Proceeds from Sale of Tax Shelter Interests Were Income to S Corporation's Sole Shareholder (Parker Tax Publishing: September 22, 2013)

Income attributable to a wholly owned S corporation from the sale of tax shelter interests to investors was taxable income to its sole shareholder because the S corporation's income was personal income to its shareholder and was not held in trust for a third party. Rogers v. Comm'r, 2013 PTC 262 (7th Cir. 8/26/13).

John Rogers, a tax attorney, created a partnership, Warwick Trading, LLC, for the purpose of selling tax shelter interests to U.S. investors. The partners in Warwick were a foreign retailer, Lojas Arapua S.A., and Jetstream Business Limited, another company owned by John. Lojas Arapua contributed to Warwick largely uncollectible receivables that were worth less than their face amount. Jetstream was designated managing partner and responsible for collecting the receivables. Because the property contributed to Warwick retained its original basis even though its market value had fallen, the receivables had the potential to generate losses that would be deductible from the taxable income of U.S. taxpayers who later entered the partnership. John also created a wholly owned S corporation, Portfolio Properties, Inc. (PPI), to act as an intermediary between himself and Jetstream. The tax shelter interests were sold to U.S. investors for a total of $2.4 million. John directed the shelter investors to wire their funds to PPI's bank account, rather than Warwick's, stating that Warwick lacked adequate banking facilities. PPI forwarded $1.2 million of the funds to Lojas Arapua for the receivables. Of the $1.2 million PPI retained, $732,000 was distributed to John.

John filed his federal income tax return in 2003 and reported $513,000 of the distribution as personal income. The IRS assessed a deficiency, saying that John failed to report the income attributable to PPI and the distribution he received from PPI. John argued that the $1.2 million retained by PPI was held in trust for the benefit of Warwick and the tax deficiency was a partnership item that should be resolved at the partnership level.

The Tax Court held that the $1.2 million retained by PPI was taxable income to John. John appealed to the Seventh Circuit.

The Seventh Circuit affirmed the Tax Court and held that the amount retained by PPI from the sale of the shelter interests was income to John as the S corporation's sole shareholder rather than funds held in trust by PPI or John. The court stated that, although PPI kept the tax shelter interest sale proceeds in a segregated account, John did not claim that PPI wrongfully deprived Warwick of any money or property. The court rejected John's testimony that the proceeds PPI retained were held in trust for Warwick for pay for future expenses as not credible. John's argument that he held his $732,000 distribution from PPI in trust for Warwick was also rejected. He reported on his return a portion of the distribution as personal income for rendering legal services to PPI and paid income tax on the amount. Further, the court noted that if John had held the distribution in trust for Warwick and used it to reimburse himself for legal services, then he committed a grave breach of trust. Finally, with respect to the funds that PPI retained and did not distribute to John, the court presumed that they were intended to compensate John for organizing the tax shelter. Thus, the court concluded the distribution was income to John as PPI's sole shareholder.

For a discussion of S corporation distributions, see Parker Tax ¶84,515.

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