The owner of an engineering firm who was cheated by his two partners still had to pay tax on the $1 million stolen by his partners. Let’s see what happened and why if you have an S corporation it’s important to pay attention to how you take money out from your business.
S Corporation Distributions
Now let’s do a quick tax law lesson and talk about the intricacies of the S corporation distributions. This is helpful information to know as a business owner, even if you have a CPA or another tax professional doing your taxes at the end of the year. That is because, in order to save on tax money or even to avoid some unexpected tax traps, you, with the help of your CPA should monitor your S corporation distributions throughout the year, not only at tax time. This ensure you catch any problems with the distributions on time and you can correct them before year-end. You should also monitor your distributions in connection to a concept called shareholder basis, to ensure your distributions remain non-taxable.
Ways To Take Money Out From An S Corporation
When you take money out from an S corporation as a business owner, you can do so in three ways:
- You have to take a reasonable salary for the work you do for your business; which is subject to income tax and payroll tax,
- You can take out distributions of the remaining profits; generally are not subject to income tax or payroll tax, unless you have distributions over basis and this is a discussion for another blog,
- The business can loan you money;
If not done properly, both the distributions and the loans you take out from the business can create a second class of stock for your business.
Why Having A Second Class Of Stock Is A Bad Thing For An S Corporation?
Well, because an S corporation can have only one class of stock. Once you create another class of stock, your S corporation status is invalidated, changing your business’ tax classification to another tax status with unintended tax consequences for you and your business.
Let’s see how distributions could create a second class of stock when the business has more than one owner. The regulations state that a corporation has only one class of stock so long as all the shares confer equal rights to dividends and liquidation proceeds. The regulations also state that identical rights distributions and liquidation proceeds are determined based on the corporations governing provisions. Such as a corporate charter, articles of incorporation, bylaws, or an LLC’s operating agreement. And yes, an LLC can be treated as an S corporation for tax purposes. This means that the S corporation governing provisions should require distributions to owners according to their ownership percentages.
But what happens when even though the business documents require proportional distributions, the partners pay themselves disproportionate distributions? Will your business lose its S corporation status? This is the answer that this new tax court ruling provides. So, let’s see what went on.
Court Case
The business owner in this case opened an engineering firm with a friend who was an investor and they organized their company as an S corporation. In July 2003 the investor friend sold his business interest to our business owner and left the company. Then our business owner sold a 60% interest to two of his friends. One who bought 40% and one who bought 20%. By 2005 our business owner was left with 40%. This meant that each of these three people had to pay tax on their own share of the business profits. Because this is how an S corporation works.
An S corporation is a flow through entity. This means that the business does not pay tax on the profits. Instead, the owners report their share of the profits on their personal tax returns and pay the tax at the individual level. The partners have to pay tax on the profits regardless if they receive the profits or not. Thus, with an S corporation it is important that the business distributes the profits to its owners. Otherwise the owners pay tax on money that they did not receive.
What Happened?
Let’s see what happened in our story. These two new partners joined the board of directors and took on executive roles while our business owner remained the company’s lead engineer. The new co-owner friends almost immediately began to loot the business, or as one says in tax speak, made unauthorized distributions to themselves in excess of their proportionate ownership share. After quite a number of years, by 2012 our business owner had caught on to his new co-owner friends. He hired a CPA to reconcile the corporations accounts. They discovered that his friends embezzled more than 1 million from the company. Or at least this is what our business owner accused his friends of doing.
Eventually they did reach a state court settlement. But our business owner still had the problem of paying taxes on money that he did not receive. In order to avoid having to pay these taxes, he tried to argue that the S corporation status was involuntarily revoked by the unauthorized and grossly unequal distributions that the friends made to themselves. So, in his case, having an S corporation was not advantageous anymore. By looking to have the S corporation status revoked, he was hoping to cause the business to be taxed as a C corporation. In which case the owners have to pay tax only on the money received. But the IRS did not agree and said that doesn’t matter. Because the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what shareholders actually do.
Court’s Opinion
The court sided with the IRS saying that ” The regulation plainly states that uneven distributions don’t mean that the corporation has more than one class of stock. Treas. Reg. §1.1361-1. A corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights.”
Conclusion
In the end our business owner had to pay taxes on money he did not receive. Unfortunately for him, he did not employ a CPA from the beginning. A CPA who could have brought to his attention the discrepancies. And only when after years and years, when he started to suspect there is something wrong, he decided to turn to a tax professional. His case is riddled with a lot more issues that could have been avoided with the help of a tax professional.
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Please note that this blog post is for informational purposes only and does not constitute tax, legal or accounting advice.