Taxpayers who own an interest in an S corporation but who are not familiar with the tax rules are often surprised to learn that they have to pay tax on the business profits even if they do not receive distributions from the business. The court recently addressed this fundamental concept in Dalton v. Commissioner, T.C. Memo. 2017-43. The case stands as a strong reminder that a tax advisor should be involved when shareholders sell or otherwise transfer their shares.
The facts and procedural history are as follows:
- The disputed involved a construction company that was taxed as an S corporation.
- The company was owned equally by two brothers.
- One of the brothers decided he wanted to resign and turn in his shares.
- The non-resigning brother took steps to lock his brother out of the business.
- Litigation ensued and the resigning brother ended up transferring his shares to his brother as part of a mediation agreement.
- The agreement provided the “transfer shall be effective no earlier than January 1, 2008, and no later than July 24, 2008, as determined by” the non-resigning brother.
- The company then issued a Schedule K-1 to the resigning brother for $451,531 of pass-through income through July 24, 2008.
- The resigning brother did not receive a distribution for this short tax year.
The issue in the tax court case was whether the resigning brother was liable for taxes on a distribution he did not receive.
S Corporation Rules
S corporations are not subject to Federal income tax. Rather, their items of income, deduction, credit, etc. flow through to the shareholder’s personal income tax returns. This is true regardless of whether any distributions are made to the shareholders. This often comes as a surprise to those who are not familiar with S corporations.
This aspect of S corporations often causes problems when there is a minority shareholder that cannot afford to pay taxes on the distributions and the S corporation retain earnings to invest in the business or uses the funds for other business expenses. The owners of S corporations will normally agree to make distributions to help the minority shareholders to address this problem.
Distributions That Are Not Made
In the Dalton case, the brother’s relationship had deteriorated. This may be why the company did not make distributions.
It might also be that the agreement between the brothers did not require a distribution or that one was needed for the retiring brother to be able to afford the taxes. The court opinion does not go into these details, but it would seem that the retiring brother would have received some sort of payout in exchange for his shares. This may have been pursuant to an installment agreement over a period of time, however. It could have also been treated as a guaranteed payment rather than a distribution. In either case, it would seem that the non-retiring brother had some funds from which to pay the resulting tax.
The unspecified closing date that could be determined by the non-retiring partner is also problematic. The agreement should have set a specific closing date, rather than leaving the closing date open for such a long period and allowing one party to decide what the actual date would be. This allowed time for the company to accrue profits that would be subject to tax. It could have also presented a situation where the non-retiring brother accelerated income and delayed deductions for the business in an effort to shift more of the Federal income tax liability to the retiring brother. The case does not indicate that this happened here, but it may very well have.
Suffice it to say that the agreement should have addressed these details and the resulting tax consequences. In reading the case, it seems like the retiring brother did not hire a tax advisor to help negotiate the agreement. One is left wondering if the non-retiring brother did have a tax advisor advising him.