Physician Who Retained Beneficial Ownership of S Corp Stock Is Taxed on Income Never Received (Parker's Federal Tax Bulletin: September 2, 2013)

A physician was required to report the business and interest income from his S corporation shares because he retained the beneficial ownership of the shares and his rights were not given away following a dispute with another shareholder. Kumar v. Comm'r, T.C. Memo. 2013-184 (8/13/13).

Dr. Ramesh Kumar, a physician, and Dr. Woody, another physician, agreed to provide radiation oncology services to patients through three business entities: Okeechobee Business Ventures, Inc. (OBV), Mid-Florida Radiation Oncology, P.A. (MFRO), and Port St. Lucie Ventures, Inc., (PSLV). PSLV was an S corporation. Dr. Kumar owned 40 percent of the shares of PSLV and Dr. Woody owned 60 percent of the remaining shares. Dr. Kumar, Dr. Woody, and a third physician each owned one-third of the outstanding shares of stock in OBV.

A dispute arose between Dr. Kumar and Dr. Woody resulting in Dr. Kumar being shut out of PSLV's operations and management. In 2004, Dr. Kumar filed a complaint against Dr. Woody and PSLV, seeking court-ordered inspection of corporate records, dissolution of PSLV, and reinstatement of his medical privileges at PSLV. The lawsuit was settled in 2012, and the parties agreed that Dr. Woody would sell his OBV stock to Dr. Kumar and Dr. Kumar would transfer his PSLV stock to PSLV in total redemption of his interest. The settlement agreement also provided that the transactions close on December 31, 2011, and as of that date, Dr. Woody would no longer be a shareholder of OBV and Dr. Kumar would no longer be a shareholder of PSLV.

PSLV made no distributions to shareholders in 2005. Dr. Kumar did not receive any wages or take part in the operation or management of PSLV in 2005 or any year thereafter. PSLV issued a Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., to Dr. Kumar for the 2005 tax year and reported his share of PSLV's ordinary business income as $215,920 and interest income as $2,344. Dr. Kumar, and his wife, Pushparani, filed their 2005 Form 1040, Individual Income Tax Return, and listed on their attached Schedule E, Supplemental Income and Loss, PSLV as an S corporation in which they held an interest. They did not report any income from Dr. Kumar's Schedule K-1 on their Schedule E. The IRS determined a $78,760 deficiency in the couple's federal income tax for the unreported business and interest income from Dr. Kumar's shareholder interest in PSLV.

Under Code Sec. 1366(a), an S corporation's items of income, gain, loss, deduction, and credit - whether or not distributed - flow through to the shareholders, who must report their pro rata shares of such items on their individual income tax returns.

For purposes of determining a shareholder's pro rata share of income loss, deduction, or credit for a tax year, the beneficial owners of an S corporation are treated as the shareholders of the corporation.

OBSERVATION: To determine if beneficial ownership has passed from one person to another, it is important to determine whether the transferee has more attributes of ownership than the transferor.

Dr. Kumar argued that he was not liable for tax on PSLV's income because he was not the beneficial owner of his shares in 2005. When the record owner of S corporation stock holds the stock for the benefit of another, as a nominee, agent or passthrough entity, then the income, losses, deductions, and credits of the corporation are passed through to the beneficial owner of the stock and not to the record owner under Reg. Sec. 1.1361-1(e). Thus, he argued, a taxpayer is the beneficial owner of the property if the taxpayer controls the property or has the economic benefit of ownership of the property.

The Tax Court held that Dr. Kumar retained beneficial ownership of his PSLV stock and was required to report his share of the PSLV business and interest income on his individual tax return. The court noted that a previous case, Hightower v. Comm'r, T.C. Memo. 2005-274, applied the beneficial ownership test when the parties had some agreement or understanding regarding their relationship with each other. In that case, the court found that when one shareholder merely interferes with another shareholder's participation in the corporation as a result of a poor relationship between the shareholders, the interference does not amount to deprivation of the economic benefit of the shares.

The court rejected Dr. Kumar's claim that he was not the beneficial owner of the PSLV stock in 2005 because he was improperly excluded from the benefits of ownership of the stock. He cited no precedent where a shareholder took beneficial ownership of stock away from another shareholder absent an agreement between the two shareholders. There was no agreement to give Dr. Woody any rights to Dr. Kumar's PSLV stock and Dr. Woody's interference with Dr. Kumar's participation in PSLV did not deprive him of the economic benefit of his shares. Thus, the court concluded that the beneficial ownership test did not relieve Dr. Kumar from his obligation to report his share of PSLV's profits and interest income.

Practice Tip: This is a potential trap for the unwary. It may seem logical that if a shareholder is shut out of the operation and management of an S corporation and is precluded from receiving any distributions from the S corporation by the other shareholders, the shareholder would not be taxable on the income allocated to him or her. However, this is not the case and like the situation in Kumar, the shareholder may find him or herself with taxable income and no way to pay the tax on that income. If, in Kumar, the S corporation's governing articles provided that such situations (i.e., where a shareholder is shut out of the operations and management of the S corporation and not entitled to distributions) would result in a beneficial transfer of stock from the excluded shareholder to the other S shareholders, Dr. Kumar may have been successful in arguing that there was a transfer of beneficial ownership.

For a discussion of rules for determining an S shareholder's pro rata share of S corporation income, see Parker Tax ¶31,935.

Parker Tax Publishing Staff Writers

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