In Uncategorized on 11/14/2016 at 16:35

IRS’ counsel seems to have a limited grasp of how distributions from S Corps are taxed in Philip Joseph Franklin, 2016 T. C. Memo. 207, filed 11/14/16.

Phil’s various delictions take up 32 pages of Judge James S. (“Big Jim”) Halpern’s prose, but only one is of interest today.

At the behest of a creditor and his accountant, the books of one of Phil’s sub S Corps shows a loan to shareholder of $218K at the start of one of the years at issue, and zero at the end thereof. IRS claims that the release of the debt was an ordinary dividend. Phil claims that the $218K was money gotten from the sub S in prior years upon which he paid tax, which was mischaracterized as a loan.

“Respondent’s [IRS’] argument on brief raises principally an issue of timing and not one of character (i.e., whether the distribution constituted a dividend).  We say that because, unless an S corporation has accumulated earnings and profits, no distribution of property (including money) by the corporation to a shareholder with respect to his stock will constitute a dividend within the meaning of section 316(a).  Sec. 1368(b) and (c).  Instead, distributions by an S corporation with no accumulated earnings and profits to a shareholder with respect to his stock are excluded from the shareholder’s gross income to the extent that the distribution does not exceed the adjusted basis of the shareholder’s stock.  See sec. 1368(b)(1). Any excess is treated as gain from the sale or exchange of property.  See sec. 1368(b)(2).” 2016 T. C. Memo. 207, at p. 14.

Well, as sub S Corps are pass-throughs, how can there be accumulated earnings and profits?

Judge Big Jim tells us. The main source is what was still held by a C Corp when it converted to S, which goes into the AAA. That’s not the guys with the tow truck and jumper cables, that’s the accumulated adjustment account, wherein is held those leftover earnings and profits.

But Phil’s C Corp went S three days after it was incorporated, so no chance to pick up that kind of earnings and profits. And there is no evidence of any reorganizations that would trigger Section 1371(c)(2) adjustments.

IRS has no evidence of what Phil’s basis might have been.  But Phil has a demand from the aforesaid creditor, and testifies that he had guaranteed the S Corp’s debt. And Phil swears the creditor grabbed and sold Phil’s own property in partial satisfaction of the debt.

We all know that payment by guarantor subrogated guarantor to creditor, making guarantor creditor of debtor instanter (as the Supremes and the high-priced lawyers say). Corporate debt to shareholder is part of shareholder basis in S Corp stock. But there must be payment; Phil’s claim he guaranteed more than what the creditor seized from him doesn’t cut it. Pay to play, Phil.

However, Judge Big Jim has a bonus for Phil.

“Indeed, it may be that, as indicated by [Sub S’] negative accumulated adjustments account, petitioner could…deduct an increased passthrough loss….  See sec. 1366(d)(2).  Petitioner, however, has made no such claim, and the issue is not before us to decide.” 2016 T. C. Memo. 207, at p. 22. (Footnote omitted, but read it. Phil could make a Rule 41(b) motion to conform pleadings to proof and claim a bigger loss than the $218K, based on how much the creditor took from Phil personally).

In short, it’s time for IRS’ counsel to reread Eustice, Kunz & Bogdanski’s tome on taxation of S Corps. The 2015 edition.


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