Or, If You Choose the Form, You’re Stuck With the Substance

That’s the takeaway from Judge Cohen’s dissection of Jess Miller’s corporate machinations in Jess L. Miller, 2011 T.C. Mem. 189, filed 8/9/11.

Jess had an S corp of which he was sole shareholder. In the year before the year at issue, he entered into a contract of sale with his son, to sell Sonny a majority interest. The contract set no closing date; Jess was supposed to resign as officer and director at closing (which never happened so he never did); and Sonny was supposed to pay Jess $95K, which he didn’t do either. Incidentally, Jess had amended the Certificate of Incorporation of his S corp to create a second class of stock, but although Judge Cohen mentions this, the corp is still treated as an S corp throughout.

Jess later filed a 709 claiming he gifted his son 95% of the S corp in the year before the year at issue.

In the year at issue, Jess got substantial cash distributions from the S corp, disproportionately greater to his now-minority interest, and Sonny got less than he should have gotten, given his majority interest. The S corp apparently had neither current nor accumulated E&P, so the only question was whether the distributions  Jess got exceeded Jess’ basis in his S corp stock, and therefore were taxable as long-term capital gains. Section 1368(b) controls.

Judge Cohen: “For S corporations without accumulated earnings and profits, distributions are not included in a shareholder’s gross income to the extent that they do not exceed the adjusted basis of the shareholder’s stock (but are applied to reduce basis), while any distribution amount in excess of basis is treated as gain from the sale or exchange of property. Sec. 1368(b). For purposes of section 1368(b), a distribution is taken into account on the date the corporation makes the distribution, regardless of when the distribution is treated as received by the shareholder. Sec.1.1368-1(b), Income Tax Regs.

“The parties agree that petitioner’s [Jess’] JAM stock basis was $866,795 before he transferred 95 percent of his shares to his son. On his 2002 Form 709, petitioner reported that his adjusted basis in stock transferred by gift on December 31, 2002, was $823,456. Respondent notes that in the notice of deficiency, petitioner’s adjusted basis in his remaining 5,000 shares after the transfer of JAM shares to his son was improperly calculated as $51,661 (instead of $43,339), but respondent does not argue for application of a figure other than $51,661.” 2011 T.C. Mem 189, at pp. 8-9.

Jess claimed he didn’t give Sonny the stock until the year at issue, not the prior year, but his original 709 and the stock ledger book of the S corp say otherwise. Then Jess argues that the transfer to Sonny was part gift and part sale. No, says Judge Cohen, your contract of sale says what you should have done, and you didn’t do it. And there is no sign of any payment for the stock, so no sale.

Since the distributions were certainly disproportionate, Jess argues they didn’t create a second class of stock but should be recharacterized, citing Regulation Section 1.1361-1(l)(2)(i), which provides, in part:

“Although 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, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.”

Jess argues that the facts and circumstances test should not be applied to change the character of the distributions, but rather to change the date of transfer of the shares. Misplaced, says Judge Cohen. The facts and circumstances clearly show when the stock was transferred.

Judge Cohen again: “It is well established that ‘a transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred’ and that ‘while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not’. Commissioner v. Natl. Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-149 (1974).” 2011 T.C. Mem. 189, at p. 10.

In short, choose the form, and you’re stuck with the substance.