As I await the celebrated blizzard promised us in the Apple by the National Weather Service, I turn my attention to anti-freeze assisted by Judge Vasquez in Michael Howard Dalton, 2017 T. C. Memo. 43, filed 3/13/17.
No, this is not the anti-freeze one has in one’s automobile. I mean the kind that a partner, member or shareholder in a pass-through needs when s/he doesn’t call the shots, and therefore is at risk of being frozen out by unfriendly colleagues. Remember, tax is not imposed at entity level, but all tax incidents, the good, the bad and the ugly, pass through to the partner, member or shareholder.
In today’s entry, Mike and Brother John fell out figuratively, and Mike fell out literally, of their construction company, a Sub S. Mike departed after settling the litigation that followed the break-up, transferring his shares to Brother John.
Judge Vasquez doesn’t tell us whether Mike sold his shares or just handed them over, but that’s not the issue.
The Sub S reported for tax purposes on the completed contract method. This means that the Sub S recognized taxable income in the year when each contract was completed, even if payments were received or accrued, and costs paid or incurred, in a prior year. None thereof showed up on the 1120-S or the K-1s until the year of completion.
So in the year of the break-up, the Sub S filed a short year for the period January 1 through Mike’s exit date. The same CPA firm prepared both the short-year 1120-S and K-1s, and Mike’s and Anna’s 1040. And Mike’s 1040 showed a bunch of income from the Sub S for the short year.
Mike hand-wrote on the 1040 “(LINE 17 IS INCORRECT * * * WILL FILE AMENDED RETURN)”. 2017 T. C. Memo. 43, at p. 4. Line 17 on the 1040 is the bottom line for items on Schedule E (all that other income stuff, like rents, royalties, and pass-throughs).
Except he didn’t. And he and Anna signed the return, with the usual “under penalty of perjury” language. And Mike didn’t pay the tax shown on the return.
IRS assessed (no SNOD necessary for a self-assessed tax). Mike claimed on the 12153 he filed when he got the NITL “…TAX CALCULATED INCORRECTLY. ACCOUNTANT USED CREDIT LINE TRANSACTION AS INCOME.” 2017 T. C. Memo. 43, at p. 5. Mike likes capital letters. And Mike didn’t ask for any collection alternative.
The SO suggested a doubt as to liability OIC, but Mike’s number was way low, so NOD.
Mike claimed he got no cash from the Sub S, but Judge Vasquez puts Mike wise.
“An S corporation is not subject to Federal income tax at the entity level. Sec. 1363(a); see also Taproot Admin. Servs., Inc. v. Commissioner, 133 T.C. 202, 204 (2009), aff’d, 679 F.3d 1109 (9th Cir. 2012). Instead, 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. Sec. 1366(a); Mourad v. Commissioner, 121 T.C. 1, 3 (2003), aff’d, 387 F.3d 27 (1st Cir. 2004); see, e.g., Dunne v. Commissioner, T.C. Memo. 2008-63; sec. 1.1366-1(a), Income Tax Regs.” 2017 T. C. Memo. 43, at pp. 9-10.
And the lucky shareholder must pay tax, whether s/he got anything or not. I include citations here so that when you break the bad news to the client, you can prove you didn’t make this stuff up.
Mike claims the Sub S’s 1120-S was wrong, but can’t prove it.
Takeaway- When negotiating a buyout, break-up, shareholder’s agreement, operating agreement, partnership agreement or any other deal that gives rise to passthrough tax, require distribution of cash sufficient to pay tax for all passcatchers. And tell ‘em Mike sent you.