Agreement to Reimburse S Shareholders' Tax Liability Was Not a Fraudulent Conveyance by S Corp
(Parker's Federal Tax Bulletin: August 2012)

Even though a fully executed agreement in which an S corporation agreed to reimburse its shareholders for their pass-through liability could not be found, the fact that the shareholders operated in accordance with such an agreement and that the corporation received consideration for such an agreement precluded a finding that the corporation made a fraudulent conveyance. In re Kenrob Information Technology Solutions, Inc., 2012 PTC 214 (E.D. Va. 7/10/12).

Kenrob Information Technology Solutions, Inc., an S corporation, had three shareholders: Kenneth and Sylvia Robinson and Mark Schuler. By agreement between the shareholders and Kenrob, the corporation was obligated to reimburse the shareholders for the income taxes attributable to the pass-through liability from the corporation. In April 2007, the corporation paid the personal income taxes attributable to the pass-through liability directly to the IRS. The tax payments were applied to the shareholder's personal tax returns. The corporation did this again in April 2008. According to Mark, he was not fully reimbursed for all the taxes for which he should have been reimbursed. However, he did not request reimbursement because he wanted to assist the corporation in its cash flow. Subsequently, Kenrob filed for bankruptcy. During the bankruptcy proceedings, the bankruptcy trustee asserted that Kenrob's payments of the shareholders' tax liabilities were fraudulent conveyances because they were made without consideration by the corporation.

The trustee disputed some of the facts asserted by the IRS to be undisputed, in particular, the existence of a shareholder agreement obligating the corporation to reimburse the shareholders for taxes attributable to the pass-through liability. The trustee pointed to deposition testimony of both Ken and Mark that they did not recall signing the shareholder agreement and the absence of a fully executed agreement. There was a copy of a redlined agreement, but not a final executed document. The IRS pointed to the unequivocal testimony of both Ken and Mark that there was an agreement, that all the parties acted in accordance with the agreement, and that the shareholders would not have agreed to a subchapter S election had there not been an agreement to reimburse them for the additional tax liability. The trustee asserted that a shareholders' agreement made years before the transaction was not sufficient.

A district court rejected the bankruptcy trustee's objections and held that the payment of the shareholders' associated tax liability did not constitute a constructively fraudulent transaction. The court concluded that the fact of the existence of the agreement was not generally in dispute and the mere absence of a copy of the executed document did not show that there was no such agreement, particularly where the agreement had been fully performed.

With respect to the issue of consideration, the court stated that consideration need not come directly from the party to whom the payment is made (i.e., in this case, the IRS). Consideration can be derived from a third party. Thus, according to the court, as long as the unsecured creditors are no worse off because the debtor, and consequently the estate, has received an amount reasonably equivalent to what it paid, no fraudulent transfer has occurred. Citing the Third Circuit's decision in Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979 (2d Cir. 1981), the district court observed that indirect benefits may also be evaluated. In this instance, it was clear to the court that there was a benefit derived by the corporation from its arrangement with the shareholders. Court records showed a taxable income of $1,560,000, which was passed through to the shareholders. The IRS calculated the tax that would have been paid by the corporation had it been a chapter C corporation and not a chapter S corporation. The benefit to the corporation of the election, the court noted, was significant.

In addition to the reduction of taxes, the corporation also received the benefit of not distributing its income to the shareholders even though that income was passed through for tax purposes. The shareholders left the money in the corporation to be used for corporate purposes. Had they insisted upon distribution to themselves, the corporation would have been stripped of more than $1.2 million that it used as operating capital.

With respect to the trustee's assertion that a shareholders' agreement made years before the transaction is not sufficient, the court noted that there is no requirement that the consideration be contemporaneous with the agreement. The consideration was the election by the shareholders of the corporation to be taxed as a chapter S corporation as long as the corporation paid their additional personal taxes. There was a continuing benefit to the corporation over the years and a continuing obligation on the part of the corporation to reimburse the shareholders.

The trustee asserted that there was a dispute as to material fact in the computation of the value of the election. According to the trustee, the calculation by the IRS was incorrect because the corporation could have planned for its taxes in other manners that might have reduced the taxes as well and would have engaged in such tax planning had there been no chapter S election. The court rejected such speculation as to what alternative tax planning measures could have been taken only the facts as presented, the court said, should be considered. And those facts were that the corporation was a chapter S corporation and it did not engage in other tax planning. The mere prospect of hypothetical alternative tax planning without any supporting documentation in the court record as to what it would have been or the effect of it does not create a genuine dispute as to a material fact, the court said.

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.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com