STJ Peter (“HB”) Panuthos tells the sad tale of Joshua M. Yaguda and Joeli Yaguda, T. C. Sum. Op. 2022-21, filed 10/20/22. Josh and Jo have 10% of EFI (a Sub S Corp), while daughter (under age 18 in year at issue) has 5%. EFI comes unglued in the Black ’08, and files Ch 11, but the year before Josh goes down for State securities fraud.

EFI gets run by a Court-appointed bankruptcy trustee, who runs the business and liquidates the assets, leaving Josh, Jo, and daughter with a $97K deficiency plus five-and-ten substantial understatement chop. Meantime, the local DA in the securities fraud case gets a receiver appointed to hold the Sub S stock for the benefit of the defrauded, but said receiver does nothing. Josh and Jo get the K-1s showing gains, but don’t report same, although they file timely and report everything else. The bankruptcy trustee told Josh and Jo that the State receiver effectively abandoned the Sub S stock.

Josh and Jo claim the State receiver should get the gain and pay the taxes, as the State court ordered the receiver to get the stock. In the case of a bankrupt S Corp, the S Corp is not a separate estate, and its shareholders still get the pass-through tax incidents even if they get no benefit therefrom; see Sections 1398 and 1399.

“Petitioners submitted the record in the criminal proceedings in support of the receivership’s notice purportedly assuming ownership of the EFI interest. The Lis Pendens notice includes the EFI interest, and the sentencing transcript notes that petitioner’s interest in EFI, subject to the bankruptcy proceedings, is assigned to the District Attorney’s Office…. Nevertheless, the record does not support a finding that the receivership exercised control or ownership of the EFI interest. Rather, the sentencing hearing transcripts reflect the [State] court’s intention to defer to the bankruptcy trustee, requesting information about the proceedings and any distributions. Even if the receivership had authority to claim the EFI interest, in the letter… the bankruptcy trustee informed petitioners that the receivership trustee had abandoned the EFI interest, leaving the shares in the ownership of petitioners.” T. C. Sum. Op. 2022-21, at p. 5.

Alternatively, Josh and Jo claim they abandoned the EFI stock. But the caselaw says abandonment must be manifested by an affirmative act, and there’s none in the record. Intention is insufficient.

Any 468B Qualified Settlement Fund argument fails, as the State receiver never took ownership of the stock.

IRS stuck Josh and Jo with daughter’s EFI phantom gain, which they try to foist onto daughter. But the Kiddie Tax (Section 1(g)) puts paid to that move.

STJ Panuthos tempers the wind to the shorn lamb. Josh and Jo avoid the chop.

“Petitioners made a reasonable, good faith effort to correctly assess their tax liability. Petitioners timely filed their tax return, reported other passive income, and provided documentation in support. Further, they relied on the assistance of a CPA in preparing their return. It was not entirely clear from the proceedings in the [State] Court and the bankruptcy court the tax treatment of the shares in EFI.

“Given the complexity of the interplay between the bankruptcy proceedings and the receivership, and further noting that petitioners did not actually receive any funds as a distribution from EFI, we conclude that petitioners’ failure to include the distributive share of income of EFI in the year in issue does not subject them to the penalty that respondent determined.” T. C. Sum. Op. 2022-21, at p. 9.