Decisions, Decisions

The reduction in the Federal income tax rate for C corporations, from a maximum of 35-percent to a flat 21-percent, along with several other changes made by the Tax Cuts and Jobs Act (the “Act”) that generally reflect a pro-C corporation bias, have caused the owners of many pass-through entities (“PTEs”) to reconsider the continuing status of such entities as S corporations, partnerships, and sole proprietorships.

Among the factors being examined by owners and their advisers are the following:

  • the PTE is not itself a taxable entity, and the maximum Federal income rate applicable to its individual owners on their pro rata share of a PTE’s ordinary operating income is 37-percent[i], as compared to the 21-percent rate for a C corporation;
  • the owners of a PTE may be able to reduce their Federal tax rate to as low as 29.6-percent if they can take advantage of the “20-percent of qualified business income deduction”;
  • a PTE’s distribution of income that has already been taxed to its owners is generally not taxable[ii], while a C corporation’s distribution of its after-tax earnings will generally be taxable to its owners at a Federal rate of 23.8%, for an effective combined corporate and shareholder rate of 39.8%;
  • the capital gain from the sale of a PTE’s assets will generally not be taxable to the PTE[iii], and will generally be subject to a Federal tax rate of 20-percent in the hands of its owners[iv], while the same transaction by a C corporation, followed by a liquidating distribution to its shareholders, will generate a combined tax rate of 39.8%.[v]

The application of these considerations to the unique facts circumstances of a particular business may cause its owners to arrive at a different conclusion than will the owners of another business that appears to be similarly situated.

Even within a single business, there may be disagreement among its owners as to which form of business organization, or which tax status, would optimize the owners’ economic benefit, depending upon their own individual tax situation and appetite.[vi]

In the past, this kind of disagreement in the context of a closely held business has often resulted in litigation of the kind that spawned the discovery issue described below. The changes made by the Act are certain to produce more than their share of similar intra-business litigation as owners disagree over the failure of their business to make or revoke certain tax elections, as well as its failure to reorganize its “corporate” structure.

A Taste of Things to Come?

Corporation was created to invest in the development, production, and sale of a product. Among its shareholders was a limited partnership (“LP”), of which Plaintiff was the majority owner.

Plaintiff asserted that Corporation’s management (“Defendants”) had breached their fiduciary duty to LP and the other shareholders. This claim was based upon the fact that Corporation was a C corporation and, as such, its dividend distributions to LP were taxable to LP’s members, based upon their respective ownership interest of LP.[vii]

Plaintiff claimed that this “double taxation” of Corporation’s earnings – once to Corporation and again upon its distribution as a dividend to its shareholders – had cost the business and its owners millions of dollars over the years, was “unnecessary,” had reduced the value of LP, and could have been avoided if Corporation had been converted into an S corporation, at which point LP would have distributed its shares of Corporation stock to its members, who were individuals.

Plaintiff stated that it had made repeated requests to Defendants to “eliminate this waste,” but to no avail.

Thus, one of the forms of relief requested by Plaintiff was “[p]ermanent injunctive relief compelling the Defendants to take all appropriate actions necessary to eliminate the taxable status of [Corporation] that results in an unnecessary level of taxation on distributions to the limited partners of [LP].”

“Prove It”

Defendants asked the Court to compel Plaintiff to produce Plaintiff’s tax returns for any tax year as to which Plaintiff claimed to have suffered damages based upon Corporation’s tax status.

Defendants asserted that, in order to measure any damages that were suffered by Plaintiff by reason of Corporation’s status, Defendants needed certain information regarding Plaintiff’s taxes, including Plaintiff’s “tax rate, deductions, credits and the like.”

Plaintiff responded that their “tax returns have no conceivable relevance to any aspect of this case.” Among other reasons, Plaintiff asserted that the action was brought derivatively on behalf of LP such that Plaintiff’s personal tax returns were not germane.

Defendants countered that, even if Plaintiff’s claims were asserted derivatively, the tax returns nevertheless were relevant since Plaintiff was a member of LP, the entity on whose behalf the claims were made.

The Court’s Decision

According to the Court, tax returns in the possession of a taxpayer are not immune from civil discovery. It noted, however, that courts generally are “reluctant to order the production of personal financial documents and have imposed a heightened standard for the discovery of tax returns.”

The Court explained that a party seeking to compel production of tax returns in civil cases must meet a two-part test; specifically, it must demonstrate that:

  • the returns are relevant to the subject matter of the action; and
  • there is a compelling need for the returns because the information contained therein is not otherwise readily obtainable.

Limited partnerships, the Court continued, “are taxed as ‘pass-through’ entities, do not pay any income tax, but instead file information returns and reports to each partner on his or her pro-rata share of all income, deductions, gains, losses, credits and other items.” The partner then reports those items on his or her individual income tax return. “The limited partnership serves as a conduit through which the income tax consequences of a project or enterprise are passed through to the individual partners.”

The Court found that Plaintiff’s tax returns were relevant to the claims asserted. The crux of Plaintiff’s argument regarding Corporation’s status, the Court stated, was that LP’s partners, including Plaintiff, were subject to “double taxation” and were thereby damaged.

The Court also found that Defendants had established a compelling need. The Court was satisfied that, in order for Defendants to ascertain whether or not Plaintiff, who owned a majority interest in LP, would have paid less tax if Corporation had been converted to an S corporation, Plaintiff had to produce their tax returns to Defendants. The tax returns would disclose, among other things, Plaintiff’s tax rate, deductions and credits that affected the tax due by Plaintiff.

Furthermore, the Court continued, Plaintiff failed to demonstrate that there were alternative sources from which to obtain the information. “While the party seeking discovery of the tax returns bears the burden of establishing relevance, the party resisting disclosure should bear the burden of establishing alternative sources for the information.”

Any concerns that existed regarding the private nature of the information contained in the tax returns could be addressed, the Court stated, by making the tax returns subject to the terms of the “stipulation and order of confidentiality” previously entered in the case.[viii]

Accordingly, the Court granted Defendants’ motion.

What’s Good for the Goose?

For years, oppressed or disgruntled shareholders and partners have often found in the tax returns of the business, of which they are owners, the clues, leads, or circumstantial evidence that help support their claims of mismanagement or worse by those in control of the business.

As a result of the Act, it is likely that some non-controlling owners will find cause for questioning or challenging the “choice of entity” decisions made on behalf of the business by its controlling owners.[ix]

In some cases, their concerns will be validated by what turn out to be true instances of oppression intended to cause economic harm and, perhaps, to force out the intended target.

In others, however, the controlling owner’s decision will have been reached only after a lot of due diligence, including financial modelling and consulting with tax advisers. In such cases, the controlling owner may want to examine the complaining party’s tax return, as in the Court’s decision described above, so as to ascertain whether the loss claimed was actually suffered.

It bears repeating, though, that even if the tax return information may be relevant to the controlling owner’s defense, there is a judicial bias against the disclosure of such information that is manifested in the application of “a heightened standard for the discovery of tax returns.” As stated earlier, the requesting party has to demonstrate that there is a “strong necessity” for the returns, and that the return information is not readily obtainable from other sources.

In the end, the best course of action for the “choice-of-entity” decision-maker, and their best defense against any claims of oppression or mismanagement, is to demonstrate that they acted reasonably and responsibly; they should thoroughly document the decision-process, and explain the basis for their decision. With that, a potential owner-claimant would be hard-pressed to second-guess them with any reasonable likelihood of success.

[i] If the PTE’s business is a passive activity with respect to the owner, the 3.8% Federal surtax on net investment income may also apply, bumping their maximum Federal tax rate up from 37% to 40.8%.

[ii] Because of the upward basis adjustment to the owner’s partnership interest or S corp. stock resulting from the inclusion of the PTE’s income or gain in the owner’s gross income.

[iii] There are exceptions; for example, the built-in gains tax for S corps. . In addition, the gain from the sale of certain assets may generate ordinary income that would be taxable to the PTE’s owners at a Federal rate of 37%; for example, depreciation recapture.

[iv] But see endnote i, supra.

[v] The operating income and capital gain of a C corporation are taxed at the same rate; there is no preferential Federal capital gain rate as in the case of individuals.

[vi] You may have heard your own clients debating the pros and cons of spinning off “divisions” so as to position themselves for maximizing the deduction based on qualified business income. All this before the issuance of any guidance by the IRS (which is expected later this month), though the Service intimated last month that taxpayers may not be pleased with its position regarding such spin-offs.

[vii] See the third bullet point, above.

[viii] Such an order may be used in cases requiring the exchange, as part of the discovery process, of what the parties to the law suit believe is confidential information.

[ix] For example, a shareholder of an S corporation that does not make distributions, who is not employed by the business, who is a passive investor in the business, and whose pro rata share of the corporation’s income is subject to federal tax at a rate of 40.8%, may wonder why the controlling shareholder does not agree to revoke the “S” election, to at least start making tax distributions.

In the weeks preceding the introduction of the bill that was just enacted as the Tax Cuts and Jobs Act (the “Act”), my colleagues teased me, “Lou, what are you going to do when Congress simplifies the Code?”

“Simplify?” I responded as I reached for the Merriam-Webster’s Dictionary that I have used since 1980 – it resides next to the HP scientific calculator that I have used since 1987 – change is not always a good thing – “Congress is incapable of simplifying anything.”

Tax Cuts and Jobs Act

“The word ‘simplify’,” I continued, “is defined as follows: to make simple or simpler; to reduce to basic essentials; to diminish in scope or complexity; to make more intelligible.”

After reviewing the final version of the legislation, two thoughts came to mind: first, Congress must not have a dictionary and, second, the most influential lobbying organization in Washington must be comprised entirely of tax professionals.

In order to better appreciate – if not fully understand – the changes wrought by the Act regarding the Federal taxation of trade or business income that is recognized, “directly or indirectly,” by non-corporate taxpayers, the reader should be reminded of the existing rules, and should also be made aware of the policy underlying the changes.


A business that is conducted by an individual as a sole proprietorship (whether directly or through a single-member LLC that is disregarded for tax purposes) is not treated as an entity separate from its owner. Rather, the owner is taxed directly on the income of the business.

A business that is conducted by two or more individuals as a general partnership, a state law limited partnership, or a state law limited liability company, is treated as a pass-through entity for tax purposes – a partnership. The partnership is not itself taxable on the income of the business. Rather, each partner/member is taxed on their distributive share of the partnership’s business income.

A corporation that is formed under state law to conduct a business is not itself taxable on the income of the business if it is a “small business corporation” and its shareholders elect to treat it as an S corporation. In that case, the corporation is treated as a pass-through entity for tax purposes. In general, it is not taxable on its business income; rather, its shareholders are taxed on their pro rata share of the S corporation’s business income.

In each of the foregoing situations, the business income of an individual owner of a sole proprietorship, a partnership, or an S corporation (each a “Pass-Through Entity” or “PTE”) is treated for tax purposes as though the owner had realized such income directly from the source from which it was realized by the PTE.

In determining the taxable business income generated by a PTE, the Code allows certain deductions that are “related” to the production of such income, including a deduction for the ordinary and necessary expenses that are paid or incurred by the PTE in carrying on the business.

Because business income is treated as ordinary income (as opposed to capital gain) for tax purposes, the taxable business income of the PTE is taxed to its individual owner(s) at the regular income tax rates.[1]

What’s Behind the Change?

The vast majority of closely-held businesses are organized as PTEs, and the vast majority of newly-formed closely-held businesses are organized as limited liability companies that are treated as partnerships or that are disregarded for tax purposes.[2]

In light of this reality, Congress sought to bestow some unique economic benefit or incentive upon the non-corporate owners of PTEs in the form of a new deduction, and reduced taxes.[3]

However, Congress restricted this benefit or incentive in several ways that reflect a bias in favor of businesses that invest in machinery, equipment, and other tangible assets:[4]

  • in general, it is limited to PTEs that do not involve only the performance of services;
  • it benefits only the net business income of the PTE that flows through to the taxpayer; it does not apply to any amount paid by the PTE to the taxpayer in respect of any services rendered by the taxpayer to the PTE;
  • it does not apply to the PTE’s investment income; it is limited to the PTE’s business income; and
  • the benefit is capped, based upon how much the PTE pays in wages or invests in machinery, equipment, and other tangible property.

Beginning in 2018: New Sec. 199A of the Code

For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer[5] (a “Taxpayer”) who owns an equity interest in a PTE that is engaged in a qualified trade or business may deduct up to 20% of the qualified business income allocated to him from the PTE.

Qualified Trade or Business

Taxpayer’s qualified business income (“QBI”) is determined by each qualified trade or business (“QTB”) in which Taxpayer is an owner.[6] A QTB includes any trade or business conducted by a PTE other than a specified service trade or business.[7]

A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities.[8] However, a trade or business that involves the performance of engineering or architectural services is not a “specified service.”

Qualified Business Income

Taxpayer’s QBI from a QTB for a taxable year means Taxpayer’s share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.[9]

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S.[10]

“Qualified items” do not include specified investment-related income, gain, deductions, or loss; for example, items of gain taken into account in determining net long-term capital gain, dividends, and interest income (other than that which is properly allocable to a trade or business) are not included[11]; nor are items of deduction or loss allocable to such income.

Taxpayer’s QBI also does not include any amount paid to Taxpayer by an S corporation that is treated as reasonable compensation for services rendered by Taxpayer. Similarly, Taxpayer’s QBI does not include any “guaranteed payment” made by a partnership to Taxpayer for services rendered by Taxpayer.[12]

The Deduction

In general, Taxpayer is allowed a deduction for any taxable year of an amount equal to the lesser of:

(a) Taxpayer’s “combined QBI amount” for the taxable year, or

(b) an amount equal to 20% of the excess (if any) of

(i) Taxpayer’s taxable income for the taxable year, over

(ii) any net capital gain for the taxable year.

The combined QBI amount for the taxable year is equal to the sum of the “deductible amounts” determined for each QTB “carried on” by Taxpayer through a PTE.[13]

Taxpayer’s deductible amount for each QTB is the lesser of:

(a) 20% of the Taxpayer’s share of QBI with respect to the QTB, or

(b) the greater of:

(i) 50% of the “W-2 wages” with respect to the QTB, or

(ii) the sum of:

(A) 25% of the W-2 wages with respect to the QTB, plus

(B) 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”.[14]

In general, the W-2 wages with respect to a QTB for a taxable year are the total wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the QTB with respect to the employment of its employees during the calendar year ending during the taxable year of Taxpayer.[15]

“Qualified property” means, with respect to any QTB for a taxable year, tangible property of a character subject to depreciation that is held by, and available for use in, the QTB at the close of the taxable year, which is used at any point during the taxable year in the production of QBI, and for which the depreciable period[16] has not ended before the close of the taxable year.


The taxpayer is single. She is a member of an LLC (“Company”) that is treated as a partnership for tax purposes (a PTE). The company is engaged in a QTB that is not a specified service trade or business.

Taxpayer’s taxable income for 2018 is $500,000 (i.e., gross income of $520,000 less itemized deductions of $20,000), which includes a guaranteed payment from Company of $120,000, for services rendered to Company during 2018, and her allocable share of QBI from Company for 2018 of $400,000. She has no investment income for 2018.

Her allocable share of W-2 wages with respect to Company’s business for 2018 is $300,000.

During 2018, Company purchases machinery and immediately places it into service in its QTB (the machinery is “qualified property”). Taxpayer’s allocable share of the purchase price is $750,000.

The taxpayer is allowed a deduction for the taxable year of an amount equal to the lesser of:

(a) her “combined QBI amount” for the taxable year (the guaranteed payment of $120,000 is not included in QBI), or

(b) 20% of her taxable income of $500,000 for the taxable year, or $100,000.

Taxpayer’s combined QBI amount for 2018 is equal to her “deductible amount” with respect to Company. The deductible amount is the lesser of:

(a) 20% of Taxpayer’s QBI (20% of $400,000 = $80,000), or

(b) the greater of:

(i) 50% of the W-2 wages with respect to the QTB (50% of $300,000 = $150,000), or

(ii) the sum of: 25% of the W-2 wages with respect to the QTB ($75,000), plus (B) 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (2.5% of $750,000 = $18,750): $75,000 + $18,750 = $93,750.

Thus, Taxpayer’s deductible amount is $80,000. Because this amount is less than $100,000 (20% of her taxable income of $500,000 for the taxable year), Taxpayer will be allowed to deduct $80,000 in determining her taxable income for 2018.

Looking Ahead

It remains to be seen whether the “20% deduction” based upon the QBI of a PTE will be a “game changer” for the individual owners of the PTE.

After all, the deduction is subject to several limitations that may dampen its effect. For example, QBI does not include the amount paid by the PTE to Taxpayer in respect of services rendered by Taxpayer. In addition, the losses realized in one QTB may offset the income realized in another, thereby reducing the amount of the deduction. Finally, the deduction is subject to limits based upon the wages paid and the capital investments made by the QTB.

Maximizing the Deduction?

Might an S corporation shareholder or a partner in a partnership reduce the amount paid to them by the entity for their services so as to increase the amount of their QBI and, so the amount of the deduction? In the case of an S corporation, this may result in the IRS’s questioning the reasonableness (i.e., insufficiency) of the compensation paid to the shareholder-employee.[17]

Or might a PTE decide to invest in more tangible property than it otherwise would have in order to set a greater cap on the deduction?

In any case, the business must first be guided by what makes the most sense from a business perspective.

Becoming a Pass-Through?

What if a business is already organized as a C corporation? Should the QBI-based deduction tip the scales toward PTE status?

Before taking any action with respect to changing its status for tax purposes, a C corporation will have to consider much more than the effect of the deduction for PTEs.

For example, does it even qualify as a small business corporation? If not, what must it do to qualify? Must it redeem the stock owned by an ineligible shareholder, or must it recapitalize so as to eliminate the second class of stock? Either option may prove to be economically expensive for the corporation and the remaining shareholders.

If the corporation does qualify, what assurances are there that all of its shareholders will elect to treat the corporation as an S corporation? Even if the election is made, will the presence of earnings and profits from “C” taxable years implicate the “excess passive income” rules?

In any case, a C corporation that is not otherwise contemplating a change in its tax status, should probably not become an S corporation solely because of the PTE-related changes under the Act, especially if the corporation does not contemplate a sale of its business in the foreseeable future.

Wait and See?

The deduction based on the QBI of a PTE will expire at the end of 2025 unless it is extended before then. It is also possible that it may be eliminated by Congress after 2020.

An existing PTE and its owners should continue to operate in accordance with good business practice while they and their tax advisers determine the economic effect resulting from the application of the new deduction to the PTE.

They should also await the release of additional guidance from the IRS regarding “abusive” situations, tiered entities, and other items.[18]

*This post is the first of several that will be dedicated to those portions of the Tax Cuts and Jobs Act of 2017 (H.R. 1) that are most relevant to the closely-held business and it owners.

[1] The Act reduces the highest income tax rate applicable to the individual owner of a PTE to 37% (from 39.6%) for taxable years beginning after December 31, 2017 and before January 1, 2026. Note that the 3.8% surtax continues to apply to the distributive or pro rata share of an individual partnership or shareholder who does not materially participate in the trade or business conducted by the PTE.

[2] Though occasionally, the owner(s) will elect to treat the LLC as a corporation for tax purposes; for example, to reduce employment taxes.

[3] The Act includes a number of business-related benefits that are applicable to both corporate and non-corporate taxpayers. It also includes some that are unique to corporations, such as the reduction of the corporate income tax rate from a maximum of 35% to a flat 21%.

[4] As we will see in the coming weeks, that Act contains a number of such provisions.

[5] More accurately, the benefit is available to non-corporate owners; basically, individual taxpayers, though trusts and estates are also eligible for the deduction.

[6] A PTE may conduct more than one QTB – different lines of business – or Taxpayer may own equity is more than one PTE.

[7] Also excluded is the trade or business of being an employee.

[8] The exclusion from the definition of a qualified business for specified service trades or businesses is phased in for a taxpayer with taxable income in excess of a “threshold amount” of $157,500 ($315,000 in the case of a joint return). The exclusion is fully phased in for a taxpayer with taxable income at least equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[9] If the net amount of the QBI is a loss (negative), it is treated as a loss from a QTB in the succeeding taxable year.

[10] Generally, when a person engages in a trade or business in the U.S., all income from sources within the U.S. connected with the conduct of that trade or business is considered to be effectively connected income.

[11] Qualified items should include the gain recognized on the sale of business assets.

[12] The IRS is authorized to issue regulations that would exclude any amount paid or incurred by the partnership to Taxpayer for services provided by Taxpayer to the partnership other than in his capacity as a partner.

[13] Taxpayer does not need to be active in the business in order to qualify for the deduction.

[14] This “wage limit” is phased in for a taxpayer with taxable income in excess of the threshold amount. The limit is fully applicable for a taxpayer with taxable income equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[15] In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner or shareholder, as the case may be, takes into account his allocable or pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages and unadjusted basis for the taxable year equal to his allocable or pro rata share of the W-2 wages and unadjusted basis of the partnership or S corporation, as the case may be.

[16] The “depreciable period” is the period beginning with the date the qualified property is first placed in service and ending on the later of the date that is 10 years after such date, or the last day of the last full year in the applicable recovery period for the property.

[17] State and local taxes also need to be considered; for example, NYC’s unincorporated business income tax and its general corporation tax.

[18] “What we do in haste, we regret at leisure?”

Old Dog, New Tricks?

It’s a concern for every new investor in a closely held business: will the founding owners continue to operate the business as they always have, or will they recognize that they now have new co-owners to whom they owe a fiduciary duty, and on whom they made be dependent for funding or services, and will this recognition inform their actions with respect to the business and guide their relationship with the new investors?

Because of this concern, the new investor will insist that the owners enter into a shareholders’ or partnership agreement that includes various provisions that seek to protect the new owners’ rights, and to limit the original owners’ ability to ignore those rights and thereby compromise the economic benefits sought by the new investors.

Unfortunately, at least from the perspective of the new investor, it is not unusual for the founder, notwithstanding any shareholders’ or partnership agreement, to “forget” that he has others to whom he has to report. While such “forgetfulness” will strain the relationship among the owners of any business entity, it can be especially stress-inducing in the context of a pass-through entity like a partnership or an S corporation, the income of which is taxed to its owners without regard to any owner’s ability to influence or control the entity’s activities.

Yet Another Example

In a recent case before the Tax Court, the taxpayer tried to convince the Court that she should not be required to include her share of S corporation income in her gross income because the controlling shareholder had effectively prevented her from enjoying the beneficial ownership of her shares.

Corp was created by Founder to operate a diagnostic laboratory. Founder approached Taxpayer – who worked with Merchant Bank (“MB”) – to ask whether she would consider getting involved in Corp. Taxpayer and Founder discussed certain issues that Corp was facing, including its lack of a solid financial infrastructure.

Corp eventually entered into a consulting agreement with MB, under which MB would assist Corp with settling existing liabilities, diversifying the business, and implementing a financial infrastructure. In consideration for these services, Corp would pay MB a fixed monthly fee.

As part of this arrangement, Founder’s ownership of Corp was reduced to 50%, and members of MB or their designees (MB shareholders, including Taxpayer) acquired ownership of the other 50%.

Shareholders’ Agreement

The shareholders of Corp executed a Shareholders’ Agreement. The Agreement named various individuals, including Founder and Taxpayer, as officers of Corp. The board of directors of Corp consisted of its officers, including Taxpayer. The Shareholders’ Agreement stated that “[a]ll matters relating to the management of [Corp’s] business and operations of any kind or nature whatsoever shall be approved by a majority vote of [Corp’s] Board of Directors.” The board of directors, however, met only once after executing the Shareholders’ Agreement.

The Shareholders’ Agreement further stated:

The timing and amount of any distributions of net profits or cash flow from [Corp’s] operations or otherwise (the “Distributions”) to be made by [Corp] to the Shareholders hereunder shall be approved by the Board of Directors . . . . All Distributions shall be made by [Corp] to the Shareholders pari passu in accordance with their proportionate Share ownership hereunder.

In addition, the Agreement implemented a new payment approval procedure for Corp, stating:

The authorizing resolution to be delivered to the bank or other depository of funds of [Corp] shall provide that any officer signing singly may execute all checks or drafts of [Corp] in an amount up to $100,000.00, and two (2) persons consisting of [Founder] and one (1) member of the MB shareholders, shall be authorized as joint signatories in respect of all checks or drafts on behalf of the [Corp] in excess of $100,000.00.

Nevertheless, Corp frequently made payments in excess of $100,000 that were not authorized in conformity with the Shareholders’ Agreement.

Finally, the Agreement gave the shareholders the right to inspect and copy all books and records of Corp. At the beginning of MB’s relationship with Corp, Corp’s CFO distributed copies of monthly financial statements to representatives of the MB shareholders.

The Loan

One concern raised by Corp’s financial statements involved a loan from Founder to Corp close to the time of its organization. General ledgers made available to the MB shareholders, and reviewed as part of MB’s due diligence, showed a loan balance in excess of $7 million. Money paid by Corp on Founder’s behalf, including personal expenses, was charged against this loan, reducing the loan balance, and interest on the loan was paid to Founder monthly.

An audit of Corp’s financial statements found that payments made from Corp to Founder were recorded on the loan payable’s general ledger account, and the loan appeared as a “Note Payable” on the audited financial statements, and appeared as “Liabilities” on Corp’s Federal income tax returns. However, no “Loan from Shareholder” was reflected on the Schedules L of Corp’s Federal income tax returns on Form 1120S.

As Founder’s relationship with MB and the MB shareholders began to deteriorate, Taxpayer approached Founder concerning certain Corp expenses that Taxpayer believed were personal and unrelated to Corp’s business.

At that point, Founder no longer permitted MB and the MB shareholders to enter Corp’s premises, and he instructed Corp’s employees to stop providing financial information to them. Corp also stopped paying MB for its consulting services.

Unbeknownst to the MB shareholders, Founder also filed a complaint seeking judgment against Corp for the loans he claimed to have made to Corp over the course of many years. Founder served the complaint on the comptroller of Corp, Corp did not defend the lawsuit, and a default judgment was entered against Corp.

MB sued Founder for breach of the consulting agreement and failure to pay consulting fees. In reaction to this lawsuit, Founder filed for chapter 11 bankruptcy.

The bankruptcy court appointed a forensic accountant to investigate Corp’s business operations. The accountant’s report determined that the transfers of funds to Founder disputed by MB and the MB shareholders were recorded on the books by Corp as loan repayments. The report also described the default judgment that Founder had obtained against Corp.

As a result of the above findings, the bankruptcy court appointed a trustee as a financial overseer of Founder’s activities at Corp. The trustee was responsible for evaluating the financial status of Corp, taking financial control, and reporting his findings to the bankruptcy court. During the trustee’s time with Corp, payments of expenses or transfers of funds could not be accomplished without his approval. Additionally, the trustee provided Corp’s shareholders with monthly financial reports.

The Tax Returns

When Taxpayer filed her Forms 1040, U.S. Individual Income Tax Return, for the taxable years at issue, she attached to the return a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request. The Form 8082 included the following statement pertaining to Taxpayer’s ownership interest in Corp:

[Corp] has initiated litigation against the [T]axpayer retroactively contesting [T]axpayer’s ownership interest. The entity and certain shareholders have prevented [T]axpayer from exercising [her] shareholder rights including: sale of shares, voting on business matters, exercising dominion and control of the ownership interest, or enjoying any economic benefits or other ownership rights. The referenced Schedule K-1 is inconsistent with the entity’s contention that [T]axpayer is not entitled to any ownership interest. Therefore until legal ownership is resolved by the court, it was improper for the controlling shareholders to issue a Schedule K-1 to [T]axpayer, and those amounts are not reported in this return.

The issue for decision before the Tax Court was whether Taxpayer was a shareholder of Corp during the years in issue and was, therefore, liable for tax on her pro rata share of Corp’s income for the taxable years at issue.

Court’s Analysis

The Code provides that the shareholders of an S corporation are required to take into account their pro rata shares of the S corporation’s income, loss, deductions, and credits for the S corporation’s taxable year ending with or within the shareholders’ taxable year. An S corporation’s shareholders must take into account the corporation’s income regardless of whether any income is distributed to the shareholder.

The Court stated that, in determining stock ownership for Federal income tax purposes, it must look to the beneficial ownership of shares, not to mere legal title. Cases concluding that a shareholder did not have beneficial ownership, the Court continued, have considered both agreements between shareholders that effectively eliminated ownership, and provisions in the corporation’s governing articles affecting ownership rights.

Mere interference, the Court observed, with a “shareholder’s participation in the corporation as a result of a poor relationship between the shareholders * * * does not amount to a deprivation of the economic benefit of the shares.”

Taxpayer contended that while she was issued Corp shares, the removal of her power to exercise shareholder rights, as well as the actions of Founder, “removed” the beneficial ownership of her shares; therefore, Taxpayer asserted, she was not required to include in gross income her “pro rata share” of Corp’s income.

The Court noted, however, that Taxpayer identified no agreement, nor any provisions in Corp’s governing articles, removing her beneficial ownership.

Moreover, Taxpayer identified no authority supporting her position that a violation of a shareholders’ agreement could deprive shareholders of the beneficial ownership of their shares.

Further, Taxpayer cited no authority that allowed a shareholder to exclude her share of an S corporation’s income because of poor relationships with other shareholders.

In the absence of an agreement passing Taxpayer’s rights to her stock to another shareholder, a poor relationship between shareholders did not deprive Taxpayer of the economic benefit of her shares. Indeed, the Court pointed out, Taxpayer ultimately sold her shares for valuable consideration.

The Court held that because Taxpayer remained a shareholder of Corp for the taxable years at issue, she had to include in gross income her pro rata share of Corp’s income for those years.


The Taxpayer was hardly the first to argue that she was not liable for the tax on her share of S corporation income because she was improperly denied the beneficial ownership of shares in the corporation, notwithstanding her record ownership.

As in other cases, the Tax Court rejected Taxpayer’s position, noting that when a controlling shareholder merely interferes with another shareholder’s participation in the corporation, such interference does not amount to a deprivation of the economic benefit of the shares. Thus, the shareholder is not relieved from reporting her share of the S corporation’s income on her tax return.

A minority owner in any pass-through entity must appreciate the risk that she may be denied the opportunity to participate in the business in any meaningful way, that she may be denied any opportunity for gainful employment in the business, and that she may not receive any distributions from the entity.

The minority owner must also recognize that even when she is fortunate to be party to an agreement with the other owners that provides for mandatory tax distributions and for super-majority voting for certain decisions, such an agreement is meaningless in the face of a majority’s disregard of its terms unless the minority owner actually seeks to enforce the agreement.

In the face of a stubborn or determined founder, a minority owner must be prepared to act fairly quickly to protect herself, or “accept” the economic and tax consequences of having to report her share of the entity’s net income on her tax return. In that case, the minority owner must look to her other assets to provide the cash necessary to satisfy the resulting tax liabilities.  This can turn into an expensive proposition.