Many small businesses are taxed as S corporations because of tax benefits, such as the ability to avoid corporate tax on certain business earnings. Unlike C corporations, S corporations generally do not pay federal income taxes at the corporate level. Alternatively, profits and losses are passed through to owners who report taxes on earnings generated by the company.
To elect to be taxed as an S corporation, business entities cannot have (i) more than 100 shareholders (all of whom must be individuals, certain trusts and estates), (ii) non-resident alien shareholders or (iii) more than one class of stock.
The S corporation status of a company was recently challenged by the Internal Revenue Service (“IRS”), leaving a company’s founder with a hefty bill. In Maggard v. Commissioner (T.C. Memo 2024-77, Aug. 7, 2024), the United States Tax Court (the “Court”) held that the founder of an S corporation is liable for taxes on income that was never distributed to him because the S corporation election was not terminated when the S corporation made disproportionate distributions to its shareholders in contrast with the stock ownership percentages of the shareholders. 26 U.S.C. § 1361(b)(1)(D). Filing Form 2553 with the IRS to execute an election under 26 U.S.C. § 1362(a) to be an S corporation is the tip of the iceberg with respect to IRS compliance. As referenced above, a corporation must only have one class of stock to be eligible to be taxed as an S corporation. In accordance with 26 CFR § 1.1361-1(l)(1), a corporation is deemed to have only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. For these purposes, any differences in voting rights are disregarded.
In Maggard, the IRS contended that Mr. Maggard must pay taxes on his share of the corporation’s income for the years at issue, regardless of whether the income was distributed to him, because the company elected to be taxed as an S corporation. Mr. Maggard contended that the corporation’s S-corporation election terminated before the years at issue because of repeated disproportionate distributions to shareholders in violation of the single stock requirement in 26 U.S.C. § 1361(b)(1)(D).
The Court concluded that disproportionate distributions did not terminate the corporation’s S-corporation tax election. The Court relied upon the fact that the corporation did not change its governing documents or authorize a second class of shares. The corporation’s governing provisions provided for identical rights to distributions and liquidation proceeds.
In nearly all circumstances, S corporations should distribute income pro-rata based on stock ownership percentages so that shareholders do not pay tax on their pro-rata share of income without receiving a pro rata distribution of income. Aside from the significant tax implications as a result of the Court’s ruling, a major takeaway is the importance of updating governance documents (including shareholders agreements and by-laws), as a failure to do so may be costly. Companies should regularly assess and evaluate their current tax structure and coordinate with an experienced tax professional to ensure their governance documents and current practice comply with applicable laws.
Contributed by Michael L. Salad, Esquire
Cooper Levenson, Attorneys at Law
