If You Rely On State Law, Especially If It’s Unclear

That’s the takeaway from Richard J. and Jacqueline Rocchio, 2011 T.C. Sum. Op. 58, released 5/11/11. It’s another 7463 with some good principles, so you can argue it even if you can’t cite it. Unclear State law could save the taxpayer.

Richard J. was a stockholder in the family Sub S along with his siblings, but the Sub S was run exclusively by Papa. When Mama died and Papa married Wife Number 2, Papa spent all the Sub S’s profits on Wife Number 2 and cut Richard J. and the siblings out. The Sub S was a New York corporation, so under New York law Richard J. and the siblings sued for dissolution of the Sub S.

New York law provides that where stockholders seek dissolution, the non-dissolvers can buy out the dissolvers’ shares at fair value. Papa bought out Richard J. and siblings, but between buy-out and pay-out, the Sub S had taxable income, for which the Sub S filed an 1120-S, and sent Richard J. a K-1. Richard J. did not report the K-1 income on his and Jacqueline’s 1040, claiming he had been bought out before the income was earned and never got any of the income.

IRS sought unpaid tax, interest and Section 6662(a) substantial understatement penalty.

No penalty, says Tax Court. While New York law says you value the stock as of the day before dissolution, New York law seems to be that the stockholder isn’t out until he’s out. There isn’t a totally clear answer from the New York State Court of Appeals, New York State’s highest court. Under New York State’s somewhat eccentric structure, the Court of Appeals is New York State’s highest court; paradoxically, the New York State Supreme Court is its lowest court of general jurisdiction. As they say in New York, go figure.

So while various New York trial courts and intermediate appellate courts say that the bought-out but not paid-out shareholder is entitled to dividends and other income, and perhaps other benefits and burdens of share ownership, given the complexities of Sub S taxation and no clear guidance from the New York Court of Appeals, Richard J. at least had the minimal reasonable basis and good faith excuse for not paying.

He does owe the tax and interest, of course. But Special Trial Judge Armen softens the blow at the very end of his decision: “Finally, we observe, without commenting on the validity of such, that petitioner may have a remedy pursuant to New York State law with respect to the undistributed earnings…reported on the Schedule K-1….” 2011 T.C. Sum. Op. 58, at p. 13.