You Can Do What? – Disproportionate Distributions By S Corporations

Introduction

S corporations are popular among businesses because they afford shareholders the liability protection of a corporation, while having the pass-through tax aspects of a partnership. Tax items such as income and loss are not recognized by the corporation, but are passed through to the shareholders. But a corporation must comply with a strict set of rules to be an S corporation. In the recent case of Maggard v. Commissioner,[1] the Tax Court applied one of these rules to an extreme set of facts.

S Corporations Generally

Unlike C corporations, S corporations do not pay income tax. Instead, tax income and loss are passed through to the shareholders, who recognize the tax items on their individual returns.  This avoids the sort of double taxation that results from tax at the corporate level, and then again at the shareholder level on the distributed dividends.

Qualification as an S corporation requires compliance with a rigid set of rules.  An S corporation cannot have: (i) more than 100 shareholders, (ii) a shareholder other than an individual (with certain exceptions), (iii) a nonresident alien as a shareholder, or (iv) more than one class of stock.  It was this last requirement that was at issue in Maggard.

Conventional wisdom says that, in order to avoid having more than one class of stock, all issued shares of stock need to be treated equally.  This is especially true regarding the economics of the corporation: shareholders need to receive cash distributions, and allocations of tax items, pro rata in accordance with the number of shares they own.  Therefore an S corporation cannot have a complicated distribution waterfall, or special allocations of tax items, like a partnership can.  This flexibility with regard to distributions and allocations is one reason for choosing a partnership structure over the more rigid S corporation.

Distributing cash disproportionately among shareholders is one way in which issued shares can be treated unequally. To be sure, the IRS has been willing to overlook disproportionate distributions in certain instances:  accidental disproportionate distributions which were corrected with subsequent remedial distributions,[2] or temporary disproportionate distributions,[3] or disproportionate distributions due to an error in calculating ownership percentage interest,[4] or disproportionate distributions made to cover shareholders’ tax liability.[5]  But Maggard took this to another level.

Maggard v. Commissioner

The facts in Maggard are tersely summarized in the opening paragraph of the opinion:  “James Maggard is an entrepreneur who cofounded an engineering firm. When his original partner left, Maggard took on two friends as coowners. They proceeded to loot the firm or, as one says in taxspeak, made unauthorized distributions to themselves in excess of their proportionate ownership shares. Maggard says these actions effectively terminated the firm’s status as an S corporation under the Code. The Commissioner disagrees and wants Maggard and his wife to pay tax on income that they never received, as owners of S corporations must sometimes do.”

To add some detail to the above summary:

• Maggard’s two “friends” (LL and WJ) owned 60% of the outstanding stock, and Maggard owned 40%. LL served as CEO and CFO.  WJ served as corporate secretary.  Maggard was chief engineer.  LL and WJ ran the day-to-day operations of the company.  The three of them made up the board of directors.
• Over a four-year period, LL and WJ made distributions to themselves of over $1,000,000 without distributing any cash to Maggard. The company failed to file tax returns during this period.
• Using their majority positions on the board, LL and WJ cut Maggard off from the company’s books, cut him out of meetings, gave themselves raises and increased benefits, and prevented Maggard from participating as a director and shareholder of the corporation.

During this period Maggard reported no income or losses from his interest in the corporation since he didn’t receive K-1’s from the corporation. The IRS, in examining this period, determined that Maggard should have been allocated a proportionate share of income from the corporation, for which Maggard owed tax, despite having received no cash distributions. Maggard argued that the intentional grossly disproportionate distributions to the other two shareholders had the effect of creating a second class of stock, thereby terminating the corporation’s S election.  As a C corporation, the income tax would be paid by the corporation, and not allocated to Maggard.

The Tax Court disagreed with Maggard. While expressing sympathy for Maggard, the Court held that “the law is ironclad:” whether an S corporation has more than one class of stock is determined solely by the corporation’s governing documents, i.e., its articles of incorporation, certificate of formation, bylaws, etc. What the corporation actually does is of no consequence.

In forming its conclusion, the Tax Court cited Revenue Procedure 2022-19: “Section 1.1361-1(l)(2)(i) provides that a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights. Accordingly, the IRS will not treat any disproportionate distributions made by a corporation as violating the one class of stock requirement of § 1361(b)(1)(D) so long as the governing provisions of the corporation provide for identical distribution and liquidation rights.”

In Maggard, the Tax Court cited the corporation’s articles of incorporation, which provided: “The total number of shares which the corporation is authorized to issue is 10,000, all of which are of one class and of a par value of $.00 each, and all of which are Common shares.”  This “governing provision” was enough to convince the Tax Court that, despite the disproportionate distributions, the Corporation’s S election was not compromised.

The Bottom Line

The facts in Maggard are an extreme case, but the Tax Court was unwavering in its application of the rule set forth in Rev. Proc. 2022-19, relying on Section 1.1361-1(l)(2)(i).  The implication is that, as long as the governing document of a corporation provides for one class of stock, whether or not the corporation makes proportionate distributions is not relevant to its S status.  Disproportionate distributions may violate other agreements among the shareholders or other laws, but they will not compromise the corporation’s S election by creating more than one class of stock.  Conventional wisdom regarding the effect of disproportionate distributions might need to be recalibrated.

[1] T.C. Memo. 2024-77

[2] PLR 200125091

[3] PLR 9729025

[4] PLR 201633017

[5] PLR 201608006