In a recent case (see Mowry v. Commissioner, T.C. Memo 2018-105), the Tax Court ruled that disproportionate distributions were insufficient to establish that an S corporation had a second class of stock, and thus did not cause a termination of the company’s S corporation election. Interestingly, this was to the disappointment of at least one of the entity’s shareholders.
S corporations, when compared to other pass-through entities, are relatively user friendly. However, they are subject certain restrictions, including a requirement that they only have one class of stock. This means all shares must have equal rights to distribution and liquidation proceeds. Failure to comply with this restriction can have major consequences, including termination of the company’s S election.
In the case, the petitioner owned a 49 percent interest in an S corporation, with his brother owning the remaining 51 percent. During the years at issue, the S corporation did not file Forms 1120S or issue K-1s to either of its shareholders. Upon examination, the revenue agent prepared substitute returns and allocated 49 percent of the income to the taxpayer.
The substitute returns also showed disproportionate distributions – the result of the taxpayer’s brother, unbeknownst to the taxpayer, paying personal expenses with company credit cards, among other activities.
The petitioner was not interested in reporting 49 percent of the company’s income, and tried to argue that the disproportionate distributions had effectively created a second class of stock. If true, the corporation would no longer had a valid S election and should instead be taxed as a C corporation. That would have effectively shifted the tax burden associated with the company’s income from himself and his brother to the corporation. The court, however, disagreed with the taxpayer’s argument.
The court noted that the determination of whether a corporation has multiple classes of stock is based on the “rights granted to shareholders in the corporation’s organizational documents and other ‘binding agreements’ between shareholders.” It then highlighted its conclusion in a prior case (Minton v. Commissioner, T.C. Memo 2007-372) where it found that disproportionate distributions, even those occurring over multiple years, were “insufficient on [their] own” to create a second class of stock. Instead, the court concluded in Minton that:
- There would need to be a binding agreement that altered the shareholders’ rights to distributions
- An “informal, oral understanding” likely would be insufficient
- One would expect to see some type of “formal corporate action to implement the understanding”
With that as its foundation, the court concluded in Mowry that the operative agreement among the shareholders provided all shares with equal rights to distribution and liquidation proceeds. It then noted that the shareholder testified that he never discussed changing the agreement, and that the understanding was always that distributions were to be in proportion to share ownership. Finally, the court dismissed any notion that the majority shareholder had effectively changed the shareholder agreement by majority action by noting a lack of evidence to that effect, while also questioning whether such a change would be allowed under state law.
While this case is unusual–a shareholder was arguing for termination of an S election–it nevertheless echoes a recent message coming from the IRS: Disproportionate distributions won’t, by themselves, terminate an S election. Termination is reserved for more formalized actions and agreements that alter distribution and liquidation rights.
For more information regarding the previous IRS ruling policy announcement involving disproportionate distribution, see our prior alert: IRS signals change to S corporation ruling policy.