S Shareholder Is Taxed on Income Stolen from Company by CFO and Corporate Secretary

(Parker Tax Publishing August 2024)

The Tax Court held that a married couple must include in income the husband's proportionate share of an S corporation's income despite not receiving such income and despite unauthorized distributions that two other shareholders made to themselves in excess of their proportionate ownership interests. The court also concluded that the S corporation neither authorized nor created a second class of stock and thus continued to maintain its S corporation status regardless of the disproportionate distributions made to the other shareholders. Maggard v. Comm'r, T.C. Memo. 2024-77.

Background

James Maggard lives in Silicon Valley with his wife, Szu-Yi Chang. In 2000, he co-founded Schricker Engineering Group, an engineering consulting partnership, with his friend and business partner, Todd Schricker. Two years later, in 2002, they incorporated the business as an S corporation.

In July 2003, Schricker sold his interest in the company to Maggard and left. Maggard then sold a 60 percent interest in Schricker to two individuals, LL and WJ. LL and WJ joined Schricker's board and took on executive roles of their own. LL served as Schricker's CEO and CFO and handled Schricker's accounting and books. Maggard trusted him to do so because he was an old family friend. WJ was Schricker's new corporate secretary. Both LL and WJ oversaw the company's day-to-day operations and all three served on the board of directors.

By 2005, Maggard and LL each owned 40 percent of the company while WJ owned the remaining 20 percent. Per the company's governing documents, each was entitled to a proportionate share of Schricker's distributions. The three men never changed Schricker's articles of incorporation or its bylaws to allow for disproportionate distributions or liquidation rights under this new regime.

LL almost immediately began to misappropriate funds by inflating reimbursements for his expense accounts. He and WJ also began a process of making disproportionate distributions of Schricker's earnings to themselves at the expense of Maggard. Additionally, LL stopped filing Forms 1120S, U.S. Income Tax Return for an S Corporation, as soon as he became CFO and stopped sending Schedules K - 1, Shareholder's Share of Income, Deductions, Credits, etc., to Maggard.

By 2012 Maggard had caught on to LL and WJ. He hired a CPA and asked him to reconcile Schricker's accounts. They discovered that LL overdistributed $160,800 from Schricker to himself and failed to distribute nearly $165,000 of Schricker's profits to Maggard, to whom it was owed.

After Maggard confronted WJ about the unauthorized distributions, LL and WJ cut him off from the company's books, cut him out of meetings, and altogether made his position untenable. Using their majority positions on the board, LL and WJ also voted to increase their salaries, vacation time, and other benefits and authorized additional payouts to themselves. Maggard filed suit in state court and, while the state court ordered Schricker to make a corrective distribution to Maggard, LL and WJ refused to do so. Instead, LL offered to buy Maggard's entire stake in the company for $1,262,500 and Maggard agreed.

Maggard completed his and his wife's tax returns and did so without much help from Schricker. To obtain his share of Schricker's income and expenses for his return, he had his attorney contact LL to get these numbers. LL came back with a single number written on a napkin for each year that purportedly represented Maggard's share of losses for the year, i.e., a loss of $300,000 for 2014; a loss of $50,000 for 2015; and no income or loss for 2016. In April of 2018, Schricker filed its own Forms 1120S for tax years 2011-2016 and issued the Schedules K-1 to Maggard and its other shareholders. Maggard's K-1s showed his proportionate share of Schricker's earnings as profits, not losses.

The IRS determined that Maggard and Chang had incorrectly reported their income from Schricker for the years 2014-2016, and that their income during those years was passive because Maggard hadn't been actively participating in the business.

Under Code Sec. 1361(b)(1)(D), a corporation can be an S corporation only if it has no more than one class of stock. Reg. Sec. 1.1361-1(l)(1) generally treats a corporation as having only one class of stock so long as all the S corporation's shares confer equal rights to dividends and liquidation proceeds. This determination depends on the corporation's governing provisions. In Rev. Proc. 2022-19, the IRS said it will not treat any disproportionate distributions made by a corporation as violating the one-class-of-stock requirement if the governing provisions provide for identical rights.

Maggard's case went before the Tax Court which had to decide whether Schricker lost its S corporation status because of disproportionate distributions made to the three shareholders and, if so, what adjustments should be made to Maggard's and Chang's income.

Analysis

The Tax Court held that Maggard and his wife must include in their income for the years 2014-2016 Maggard's proportionate share of Schricker's income despite the disproportionate distributions made to LL and WJ. The court cited Reg. Sec. 1.1361-1(l)(2) and Minton v. Comm'r, T.C. Memo. 2007-372, aff'd, 562 F.3d 730 (5th Cir. 2009), in holding that disproportionate distributions by themselves do not change a company's S corporation status. The court observed that, while the unauthorized distributions were hidden from Maggard, WJ and LL did not memorialize them by formal amendments to Schricker's governing documents. The court said that, without that formal memorialization, there was no formal change to Schricker's having only one class of stock. To the court, this meant that Schricker's S election could not be revoked for disproportionate distributions under Reg. Sec. 1.1361-1(l)(2). Thus, the court concluded, Schricker as an entity neither authorized nor created a second class of shares by way of a formal corporate action and Schricker thus continued to maintain its S corporation status for the years at issue.

The Tax Court rejected Maggard's theory that besides the case being about disproportionate distributions, it was also about deferred income, the removal of shareholder and board member rights, and Schricker's failure to provide him with sufficient information to complete his tax return. According to the court, because Schricker as an entity neither authorized nor created a second class of shares by way of a formal corporate action, Schricker continued to maintain its S corporation status for the years at issue and Maggard was thus responsible for reporting his share of Schricker's income for those years.

For a discussion of the rules relating to S corporations and the one-class-of-stock rules, see Parker Tax ¶30,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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