shareholder oppression

Home for the Holidays?

Our last post considered the division of a business between family members as a means of preempting the adverse consequences that will often follow disagreements within the family as to the management or direction of the business. https://www.taxlawforchb.com/2018/12/business-purpose-and-dividing-the-family-corporation-think-before-you-let-it-rip/.

This week, as family members return to work – after having come together to celebrate the holidays and renew their commitment to one another – we turn to a recent IRS ruling that considered a situation that presents the proverbial “trap for the unwary,” and that arises more often than one might think in the context of a business that is plagued by family discord. https://www.irs.gov/pub/irs-wd/201850012.pdf.

Another Family Mess

Corp was formed by Dad, who elected to treat it as an S corporation for federal tax purposes.[i] Immediately prior to the events described in the ruling, Dad owned more than 50% of Corp’s non-voting shares, but less than 50% of Corp’s voting shares. Mom and Daughter owned the balance of Corp’s issued and outstanding shares.

Following Mom’s death, Daughter – who was also the CEO of the business – received a testamentary transfer of all of Mom’s voting shares, resulting in Daughter’s owning a majority of Corp’s voting shares.

For reasons not set forth in the ruling, Daughter subsequently terminated Dad’s employment with Corp. In response, Dad filed a lawsuit against Corp and Daughter (the “Litigation”) in which he alleged shareholder oppression and breach of fiduciary duties. Dad asked the court to enter an order requiring Daughter and/or Corp to buy Dad’s shares in Corp (“Dad’s Shares”), or an order requiring Dad to purchase Daughter’s shares.[ii]

Within three months after Dad initiated the Litigation, Corp and Daughter filed a notice under the Litigation (the “Election”) for Corp to purchase Dad’s Shares (the “Proposed Transaction”). Dad filed a motion to nullify the Election.[iii] The court denied Dad’s nullification motion, and ruled that the Election was valid.

Proposed Buyout

Dad died before the Litigation could be resolved and his shares in Corp purchased. His revocable trust (the “Trust”) – which became irrevocable upon his death – provided that Dad’s Shares would pass to Foundation, a tax-exempt charitable organization that was created and funded by Mom and Dad, and that was treated as a private foundation under the Code. [iv]

Pursuant to the terms of the Trust, the trustee had the power and authority to sell any stock held by or passing to the Trust, including Dad’s Shares.[v] However, because of the Litigation, Foundation did not receive Dad’s Shares from the Trust; nor could the Trust sell Dad’s Shares to anyone other than Corp during the Litigation.[vi]

The court in the Litigation was required by state law to determine the “fair value” of Dad’s Shares as of the date the Litigation was initiated, or such other date the court deemed appropriate. The Foundation represented to the IRS that the Litigation court could determine the fair value of Dad’s Shares to be less than their fair market value after marketability and control discounts were applied.[vii]

The administration of the Trust was overseen by a probate court, not the court in which the Litigation was ongoing. The probate court had the responsibility to ensure that Foundation received the full value of Dad’s Shares, and was required to approve the valuation of Dad’s Shares and the Proposed Transaction. According to the Foundation, if the probate court approved the Proposed Transaction, the Litigation court would honor the probate court’s decision.

Self-Dealing

The foregoing may seem innocuous to most persons – just a buyout of a decedent’s shares in a corporation. Fortunately, Foundation recognized that Corp’s redemption of Dad’s Shares could be treated as an act of “self-dealing” under the Code, which could in turn result in the imposition of certain penalties (i.e., excise taxes) on the “self-dealer” and on the “foundation managers.”

The Code imposes a tax on acts of self-dealing between a “disqualified person”[viii] and a private foundation.[ix] The tax with respect to any act of self-dealing is equal to 10% of the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received in the transaction.[x] In general, the tax imposed is paid by any disqualified person who participated in the act of self-dealing.

The term “self-dealing” includes any direct or indirect sale or exchange of property between a private foundation and a disqualified person. For purposes of this rule, it is immaterial whether the transaction results in a benefit or a detriment to the private foundation; the act itself is prohibited.

An “indirect sale” may include the sale by a decedent’s estate (or revocable trust),[xi] to a disqualified person, of property that would otherwise have passed from the estate to the private foundation pursuant to the terms of the decedent’s will; in other words, property in which the foundation had an expectancy.

However, the term “indirect self-dealing” does not include a transaction with respect to a private foundation’s interest or expectancy in property held by a revocable trust, including a trust which became irrevocable on a grantor’s death, and regardless of when title to the property vested under local law, provided the following conditions are satisfied:

(i) The trustee of the revocable trust has the power to sell the property;

(ii) The transaction is approved by a court having jurisdiction over the trust or over the private foundation;

(iii) The transaction occurs, in the case of a revocable trust, before the trust is considered a “non-exempt charitable trust”;[xii]

(iv) The trust receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in the property at the time of the transaction; and

(v) The transaction results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up.[xiii]

The IRS Ruling

Foundation conceded that Dad was a disqualified person (a “substantial contributor”) as to Foundation while he was alive, having funded Foundation with Mom.[xiv] Daughter was a disqualified person as to Foundation because her father (a “member of her family”) was a substantial contributor to Foundation. Corp was also a disqualified person as to Foundation because Daughter owned more than 35% of Corp’s voting shares.[xv]

Because Corp was a disqualified person as to Foundation, and because of Foundation’s expectancy interest in receiving Dad’s Shares from the Trust, the proposed sale of Dad’s Shares by the Trust to Corp pursuant to the Litigation court’s order (the Proposed Transaction) could be an act of indirect self-dealing.

Foundation requested a ruling from the IRS that Corp’s purchase (i.e., redemption) of Dad’s Shares – which were held by the Trust – would satisfy the indirect self-dealing exception, described above, and would not be treated as an act of self-dealing for which a penalty could be imposed.

The IRS reviewed each of the requirements for the application of the exception.

First, a trustee must have the power to sell the trust’s property. Pursuant to the trust agreement that created Trust, Trust’s trustee had the power to sell any Trust assets, including Dad’s Shares. Thus, the Proposed Transaction met the first requirement.

Second, a court with jurisdiction over the trust must approve the transaction. Foundation sought, and was waiting to obtain, the approval of the Proposed Transaction from the probate court that had jurisdiction over, and was overseeing administration of, the Trust. Thus, the Proposed Transaction would meet the second requirement upon the Trust’s receipt of the probate court’s approval of the proposed sale.

Third, the Proposed Transaction must occur before the Trust became a non-exempt charitable trust. Foundation represented that because of the active and on-going status of the Litigation, the Trust’s trustees were, and would continue to be, unable to complete the ordinary duties of administration necessary for the settlement of Trust prior to the date of the sale of Dad’s Shares. Thus, the Trust would not be considered a non-exempt charitable trust prior to the date of the sale of Dad’s Shares; until then, the trustee would still be performing the ordinary duties of administration necessary for the settlement of the Trust.

In addition, before the sale of Dad’s Shares, the Trust will have made those other distributions required to be made from the Trust to any beneficiary other than Foundation, which would then be the sole remaining beneficiary.

Thus, if the Trust were not considered terminated for Federal income tax purposes prior to the Proposed Transaction, the Proposed Transaction would meet the third requirement.

Fourth, the Trust must receive an amount that equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction. The Litigation court was tasked with valuing Dad’s Shares. Foundation would endeavor to ensure that the Litigation court ordered the sale of Dad’s Shares to Corp at a price that was not less than the fair market value at the time of the Proposed Transaction. Thus, the Proposed Transaction would meet the fourth requirement if Dad’s Shares were sold to Corp at no less than their fair market value at the time of the transaction.

Fifth, the sale of Foundation’s interest or expectancy must result in its receiving an interest as liquid as the one that was given up. Pursuant to the trust agreement, Foundation had the expectancy of receiving Dad’s Shares, which were illiquid. Upon the completion of the Proposed Transaction, Foundation would receive the money that Corp paid Trust for Dad’s Shares. Thus, the Proposed Transaction would meet the fifth requirement if Foundation received the money proceeds from the Proposed Transaction.

Based on the foregoing, the IRS ruled that Corp’s purchase of Dad’s Shares held by the Trust would satisfy the “probate exception” from indirect self-dealing provided the following contingencies occurred:

  1. The probate court approved the Proposed Transaction;
  2. The Trust did not become a non-exempt charitable trust prior to the date of the sale of Dad’s Shares by the Trust; and
  3. The Trust received from the sale of Dad’s Shares to Corp an amount of cash or its equivalent that equaled or exceeded the fair market value of Corp’s Shares at the time of the transaction.

Trap for the Unwary?

Some of you may be thinking that the issue presented in the ruling discussed above, although somewhat interesting, is unlikely to arise with any regularity and, so, does not represent much of a trap for the unwary.[xvi]

I respectfully disagree. The fact pattern of the ruling is only one of many scenarios of indirect self-dealing that are encountered by advisers whose practice includes charitable planning for the owners of a closely held business.

There are two major factors that contribute to this reality: (i) the owner’s business will likely represent the principal asset of their estate, and (ii) the owner may have established a private foundation that they plan to fund at their demise (and thereby generate an estate tax deduction), either directly or through a split-interest trust.[xvii]

It is likely that the owner’s spouse, or some of their children, or perhaps a trust for their benefit, will be receiving an interest in the family business (an illiquid asset). It is also possible that the foundation will be funded with an interest in the business.

In these circumstances, the foundation may have to divest its interest in the family business in order to avoid the imposition of another private foundation excise tax (the one on “excess business holdings”).[xviii] Because of the limited market for such an interest, the foundation (or the owner’s estate or revocable trust) will probably have to sell its interest to the business itself (a redemption, as in the ruling above) or to another owner – each of which may be a disqualified person, thereby raising the issue of self-dealing. https://www.taxlawforchb.com/2018/10/private-foundations-and-business-ownership-a-new-day/.

In other circumstances, the divergent interests of the foundation to be funded, on the one hand, and of the individual beneficiaries of the owner’s estate or trust, on the other, may require that the foundation’s interest in the business be eliminated. For example, the foundation will need liquidity in order to engage in any charitable grant-making, while the other owners may prefer that the business reinvest its profits so as to expand the business; the foundation may prefer not to receive shares of stock in an S corporation, the ownership of which would result in the imposition of unrelated business income tax;[xix] or the foundation may be managed by individuals other than those operating the business, thereby setting the stage for a shareholder dispute as in the above ruling.

Bottom line:  It behooves the owners of the closely held business to consider these issues well before they arise. In many cases, it will be difficult to avoid them entirely, but the relevant parties should plan a course of action that is to be implemented after the demise of an owner.[xx] In this way, they may be able to avoid the personal, financial, and business disputes that may otherwise arise.

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[i] IRC Sec. 1361; IRC Sec. 1362.

[ii] The ruling does not disclose the jurisdiction under the laws of which Corp was formed.

In New York, the holders of shares representing 20% or more of the votes of all outstanding shares of a corporation may present a petition of dissolution on the ground that the directors or those in control of the corporation are guilty of oppressive acts toward the complaining shareholders. In determining whether to proceed with involuntary dissolution, the court must take into account whether liquidation of the corporation is the only feasible means by which the petitioners may reasonably expect to obtain a “fair return” on their investment. BCL 1104-a. This typically involves the valuation and buyout of the petitioners’ shares. However, the other shareholder(s) or the corporation may also elect to purchase the shares owned by the petitioners at fair value. BCL 1118. “Fair value” is not necessarily the same as “fair market value.” See Friedman v. Beway Realty Corp. 87 N.Y.2d 161 (1995).

[iii] Go figure. If the goal was to be bought out, congratulations. Why fight it? Or was Dad concerned that Daughter would render Corp unable to buy him out and, so, he wanted to pursue his own remedies?

[iv] Exempt from federal income tax under Sec. 501(a) of the Code, as an organization described in Sec. 501(c)(3) of the Code (educational, religious, scientific, and charitable purposes); a “private foundation” in that it did not receive financial support from the “general public.”

[v] Although a decedent should fund their revocable trust to the fullest extent possible prior to their demise, it is often the case that they forget to transfer – or that they intentionally retain direct ownership of – an asset, which thereby becomes part of their probate estate. In that case, the decedent’s last will and testament typically provides that the probate estate shall “pour over” into the now irrevocable trust – which acts as a “will substitute” – to be disposed of in accordance with the terms of the trust.

[vi] It should be noted that, effective for tax years beginning after December 31, 1997, certain tax-exempt organizations became eligible to own shares of stock in an S corporation; however, a qualifying organization’s share of S corporation income is treated as unrelated business income. IRC Sec. 1361(c)(6) and Sec. 512(e).

[vii] In general, “fair market value” as of the date of a decedent’s death is the value at which the property included in the decedent’s gross estate must be reported on their estate tax return. Reg. Sec. 20.2031-1(b).

[viii] The term “disqualified person” means, in part, with respect to a private foundation, a person who is:

(A) a “substantial contributor” to the foundation,

(B) a “foundation manager”,

(C) an owner of more than 20% of:

(i) the total combined voting power of a corporation,

(ii) the profits interest of a partnership, or

(iii) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation,

(D) a “member of the family” of any individual described in subparagraph (A), (B) or (C), or

(E) a corporation of which persons described in subparagraph (A), (B), (C), or (D) own more than 35% of the total combined voting power.

The term “members of the family” with respect to any person who is a disqualified person includes the individual’s spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. IRC Sec. 4946.

[ix] The Code authorizes the imposition of certain excise taxes on a private foundation, on those who are disqualified persons with respect to such foundation, and on the foundation’s managers. These taxes are intended to modify the behavior of these parties – who are not otherwise dependent upon the public for financial support – by encouraging certain activities (e.g., expenditures for charitable purposes) and discouraging others (such as self-dealing).

[x] https://www.law.cornell.edu/uscode/text/26/4941

[xi] See EN iv, above.

[xii] See IRC Sec. 4947, which treats such a trust as a private foundation that is subject to all of the private foundation requirements.

A revocable trust that becomes irrevocable upon the death of the decedent-grantor, from which the trustee is required to distribute all of the net assets in trust for or free of trust to charitable beneficiaries, is not considered a charitable trust under section 4947(a)(1) for a reasonable period of settlement after becoming irrevocable. After that period, the trust is considered a charitable trust under section 4947(a)(1). The term “reasonable period of settlement” means that period reasonably required (or if shorter, actually required) by the trustee to perform the ordinary duties of administration necessary for the settlement of the trust. These duties include, for example, the collection of assets, the payment of debts, taxes, and distributions, and the determination of the rights of the subsequent beneficiaries.

[xiii] Reg. Sec. 53.4941(d)-1(b)(3); the so-called “probate exception.” https://www.law.cornell.edu/cfr/text/26/53.4941%28d%29-1 This exception had its genesis in the IRS’s recognition that a private foundation generally needs liquidity in order to carry out its charitable grant-making mission. With the appropriate safeguards (supervision by a probate court) to ensure that the foundation receives fair market value and attains the requisite liquidity, the act of self-dealing presented by the foundation’s sale of an interest in a closely held business may be forgiven.

[xiv] Interestingly, a substantial contributor’s status as such does not terminate upon their death; thus, a member of their family also remains a disqualified person.

[xv] See EN vii.

[xvi] A group of individuals to which the reader no longer belongs.

[xvii] For example, a charitable lead trust or a charitable remainder trust. IRC Sec. 2055(e). https://www.law.cornell.edu/uscode/text/26/2055.

[xviii] IRC Sec. 4943. https://www.law.cornell.edu/uscode/text/26/4943.

[xix] Taxable at 21% – as opposed to a 1% or 2% tax on investment income under IRC Sec. 4940 – and perhaps without a distribution from the corporation with which to pay the tax.

[xx] For example, corporate-owned life insurance to fund the buyout of the foundation’s interest, or the granting of options to family members to acquire the foundation’s interest.

Woe to the Oppressed Shareholder
As I write this post on Bastille Day, I am reminded how an oppressed people, realizing the injustice of their circumstances, and having reached the limits of their endurance, took the first step toward “replacing” the lords and ladies that had long lived lavishly on their labors. [1]

If only it were so straightforward for an oppressed shareholder, especially in a pass-through entity such as an S corporation. As a minority owner, they have little to no say in the management or operation of the business, or in the distribution of the profits therefrom. Oftentimes, they are denied information regarding the finances of the business, with one exception: every year they receive a Schedule K-1 that sets forth their share of the corporation’s items of income, deduction, gain, loss, and credit for the immediately preceding year.

As a matter of Federal tax law, they are required to report these K-1 items on their own income tax returns, and – regardless of whether or not they received a distribution from the corporation – they must remit to the IRS the resulting income tax liability.

As one might imagine, this may create a cash flow problem for the oppressed shareholder. They are typically denied employment in the business and, so, do not receive compensation from the corporation. Thus, in order to satisfy their tax liability attributable to the S corporation, they are often forced to withdraw cash from other sources, or to liquidate personal assets (which may generate additional taxes).

In some cases, the oppressed shareholder in an S corporation has sought to “revoke” the “S” election and, thereby, to stop the flow-through of taxable income and the resulting outflow of cash. [2]

An S corporation may lose its tax-favored status by ceasing to qualify as a “small business corporation,” which means that it admits an ineligible person as an owner, or it has more than one class of stock outstanding. The Tax Court recently considered a situation in which an oppressed shareholder sought to use the disproportionate sharing of economic benefits between the shareholders as a basis for concluding that the corporation had more than one class of stock.

So Much for Egalité et Fraternite
Taxpayer and his brother (“Bro”) incorporated Corp. During the years in issue, Taxpayer owned 49% of the shares of Corp, and Bro owned 51%. The brothers elected to treat Corp as an S corporation for Federal income tax purposes. They also agreed that distributions would be proportional to their ownership shares.

Taxpayer, Bro and Bro’s spouse (“B-Spouse”) were the directors of Corp, and each participated in its business. Bro served as Corp’s president, B-Spouse as corporate secretary, and Taxpayer as vice president. Bro directed the administrative aspects of Corp’s business, while B-Spouse was Corp’s office manager. Bro and B-Spouse were responsible for the corporation’s bookkeeping and accounting.

Taxpayer’s work for Corp primarily involved managing operations in the field. He spent most of his working hours at jobsites, not in the office. Taxpayer received compensation as an employee of Corp for the years in issue.

Prior to the years in issue, Corp filed Forms 1120S, U.S. Income Tax Return for an S Corporation, and issued Schedules K-1 to Bro and Taxpayer. These filings reflected that the shareholders received cash distributions from Corp proportional to their stock ownership.

During the years in issue, Taxpayer began to examine more closely the administration of Corp’s business.

Taxpayer noticed that certain credits cards in his name, which he maintained for business purposes, were being used without his authorization to pay personal expenses of Bro’s children. Shortly thereafter, he reviewed the corporation’s QuickBooks records and determined that numerous items, including handwritten checks drawn on its bank accounts, had not been entered into the corporation’s accounting records. He also obtained and reviewed online banking statements for the corporation’s bank accounts. Taxpayer determined that, during the years in issue, Bro and B-Spouse had been making substantial check and ATM withdrawals from Corp’s bank accounts without his knowledge. [3]

Also during this period, Corp’s business began to struggle. Taxpayer received calls from Corp’s vendors who had tried unsuccessfully to contact Bro and B-Spouse regarding payments that they were owed and wanted to know when they would be paid. Corp had trouble paying its employees, and some of its checks were returned. Taxpayer had multiple discussions with Bro and B-Spouse about Corp’s cash flow problems. They told him that they were working on getting more money into the business.

Taxpayer became frustrated with the progress of Corp’s business and with the discussions that he was having with Bro. Finally, Taxpayer sent Bro an email stating that if Bro would not help him try to remedy the business, then Taxpayer would have no choice but to resign and sell his shares to Bro for a nominal amount. Bro responded that he would accept that offer effective immediately.

With that, Taxpayer completed some tasks for ongoing projects, and then quit his work for Corp. He never received payment from Bro for his shares of Corp.

The IRS Audit
Taxpayer filed Federal income tax returns for the years in issue. He attached Schedules E to the returns for these years, on which he listed Corp as an S corporation in which he held an interest. Taxpayer did not report any items of income or loss from Corp for the years in issue – these lines were left blank.

Taxpayer also attached to these returns Forms 8082, Notice of Inconsistent Treatment, relating to his interest in Corp, on which Taxpayer notified the IRS that he had not received Schedules K-1 from Corp.

Corp did not file Forms 1120S or issue Schedules K-1 for the years in issue. The IRS examined Corp, and prepared substitute tax returns using Corp’s banking records, general ledger, available employment tax returns, and other records to determine the corporation’s income and allowable deductions. The IRS allocated Corp’s net income as ordinary income to Taxpayer and Bro according to their 49% and 51% ownership shares, respectively.

The IRS also analyzed the shareholders’ distributions for the years in issue. For one year, the IRS determined that Taxpayer received less than one-third the amount of the distributions actually or constructively received by Bro; for the other year, it found that Taxpayer received less than one-ninth the amount of the distributions received by Bro. The IRS prepared basis computation worksheets for Taxpayer’s shares of Corp, and determined that Taxpayer was not required to include the distributions that he received in gross income for the years in issue because the amounts did not exceed his adjusted stock basis.

The notice of deficiency issued to Taxpayer determined increases to his Schedule E flow-through income for the years in issue, based upon the determinations set forth in the substitute returns prepared by the IRS for Corp.

Taxpayer disagreed with the IRS’s determination, and timely petitioned the Tax Court. Taxpayer contended that the income determined for Taxpayer – i.e., 49% of Corp’s net income for each of the years in issue – should not be attributable to him. [4]

Second Class of Stock?
Generally, an S corporation – or an electing “small business corporation” – is not subject to Federal income tax; rather, it is a conduit in that its income “flows through” to its shareholders, who are required to report and pay taxes on their pro rata shares of the S corporation’s taxable income.

The Code defines a small business corporation as a domestic corporation which must satisfy a number of requirements, including the requirement that it not have “more than 1 class of stock.” [5]

Generally, a corporation will be treated as having only one class of stock “if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.” [6]
Once an eligible corporation elects S corporation status, that election is effective for the tax year for which it is made and for all succeeding tax years until it is terminated. The Code provides that an election shall be terminated automatically whenever the corporation ceases to qualify as a small business corporation.

When Taxpayer and Bro organized Corp, they clearly intended to create one class of stock. They agreed that all distributions would be proportional to their stock ownership, and their tax filings before the years in issue reflected that their shares of stock each had equal rights to distributions. Corp elected to be treated as an S corporation. For years before the years in issue it filed Forms 1120S and issued Schedules K-1 to Taxpayer reflecting his pro rata shares of the corporation’s taxable income.

Taxpayer contended that Corp’s “S” election was terminated during the years in issue because it ceased to be a small business corporation. Specifically, he contended that Corp no longer satisfied the requirement that it have only one class of stock – Bro withdrew large sums of money from Corp’s bank accounts during the years in issue without Taxpayer’s knowledge, and the IRS’s computations showed that Bro and Taxpayer received distributions for the years in issue that were not proportional to their stock ownership. Taxpayer argued that “these substantially disproportionate distributions appear to create a preference in distributions and . . . effectively a second class of stock”. He contended that Corp should be treated as a C corporation, and that Taxpayer should be taxed only on the distributions that he received, which he contended should be treated as dividends.

The Court’s Analysis
According to the Court, in determining whether a corporation has more than one class of stock, the rights granted to shareholders in the corporation’s organizational documents and other “binding agreements” between shareholders have to be considered. The applicable IRS regulations, the Court stated, provide that “[t]he determination of whether all outstanding shares of stock confer identical rights . . . is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).”

Evidence of distributions paid to one shareholder and not to others over the course of multiple years was insufficient on its own, the Court stated, to establish that a separate class of stock was created.

The Court concluded that Taxpayer had failed to prove that a binding agreement existed that granted Bro enhanced or disproportionate “rights to distribution and liquidation proceeds.” Rather, the Court found that, at most, there had been “an informal, oral understanding among the board members/shareholders”, and there was no evidence that the directors or shareholders ever took “formal corporate action to implement that understanding.”

The original, operative agreement between Corp’s shareholders (Taxpayer and Bro) was that distribution rights for each of their shares would be identical. Taxpayer testified that he and Bro never discussed changing the agreement regarding distributions and, during the years in issue, his understanding continued to be that distributions should be proportional to stock ownership. The record reflected that the shareholders never reached, or even considered, a new binding agreement that would change their relative rights to distributions.

Taxpayer argued that Bro’s withdrawals “effectively changed . . . [the shareholders’ agreement] by majority action.” However, the Court replied, nothing in the record indicated that Bro intended to act as Corp’s majority shareholder to grant himself rights to disproportionate distributions. Taxpayer offered no evidence of any actions taken at the corporate level to redefine shareholders’ rights or to issue a new class of stock. Moreover, he did not establish that a unilateral change of the kind described (i.e., the creation of a new class of stock) would be allowable under the applicable State law.

Taxpayer contended that the Court should regard “the substance of the actions” taken by Bro as creating a second class of stock. The Court noted, however, that Taxpayer’s own tax returns for the years in issue identified Corp as an S corporation. It then explained that taxpayers are generally bound by the form of the transaction that they choose unless they can provide “strong proof” that the parties intended a different transaction in substance. There was no proof, the Court observed, that either Taxpayer or Bro intended an arrangement different from that which they agreed to and reported consistently on their tax filings.

In short, Bro’s withdrawals during the years in issue did not establish that he held a different class of stock with disproportional distribution rights. Taxpayer failed to show that there were any changes to Corp’s governing provisions. Thus, he failed to carry his burden of proving that Corp’s election to be treated as an S corporation terminated during the years in issue and, consequently, the Court sustained the IRS’s determination that Taxpayer should be allocated 49% of Corp’s net income for each of the years in issue.

C’mon . . .?
Yes, on some visceral level, the Court’s decision seems harsh. But it is important to distinguish between the administration of the Federal tax system, on the one hand, and the protection of an oppressed shareholder, on the other. The latter may suffer certain adverse tax consequences as a result of a controlling shareholder’s inappropriate behavior, but they should not expect the Federal government to right those wrongs; rather, they have recourse to the courts and the laws of the jurisdiction under which the corporation was formed, and which govern the relationships among the shareholders and with the corporation itself.

That being said, shareholders have to be aware of what the Federal tax laws provide in order that they may take the appropriate steps to protect themselves, regardless of the size of their stockholdings. These steps are typically embodied in the terms of a shareholders’ agreement. [7]

As the Court explained, a determination of whether all outstanding [8] shares of stock confer identical rights to distribution and liquidation proceeds – i.e., whether there is only one class of stock – is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (for example, a shareholders’ agreement).

Although a corporation is not treated as having more than one class of stock so long as these governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

A commercial contractual agreement, on the other hand, such as a lease, employment agreement, or loan agreement – such as may be entered between the corporation and a controlling shareholder – is not treated as a binding agreement relating to distribution and liquidation proceeds unless a principal purpose of the agreement is to circumvent the one class of stock requirement (for example, where the terms are not at arm’s-length).

Similarly, buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights. Although such an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have other tax consequences. [9]

However, if a principal purpose of the agreement is to circumvent the one class of stock requirement, and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the FMV of the stock, the one-class of stock rule may be violated.

Again, it will behoove a shareholder of an S corporation to appreciate the parameters described above.

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[1] Alliteration has its place.

[2] This raises the question: do the shareholders have a shareholders’ agreement and, if they do, does it restrict the transfer of shares, or require that the shareholders preserve the corporation’s tax status?

[3] Basically, constructive dividends. Less euphemistically, theft?

[4] The Court began its discussion by pointing out that, in general, the taxpayer bears the burden of proving that the IRS’s determinations set forth in the notice of deficiency are incorrect. In cases of unreported income, however, the IRS bears the initial burden of producing evidence linking the taxpayer with the receipt of funds before the general presumption of correctness attaches to a determination. Once the IRS meets this burden of production, the Court explained, the burden of persuasion remains with the taxpayer to prove that the IRS’s deficiency calculations were arbitrary or erroneous.

Corp failed to file income tax returns or to maintain adequate books and records for the years in issue. The IRS obtained banking records and conducted bank deposits analyses to determine the company’s net income. Bank deposits are prima facie evidence of income, the Court stated, and the “bank deposits method” was an acceptable method of computing unreported income.

The Court found that the IRS satisfied the burden of production with respect to the unreported income items at issue.

[5] https://www.law.cornell.edu/uscode/text/26/1361 .

[6] Reg. Sec. 1.1361-1(l). https://www.law.cornell.edu/cfr/text/26/1.1361-1.

[7] When Taxpayer and Bro were still on good terms, they should have agreed that Corp would make regular tax distributions, at least annually.

[8] The reference to “outstanding” shares is important; an S corporation’s certificate of incorporation may authorize the issuance of a preferred class of stock, but so long as such preferred class has not been issued and remains outstanding, the “S” election will remain in effect.

[9] For example, gift tax.