S Corporation Owner Taxed on Earnings Not Distributed

Taxpayers who own an interest in an S corporation are often not familiar with the tax rules for S corporations.

They are often surprised to learn that they have to pay taxes on the business profits even if they do not receive distributions from the business.

The court recently addressed this fundamental concept in Dalton v. Commissioner, T.C. Memo. 2017-43.

Facts & Procedural History

The dispute involved a construction company that was taxed as an S corporation. The company was owned equally by two brothers.

One of the brothers decided he wanted to resign and turn in his shares. The non-resigning brother took steps to lock his brother out of the business. Litigation ensued and the resigning brother ended up transferring his shares to his brother as part of a mediation agreement. The agreement provided the “transfer shall be effective no earlier than January 1, 2008, and no later than July 24, 2008, as determined by” the non-resigning brother.

The company then issued a Schedule K-1 to the resigning brother for $451,531 of pass-through income through July 24, 2008. The resigning brother did not receive a distribution for this short tax year. The issue in the tax court case was whether the resigning brother was liable for taxes on a distribution he did not receive.

The S Corporation Rules

S corporations are not subject to Federal income tax. Rather, their items of income, deduction, credit, etc. flow through to the shareholder’s personal income tax returns. This is true regardless of whether any distributions are made to the shareholders.

This aspect of S corporations often causes problems when the S corporation retains earnings to invest in the business or uses the funds for other business expenses and there is a minority shareholder that cannot afford to pay taxes on the distributions. In these situations, the owners of S corporations will normally agree to make distributions to help the minority shareholders to address this problem.

Distributions That Are Not Made

In the Dalton case, the brother’s relationship had deteriorated. This may be why the company did not make distributions.

The court’s opinion does not go into these details, but it might be that the agreement between the brothers did not require a distribution, that the minority owner did not have the right to force a distribution, or even that a distribution was not needed for the minority owner to be able to afford the taxes.

Absent distributions, the parties may also address this by the windup terms in their agreement. These terms will often require a buy-out payment or payments. This payment mechanism can allow the departing partner to have funds from which to pay the resulting tax.

The Takeaway

The owners of S corporations have to pay tax on distributions. This is true even if distributions are not actually made.

Cash-strapped owners should ensure that they have sufficient rights in the terms of their agreement to remedy this. This may include the right to distributions or force distributions or payment on exit from the business. Taxpayers should consult with an experienced business tax attorney to discuss their options.