Heads You Win, Tails I Lose: Lessons from Maggard

Many taxpayers elect to have their small business taxed as an S corporation to take advantage of favorable pass-through tax treatment. However, with these favorable provisions come strict eligibility requirements. Most taxpayers who run afoul of S corporation regulations risk an inadvertent termination of their S corporation election. Yet, as the recent case Maggard illustrates, disproportionate distributions are not enough to terminate an election – even if it causes inequitable results.

S Corporation Requirements

Legally, an S corporation operates as a corporation and offers owners limited liability protection. For tax purposes, it functions like a partnership by passing income, losses, deductions, and credits directly to its shareholders. Shareholder owners typically receive wages reported on W-2 but must also report and pay taxes on their share of non-distributed income (which benefits from not being subject to self-employment taxes).

S corps are subject to multiple requirements, and failure to comply with each requirement can result in the automatic termination of an entity’s S election and reversion to C corporation status for federal income tax purposes. Among these is the requirement that an S corporation have only one class of stock.

Under Treasury regulations, an S corporation is treated as having one class of stock if all outstanding shares confer identical rights to distributions and liquidation proceeds. Whether this requirement is met is determined by reference to the S corporation’s governing provisions – such as a corporate charter, articles of incorporation, applicable state law, or any binding shareholder agreements. If those provisions grant all shares identical rights to distributions and liquidation proceeds, the one-class-of-stock requirement is satisfied. (Note: The regulations also provide specific rules for distributions made to account for state law requirements for payment and withholding of income taxes.)

Background of Maggard v. Commissioner

James Maggard co-founded Schricker Engineer Group in 2000 and incorporated the company in 2002. The articles of corporation provided that the corporation was authorized to issue 10,000 shares of stock, all of which were one class, with a par value of $0.00. The corporation then issued all 10,000 shares of stock. In 2003, Maggard brought on two new shareholders, LL and WJ, to replace his departing co-founder. By 2005, LL and WJ had collectively acquired a controlling interest in Schricker, with JJ holding 40% and WJ holding 20%. The articles of incorporation were not amended.

Without Maggard’s knowledge, both LL and WJ used their control of Schricker to enrich themselves. They inflated expense reports and issued disproportionate distributions that excluded Maggard, in direct contradiction of the corporation’s governing documents. Between 2005 and 2016, they failed to file Form 1120S or issue Maggard a Schedule K-1. In 2012, Maggard finally became aware of these discrepancies and confronted LL and WJ, who denied any wrongdoing.

Maggard filed suit against them in California, where the court found that LL and WJ had overdistributed to themselves and failed to pay Maggard his rightful share. The court ordered a corrective distribution in 2016. Maggard instead accepted an offer to sell his shares to LL and WJ for $1,262,500 in a 2018 settlement.

In the interim of the judgement and settlement, Maggard attempted to file his tax returns from 2014-2016. Relying on estimates from LL, he reported a $300,000 loss for 2014, income of $50,000 for 2015, and no income or loss for 2016. LL finally filed the company’s Forms 1120S for tax years 2012-2016 in 2018 and issued K-1s to Maggard, which allocated profits, not losses, to Maggard for those years, despite his never actually receiving distributions. The IRS issued Maggard a notice of deficiency and disallowed his losses.

Maggard’s Inadvertent Termination Argument

The IRS argued that Maggard was required to pay tax on his share of income regardless of whether it was actually distributed to him, as S corporations are treated as pass-through entities. Maggard argued that the corporation’s S election should have been terminated before the tax years at issue due to repeated disproportionate distributions, which he argued violated the “one class of stock” requirement. The IRS disagreed, arguing that the corporation’s S election remained valid as the articles of corporation conferred identical rights to distributions and liquidation proceeds. The agency argued that the regulations only require that the governing documents do not create unequal rights in the stock to the extent that it creates more than one class of stock.

The Tax Court sided with the IRS, holding that although unequal distributions were made, no formal changes were made to the governing documents, so the one-class-of-stock rule was not violated. This holding is in line with IRS guidance provided in Rev. Proc. 2022-19, which states that disproportionate distributions alone do not terminate an S election.

Takeaways for Taxpayers

The holding in Maggard is hardly groundbreaking, but it does provide a cautionary tale or comfort, depending on the outcome taxpayers are seeking. Taxpayers who wish to take advantage of an S election should keep the following in mind:

1. Substance does not override form. Disproportionate distributions, even in cases involving clear breaches of fiduciary duty, do not automatically terminate an S election. Eligibility turns on what is in the governing documents, not how distributions are made in practice.
2. LLCs taxed as S corporations carry structural risk. While LLCs can elect S status if taxed as corporations, many use operating agreements written for partnership treatment, which often include language that unintentionally violates the one-class-of-stock rule. Such agreements should be carefully reviewed and properly drafted with S corporation compliance in mind.
3. Some errors can be fixed at no cost. Rev. Proc. 2022-19 allows S corporations to correct certain governing document issues, such as provisions implying unequal distribution rights, without a fee or private letter ruling (PLR).
4. Routine document audits are essential. Practitioners should regularly review their clients’ S corporation governing provisions to identify and correct noncompliant language before it creates costly problems.

While S corporations have many advantages, taxpayers should evaluate carefully if an S election is appropriate for their business. A trusted tax advisor can assist with making this decision and help taxpayers meet the requirements. Contact us below to see how we can assist.