United States

District Court refuses to dismiss S corporation shareholder's lawsuit

Shareholder suit addresses income allocation in year of sale

TAX ALERT  | 

A district court in Manfre v. May (N.D. Ill., March 12, 2019) refused to dismiss a former S corporation shareholder’s lawsuit against the S corporation and his fellow shareholders. The lawsuit relates to the shareholder’s claim that other parties breached their stock sale agreement by refusing to make a special election that would affect the allocation of the S corporation’s income in the year the plaintiff sold his S corporation shares.

Background

The plaintiff in this case had previously filed an unrelated lawsuit against the S corporation’s other shareholders. In an effort to resolve the conflict, the parties entered into a sales agreement where the plaintiff agreed to sell his shares to the other shareholders. The agreement included a “Further Assurances” paragraph that indicated:

Each of the Parties shall execute and deliver all such other instruments and take all such other actions as each other may reasonably request from time to time to effectuate the purposes of this Agreement.

The sale occurred mid-year, and when filing its income tax return the S corporation allocated its annual income among the shareholders based on their weighted ownership for the entire year.

The issue

Each year, an S corporation must allocate its taxable income to its shareholders, who in turn report and pay tax on that income. In situations where ownership changes midyear, the normal rule is that the S corporation allocates its income for the entire year based on its shareholders’ weighted ownership for the year – just as the parties did in this case.

Understandably, selling shareholders often prefer to avoid tax obligations associated with the S corporation’s activities post-sale. To address this concern, the internal revenue code has special provisions that enable an S corporation to, “close its books,” as of the date of certain transactions, and allocate income based on actual ownership during the relevant period. Those elections, however, typically require the consent of all affected shareholders.

The plaintiff in this case requested, post-sale, that the S corporation and the other shareholders make such an election. The other parties refused. The plaintiff brought this suit claiming that the “Further Assurances” paragraph noted above effectively required that they consent to the election.

The decision and its implications

The District Court refused the defendants’ motion that the case be dismissed. In doing so, the court indicated that their task was to assess the sufficiency of the complaint, not the merits of the case. The court ultimately concluded that although the “Further Assurances” paragraph did not require that the parties make an election, the provision, “could plausibly be construed to require the Defendants to accommodate the request because it would appear reasonable for a business owner terminating his interest in a company to stop paying taxes on income earned by the company after the termination date.” As such, the court refused the defendants’ motion to dismiss.

This case highlights the importance of addressing income allocation issues during the transaction process, rather than post sale. Selling shareholders want to be sure they aren’t surprised by unexpected income allocations, while S corporations and their continuing shareholders should want to avoid the potential controversy that may arise at a later date.

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