Is a taxpayer a beneficial owner of an S corporation?
Taxpayer Says: He does not have to report income from an S corporation because he has no say in management of the corporation, and therefore is not a beneficial owner.
Internal Revenue Service Says: The taxpayer’s inability to participate in the S corporation does not relieve him of the requirement to report the income.
From Internal Revenue Code Section 1363(a): An S corporation is not subject to federal income tax at the entity level.
From Internal Revenue Code Section 1366(a): An S corporation’s items of income, gain, loss, deduction, and credit–whether or not distributed–flow through to the shareholders, who must report their pro rata shares of such items on their individual income tax returns for the shareholder taxable year within which the S corporation’s taxable year ends.
From Federal Tax Regulation 1.1361-1(e): When the record owner of S corporation stock holds that stock for the benefit of another, such as a nominee, an agent, or a passthrough entity, then income, losses, deductions, and credits of the corporation are passed through not to the record owner but to the beneficial owner of the stock.
From Anderson v. Commissioner, 164 F.2d 870 (7th Cir. 1947), aff’g 5 T.C. 443 (1945): A taxpayer is the beneficial owner of property if the taxpayer controls the property or has the economic benefit of ownership of the property.
From Hightower v. Commissioner, T.C. Memo. 2005-274: We have previously noted that cases applying the beneficial ownership test involve an arrangement between parties who had some agreement or understanding regarding their relationship with each other. We have held that when one shareholder merely interferes with another shareholder’s participation in the corporation as a result of a poor relationship between the shareholders, such interference does not amount to a deprivation of the economic benefit of the shares.
THE CAUSE OF THE DISPUTE
When you own shares in a subchapter S corporation, the corporation gives you an annual tax form (Schedule K-1) showing your share of the corporate income, deductions and other items. When you’re a beneficial owner, you report the information on your personal tax return and pay the tax personally.
In a closely held corporation, you’re generally a beneficial owner when you own stock and have a role (even if a minor or merely formal role) in corporate governance, and you bear risk of losses and benefits of successes—that is, when you have an economic interest instead of mere legal title.
In this case, the taxpayer, a radiation oncologist, owned 40% of the outstanding shares of an S corporation he formed with another doctor. He and the other doctor began arguing, and the taxpayer was shut out of the corporation’s operation and management during 2005 (and subsequent years).
The corporation made no distributions to its shareholders during 2005, and did not pay the taxpayer any wages during that year (or subsequent years). The corporation issued a Schedule K-1 for 2005, showing the taxpayer’s share of the corporation’s ordinary business income as $215,920 and his share of interest income as $2,344. He listed the K-1 on Schedule E of his personal federal tax return, but did not include any of the income.
Following litigation, which was settled in 2012, the taxpayer sold his stock to the corporation in a total redemption of his interest. The settlement agreement provided that he would no longer be a shareholder of the corporation as of December 31, 2011.
He says he did not have to report the 2005 K-1 income because he was not a beneficial owner of the corporation since he could not participate in the business and was improperly excluded from the benefits of ownership of the stock.
The IRS says one shareholder is not able to take beneficial ownership of stock away from another shareholder without an agreement between the two of them or a provision in the corporation’s governing articles to that effect. An argument between shareholders, even when one shareholder interferes with the other’s participation in the corporation, does not amount to a deprivation of the economic benefit of the shares. The K-1 income is reportable and taxable.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.