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.
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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.
About S Corporations
Subchpater S corporations are a popular business structure for many small and medium-sized businesses due to their unique tax advantages. Unlike traditional corporations (C corporations), S corporations are not subject to federal income tax at the corporate level. Instead, the income, deductions, credits, and other tax attributes flow through to the shareholders, who report these items on their personal tax returns. This pass-through taxation can lead to certain complexities, particularly when it comes to undistributed earnings.
Each shareholder’s share of the corporation’s income, deductions, and credits is reported on a Schedule K-1 form. The shareholders must pay tax on this income regardless of whether they actually receive distributions from the corporation. This aspect of S corporation taxation ensures that the income is taxed only once, at the shareholder level, which is one of the primary benefits of electing S corporation status.
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 address this problem.
Distributions That Are Not Made
One of the more common issues that arise with S corporations is the treatment of undistributed earnings. Because the income of an S corporation is passed through to the shareholders, the shareholders are liable for taxes on their share of the corporation’s income even if they do not receive any actual distributions of cash or property. This can create financial difficulties for shareholders who may not have received enough cash from the corporation to pay their tax liability on the pass-through income.
In many S corporations, especially those with multiple shareholders, it is common to establish agreements that mandate the corporation to distribute enough cash to cover the shareholders’ tax liabilities. However, when such agreements are not in place, or if the distributions are not made, shareholders can find themselves in a challenging position, as they still owe taxes on their share of the income.
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.
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