Taxpayer Who Set up Nonprofit S Corporation Can't Pass Thru Losses

(Parker Tax Publishing September 2020)

The Tax Court held that a taxpayer could not deduct losses from an S corporation organized under the Kentucky Nonprofit Corporation Act because, under state law, he was not entitled to dividends or any other distributions of earnings on the S corporation. The court noted that the Kentucky Nonprofit Act prohibits the distribution of dividends or profits to an organization's members, directors, and officers and prohibits the issuance of shares of stock. Deckard v. Comm'r, 155 T.C. No. 8 (2020).

Background

Waterfront Fashion Week, Inc. (Waterfront) was organized on May 8, 2012, as a nonstock, nonprofit corporation under the Kentucky Nonprofit Corporation Acts. The articles of incorporation were signed by attorney D. Kevin Ryan as "Organizer" and filed with the Kentucky Secretary of State. In 2014, in his capacity as Waterfront's president, Clinton Deckard filed with the IRS Waterfront's election to be treated as an S corporation, effective retroactively to the date of its incorporation in 2012. Waterfront produced an event called Waterfront Fashion Week that was held at the Louisville Waterfront Park from October 17 to 19, 2012. This event was marketed as benefiting Waterfront Development Corp., a nonprofit organization that maintains the Louisville Waterfront Park. The event failed, however, to break even. Consequently, Waterfront made no cash charitable contribution to Waterfront Development Corp.

On September 28, 2013, the Kentucky Secretary of State administratively dissolved Waterfront for failure to file its 2013 annual report. On December 16, 2013, after filing a reinstatement application, Waterfront was reinstated as a corporation duly incorporated under Kentucky law. On September 30, 2014, the Kentucky Secretary of State once again administratively dissolved Waterfront, this time for failure to file its 2014 annual report. This time Waterfront did not seek reinstatement.

In October of 2014, Waterfront mailed to the IRS Form 2553, Election by a Small Business Corporation. The Form 2553 indicated that Waterfront was electing to be an S corporation retroactively as of the date of its incorporation, May 8, 2012. Deckard signed the Form 2553 in his capacity as Waterfront's president and also signed the shareholder's consent statement, indicating that he held a 100 percent ownership interest acquired on May 8, 2012.

On January 13, 2015, Waterfront filed untimely Forms 1120S, U.S. Income Tax Return for an S Corporation, for its 2012 and 2013 tax years, reporting operating losses of $277,967 and $3,239 for 2012 and 2013, respectively. Attached to the Forms 1120S were Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., reporting that Deckard had 100 percent stock ownership of Waterfront during 2012 and 2013.

Deckard later filed untimely individual income tax returns claiming Waterfront's reported operating losses of $277,967 and $3,239 for 2012 and 2013, respectively, as offsets against his individual taxable income. The IRS disallowed these losses on the ground that Waterfront had not made a valid S corporation election or, alternatively, that Deckard was not a shareholder or beneficial owner of Waterfront for tax years 2012 and 2013 for purposes of subchapter S and so was not entitled to claim passthrough losses from Waterfront on his individual income tax returns.

The case went before the Tax Court where the IRS filed a motion for partial summary judgment and Deckard filed a cross-motion for partial summary judgment. These motions asked the Tax Court to decide (1) whether Waterfront made a valid S corporation election, and (2) whether Deckard was a shareholder of Waterfront for the 2012 and 2013 tax years.

Deckard argued that he should be considered Waterfront's sole shareholder because he held exclusive beneficial ownership of the corporation. To support his argument, he asserted the following: (1) that on or about July 22, 2011, he hired Extraordinary Events, an unrelated event-planning business, to coordinate Waterfront Fashion Week; (2) that on May 3, 2012, he hired Attorney Ryan to advise him on the creation of a legal entity to conduct Waterfront Fashion Week because Extraordinary Events had advised Deckard that a tax-exempt entity would encourage sponsors to make tax-deductible contributions to the legal entity; (3) that Attorney Ryan never advised Deckard that sponsors might be able to deduct sponsorships as trade or business expenses even if the legal entity lacked tax-exempt status; (4) that on May 8, 2012, Attorney Ryan formed Waterfront under the Kentucky Nonprofit Corporation Acts; (5) that during 2012 and 2013, Deckard was president of Waterfront and its "sole decision maker"; (6) that on or about August 10, 2012, Deckard terminated the agreement with Extraordinary Events because it had failed to recruit enough sponsors or raise enough contributions to fund Waterfront Fashion Week; (7) that he then assumed "complete control" over planning Waterfront Fashion Week, abandoned plans for Waterfront to obtain federal tax-exempt status, and began treating Waterfront as a "for-profit business that I owned entirely"; and (8) that in August 2012 he made over $275,000 of contributions to Waterfront representing over 85 percent of the total cost of Waterfront Fashion Week.

Analysis

The Tax Court began by noting that the critical question was whether Deckard should be considered a shareholder of Waterfront during 2012 and 2013. The Tax Court agreed with the IRS that Deckard was not a shareholder or beneficial owner of Waterfront for tax years 2012 and 2013 for purposes of subchapter S and thus was not entitled to claim passthrough losses from Waterfront on his individual income tax returns. The court concluded that, while it assumed Deckard's assertions with respect to the activities surrounding Waterfront were true and the IRS did not expressly dispute such assertions, Deckard was not properly treated as Waterfront's shareholder for subchapter S purposes as a matter of law. The court looked to Reg. Sec. 1.1361-1(e)(1), which provides that the person who must include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation) is considered to be the shareholder of the corporation.

Citing that same regulation, the Ninth Circuit, in Cabintaxi Corp. v. Comm'r, 63 F.3d 614 (7th Cir. 1995), observed that the determination of whether a person is an S shareholder on the date of an S election is equivalent to the question of whether, had there been a valid election, that person would have been required to report as personal income profits earned by the corporation on that date. The answer, the Tax Court noted, depends on whether the person would have been deemed a beneficial owner of shares in the corporation, entitled therefore to demand from the nominal owner the dividends or any other distributions of earnings on those shares. The Tax Court said that, in making this determination, the courts look to state law. The Tax Court noted that neither the IRS nor Deckard had cited, and the court said it could not find, any case addressing beneficial ownership in a nonstock, nonprofit corporation for purposes of subchapter S.

Nonprofits, the Tax Court noted, generally do not have owners because they are prohibited from distributing profits to insiders who are in positions to exercise control, such as members, officers, or directors. Consequently, there is no interest in a nonprofit corporation equivalent to that of a stockholder in a for-profit corporation who stands to profit from the success of the enterprise. In fact, the court noted, the Kentucky Nonprofit Act prohibits the distribution of dividends or profits to the organization's members, directors, and officers and prohibits the issuance of shares of stock. Deckard, the court found, did not otherwise possess an ownership interest in Waterfront equivalent to that of a shareholder. Thus, the court concluded that, in the light of this nondistribution constraint, treating Deckard as a shareholder of Waterfront would be fundamentally incompatible with the purpose and operation of subchapter S, which generally taxes an S corporation's income currently at the shareholder level. In addition, the court noted that Deckard lacked dissolution rights in Waterfront typical of a shareholder and thus, none of Waterfront's assets could be distributed to him upon Waterfront's dissolution.

For a discussion of eligibility to be an S corporation shareholder, see Parker Tax 30,110.

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