S Corporation Shareholder Excluded from Management and Salary Still Faces Tax Liability

US_Corporateation_Income_Tax_Return_2011_form_1120.jpgThe minority shareholder of an S corporation appealed a ruling of the Internal Revenue Service (IRS), which held him liable for tax on his pro rata share of the corporation’s income, to the U.S. Tax Court. He argued that he was not the “beneficial owner” of the shares and therefore should not be liable for the tax because he had been shut out of management and received no distributions from the corporation. Kumar v. Commissioner of Internal Revenue, T.C. Memo 2013-184 (2013). The Tax Court rejected his argument, finding that the liability of an S corporation shareholder for federal income tax on the corporation’s earnings is not dependent on factors like management authority or actual receipt of distributions or other income. This should serve as a reminder for all S corporations to maintain shareholder agreements that provide for distribution of income in minimum amounts sufficient to cover taxes.

A subchapter S corporation avoids the “double taxation” found in corporations covered by subchapter C of the Internal Revenue Code, in which the corporation first pays tax on its income, and the shareholders then pay tax on dividends they receive. S corporations do not pay federal income tax. 26 U.S.C. § 1363(a). Instead, income and losses “pass through” directly to the shareholders, who pay taxes on income and deduct losses in proportion to their number of shares on their personal tax returns.

The petitioner in Kumar owned 40 percent of Port St. Lucie Ventures, Inc. (PSLV), a Florida medical practice organized as an S corporation. A dispute arose between him and his business partners in 2004. Around the same time, the majority shareholder of PSLV allegedly shut the petitioner out of the management of the company. The petitioner did not receive any wages or distributions from PSLV for 2005 or any subsequent year. He did, however, receive a Schedule K-1 from the corporation for the 2005 tax year, which reported his share of the corporation’s taxable income as $215,920 and his share of interest income as $2,344.

The IRS determined that the petitioner owed $78,760 in federal income tax for 2005, as well as a $15,752 accuracy-related penalty. The petitioner appealed to the Tax Court, arguing that he was not the “beneficial owner” of the PSLV shares because he was shut out from the corporation. If the record owner of shares in an S corporation is holding the stock for someone else’s benefit, taxes pass through to the “beneficial owner.” 26 C.F.R. § 1.1361-1(e). The court found, however, that the petitioner did not cite any authority in support of the claim, as the court interpreted it, that the majority shareholder took beneficial ownership away from the petitioner by shutting him out. It therefore affirmed the tax judgment.

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Photo credit: By Internal Revenue Service (http://www.irs.gov/pub/irs-pdf/f1120.pdf) [Public domain], via Wikimedia Commons.