the corporation’s income because the majority shareholder had shut him out of management, and the corporation had not paid him any salary or distributions. The Internal Revenue Service (IRS) found him liable for the tax and assessed a penalty. He appealed to the United States Tax Court, which rejected his argument that he was not the beneficial owner of the shares and therefore not responsible for the tax. Kumar v. Commissioner of Internal Revenue, T.C. Memo 2013-184. Small businesses, especially those that have elected subchapter S status, should have comprehensive shareholder agreements that address management rights and income distributions.

The petitioner in Kumar owned 40 percent of the shares in Port St. Lucie Ventures, Inc. (PSLV), a medical practice in Florida organized as an S corporation. A dispute arose between him and his business partner, who owned the remaining 60 percent of the shares, in 2003 or 2004. The majority shareholder allegedly shut the petitioner out of PSLV management and operations in 2004. The corporation did not pay the petitioner a salary, nor did it make any distributions to him, in 2005 or in any year thereafter. It issued a Schedule K-1 for tax year 2005 that reported the petitioner’s taxable shares of the corporation’s business and interest income in the amounts of $215,920 and $2,344, respectively. The issue for the petitioner would ultimately be whether he personally owed tax on these amounts.

Subchapter S corporations, unlike subchapter C corporations, do not pay federal income tax directly. 26 U.S.C. § 1363(a). The income and losses of an S corporation “pass through” to the shareholders, who pay taxes or deduct losses on their personal tax returns in proportion to their ownership of outstanding shares. If the record owner of shares in an S corporation is holding them for the benefit of another, the income and losses pass through to the “beneficial owner.” 26 C.F.R. § 1.1361-1(e). In determining whether a person is a “beneficial owner” for tax purposes, courts generally look to whether the person and another party have “some agreement or understanding” of their relationship, such as an estate and an heir. Hightower v. Commission, 2005 T.C. Memo 274, slip op. at 20 n. 12.

The petitioner argued that he was not the beneficial owner of the PSLV shares because he had been shut out of management, which deprived him of any “economic benefit of ownership.” Kumar, slip op. at 6. The Tax Court affirmed the IRS Commissioner’s findings, noting that the petitioner did not present any authority that addressed his specific situation. It cited precedent holding that “a poor relationship between the shareholders” does not imply “deprivation of the economic benefit of the shares.” Id. at 7, citing Hightower, slip op. at 20-21.

The lesson of this case for S corporations and other small businesses, perhaps, is the importance of shareholder agreements that protect the rights of minority shareholders and establish procedures for management and operations. Any business that uses pass-through taxation should protect shareholders from liability for income tax by providing, at a minimum, income distributions to cover their tax liability.

If you or your business has a dispute over a contract or other business matter, a skilled business and commercial lawyer can advise you of your rights and protect your interests. James G. Schwartz has represented Bay Area businesses since 1976. To schedule a free and confidential consultation, please contact us today online or at (925) 463-1073.

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