Shareholder Oppression, S Corps, & A Second Class of Stock?
July 16, 2018
Woe to the Oppressed Shareholder
As I write this post on Bastille Day, I am reminded how an oppressed people, realizing the injustice of their circumstances, and having reached the limits of their endurance, took the first step toward “replacing” the lords and ladies that had long lived lavishly on their labors. 
If only it were so straightforward for an oppressed shareholder, especially in a pass-through entity such as an S corporation. As a minority owner, they have little to no say in the management or operation of the business, or in the distribution of the profits therefrom. Oftentimes, they are denied information regarding the finances of the business, with one exception: every year they receive a Schedule K-1 that sets forth their share of the corporation’s items of income, deduction, gain, loss, and credit for the immediately preceding year.
As a matter of Federal tax law, they are required to report these K-1 items on their own income tax returns, and – regardless of whether or not they received a distribution from the corporation – they must remit to the IRS the resulting income tax liability.
As one might imagine, this may create a cash flow problem for the oppressed shareholder. They are typically denied employment in the business and, so, do not receive compensation from the corporation. Thus, in order to satisfy their tax liability attributable to the S corporation, they are often forced to withdraw cash from other sources, or to liquidate personal assets (which may generate additional taxes).
In some cases, the oppressed shareholder in an S corporation has sought to “revoke” the “S” election and, thereby, to stop the flow-through of taxable income and the resulting outflow of cash. 
An S corporation may lose its tax-favored status by ceasing to qualify as a “small business corporation,” which means that it admits an ineligible person as an owner, or it has more than one class of stock outstanding. The Tax Court recently considered a situation in which an oppressed shareholder sought to use the disproportionate sharing of economic benefits between the shareholders as a basis for concluding that the corporation had more than one class of stock.
So Much for Egalité et Fraternite
Taxpayer and his brother (“Bro”) incorporated Corp. During the years in issue, Taxpayer owned 49% of the shares of Corp, and Bro owned 51%. The brothers elected to treat Corp as an S corporation for Federal income tax purposes. They also agreed that distributions would be proportional to their ownership shares.
Taxpayer, Bro and Bro’s spouse (“B-Spouse”) were the directors of Corp, and each participated in its business. Bro served as Corp’s president, B-Spouse as corporate secretary, and Taxpayer as vice president. Bro directed the administrative aspects of Corp’s business, while B-Spouse was Corp’s office manager. Bro and B-Spouse were responsible for the corporation’s bookkeeping and accounting.
Taxpayer’s work for Corp primarily involved managing operations in the field. He spent most of his working hours at jobsites, not in the office. Taxpayer received compensation as an employee of Corp for the years in issue.
Prior to the years in issue, Corp filed Forms 1120S, U.S. Income Tax Return for an S Corporation, and issued Schedules K-1 to Bro and Taxpayer. These filings reflected that the shareholders received cash distributions from Corp proportional to their stock ownership.
During the years in issue, Taxpayer began to examine more closely the administration of Corp’s business.
Taxpayer noticed that certain credits cards in his name, which he maintained for business purposes, were being used without his authorization to pay personal expenses of Bro’s children. Shortly thereafter, he reviewed the corporation’s QuickBooks records and determined that numerous items, including handwritten checks drawn on its bank accounts, had not been entered into the corporation’s accounting records. He also obtained and reviewed online banking statements for the corporation’s bank accounts. Taxpayer determined that, during the years in issue, Bro and B-Spouse had been making substantial check and ATM withdrawals from Corp’s bank accounts without his knowledge. 
Also during this period, Corp’s business began to struggle. Taxpayer received calls from Corp’s vendors who had tried unsuccessfully to contact Bro and B-Spouse regarding payments that they were owed and wanted to know when they would be paid. Corp had trouble paying its employees, and some of its checks were returned. Taxpayer had multiple discussions with Bro and B-Spouse about Corp’s cash flow problems. They told him that they were working on getting more money into the business.
Taxpayer became frustrated with the progress of Corp’s business and with the discussions that he was having with Bro. Finally, Taxpayer sent Bro an email stating that if Bro would not help him try to remedy the business, then Taxpayer would have no choice but to resign and sell his shares to Bro for a nominal amount. Bro responded that he would accept that offer effective immediately.
With that, Taxpayer completed some tasks for ongoing projects, and then quit his work for Corp. He never received payment from Bro for his shares of Corp.
The IRS Audit
Taxpayer filed Federal income tax returns for the years in issue. He attached Schedules E to the returns for these years, on which he listed Corp as an S corporation in which he held an interest. Taxpayer did not report any items of income or loss from Corp for the years in issue – these lines were left blank.
Taxpayer also attached to these returns Forms 8082, Notice of Inconsistent Treatment, relating to his interest in Corp, on which Taxpayer notified the IRS that he had not received Schedules K-1 from Corp.
Corp did not file Forms 1120S or issue Schedules K-1 for the years in issue. The IRS examined Corp, and prepared substitute tax returns using Corp’s banking records, general ledger, available employment tax returns, and other records to determine the corporation’s income and allowable deductions. The IRS allocated Corp’s net income as ordinary income to Taxpayer and Bro according to their 49% and 51% ownership shares, respectively.
The IRS also analyzed the shareholders’ distributions for the years in issue. For one year, the IRS determined that Taxpayer received less than one-third the amount of the distributions actually or constructively received by Bro; for the other year, it found that Taxpayer received less than one-ninth the amount of the distributions received by Bro. The IRS prepared basis computation worksheets for Taxpayer’s shares of Corp, and determined that Taxpayer was not required to include the distributions that he received in gross income for the years in issue because the amounts did not exceed his adjusted stock basis.
The notice of deficiency issued to Taxpayer determined increases to his Schedule E flow-through income for the years in issue, based upon the determinations set forth in the substitute returns prepared by the IRS for Corp.
Taxpayer disagreed with the IRS’s determination, and timely petitioned the Tax Court. Taxpayer contended that the income determined for Taxpayer – i.e., 49% of Corp’s net income for each of the years in issue – should not be attributable to him. 
Second Class of Stock?
Generally, an S corporation – or an electing “small business corporation” – is not subject to Federal income tax; rather, it is a conduit in that its income “flows through” to its shareholders, who are required to report and pay taxes on their pro rata shares of the S corporation’s taxable income.
The Code defines a small business corporation as a domestic corporation which must satisfy a number of requirements, including the requirement that it not have “more than 1 class of stock.” 
Generally, a corporation will be treated as having only one class of stock “if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.” 
Once an eligible corporation elects S corporation status, that election is effective for the tax year for which it is made and for all succeeding tax years until it is terminated. The Code provides that an election shall be terminated automatically whenever the corporation ceases to qualify as a small business corporation.
When Taxpayer and Bro organized Corp, they clearly intended to create one class of stock. They agreed that all distributions would be proportional to their stock ownership, and their tax filings before the years in issue reflected that their shares of stock each had equal rights to distributions. Corp elected to be treated as an S corporation. For years before the years in issue it filed Forms 1120S and issued Schedules K-1 to Taxpayer reflecting his pro rata shares of the corporation’s taxable income.
Taxpayer contended that Corp’s “S” election was terminated during the years in issue because it ceased to be a small business corporation. Specifically, he contended that Corp no longer satisfied the requirement that it have only one class of stock – Bro withdrew large sums of money from Corp’s bank accounts during the years in issue without Taxpayer’s knowledge, and the IRS’s computations showed that Bro and Taxpayer received distributions for the years in issue that were not proportional to their stock ownership. Taxpayer argued that “these substantially disproportionate distributions appear to create a preference in distributions and . . . effectively a second class of stock”. He contended that Corp should be treated as a C corporation, and that Taxpayer should be taxed only on the distributions that he received, which he contended should be treated as dividends.
The Court’s Analysis
According to the Court, in determining whether a corporation has more than one class of stock, the rights granted to shareholders in the corporation’s organizational documents and other “binding agreements” between shareholders have to be considered. The applicable IRS regulations, the Court stated, provide that “[t]he determination of whether all outstanding shares of stock confer identical rights . . . is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).”
Evidence of distributions paid to one shareholder and not to others over the course of multiple years was insufficient on its own, the Court stated, to establish that a separate class of stock was created.
The Court concluded that Taxpayer had failed to prove that a binding agreement existed that granted Bro enhanced or disproportionate “rights to distribution and liquidation proceeds.” Rather, the Court found that, at most, there had been “an informal, oral understanding among the board members/shareholders”, and there was no evidence that the directors or shareholders ever took “formal corporate action to implement that understanding.”
The original, operative agreement between Corp’s shareholders (Taxpayer and Bro) was that distribution rights for each of their shares would be identical. Taxpayer testified that he and Bro never discussed changing the agreement regarding distributions and, during the years in issue, his understanding continued to be that distributions should be proportional to stock ownership. The record reflected that the shareholders never reached, or even considered, a new binding agreement that would change their relative rights to distributions.
Taxpayer argued that Bro’s withdrawals “effectively changed . . . [the shareholders’ agreement] by majority action.” However, the Court replied, nothing in the record indicated that Bro intended to act as Corp’s majority shareholder to grant himself rights to disproportionate distributions. Taxpayer offered no evidence of any actions taken at the corporate level to redefine shareholders’ rights or to issue a new class of stock. Moreover, he did not establish that a unilateral change of the kind described (i.e., the creation of a new class of stock) would be allowable under the applicable State law.
Taxpayer contended that the Court should regard “the substance of the actions” taken by Bro as creating a second class of stock. The Court noted, however, that Taxpayer’s own tax returns for the years in issue identified Corp as an S corporation. It then explained that taxpayers are generally bound by the form of the transaction that they choose unless they can provide “strong proof” that the parties intended a different transaction in substance. There was no proof, the Court observed, that either Taxpayer or Bro intended an arrangement different from that which they agreed to and reported consistently on their tax filings.
In short, Bro’s withdrawals during the years in issue did not establish that he held a different class of stock with disproportional distribution rights. Taxpayer failed to show that there were any changes to Corp’s governing provisions. Thus, he failed to carry his burden of proving that Corp’s election to be treated as an S corporation terminated during the years in issue and, consequently, the Court sustained the IRS’s determination that Taxpayer should be allocated 49% of Corp’s net income for each of the years in issue.
C’mon . . .?
Yes, on some visceral level, the Court’s decision seems harsh. But it is important to distinguish between the administration of the Federal tax system, on the one hand, and the protection of an oppressed shareholder, on the other. The latter may suffer certain adverse tax consequences as a result of a controlling shareholder’s inappropriate behavior, but they should not expect the Federal government to right those wrongs; rather, they have recourse to the courts and the laws of the jurisdiction under which the corporation was formed, and which govern the relationships among the shareholders and with the corporation itself.
That being said, shareholders have to be aware of what the Federal tax laws provide in order that they may take the appropriate steps to protect themselves, regardless of the size of their stockholdings. These steps are typically embodied in the terms of a shareholders’ agreement. 
As the Court explained, a determination of whether all outstanding  shares of stock confer identical rights to distribution and liquidation proceeds – i.e., whether there is only one class of stock – is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (for example, a shareholders’ agreement).
Although a corporation is not treated as having more than one class of stock so long as these 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.
A commercial contractual agreement, on the other hand, such as a lease, employment agreement, or loan agreement – such as may be entered between the corporation and a controlling shareholder – is not treated as a binding agreement relating to distribution and liquidation proceeds unless a principal purpose of the agreement is to circumvent the one class of stock requirement (for example, where the terms are not at arm’s-length).
Similarly, buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights. Although such an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have other tax consequences. 
However, if a principal purpose of the agreement is to circumvent the one class of stock requirement, and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the FMV of the stock, the one-class of stock rule may be violated.
Again, it will behoove a shareholder of an S corporation to appreciate the parameters described above.
 Alliteration has its place.
 This raises the question: do the shareholders have a shareholders’ agreement and, if they do, does it restrict the transfer of shares, or require that the shareholders preserve the corporation’s tax status?
 Basically, constructive dividends. Less euphemistically, theft?
 The Court began its discussion by pointing out that, in general, the taxpayer bears the burden of proving that the IRS’s determinations set forth in the notice of deficiency are incorrect. In cases of unreported income, however, the IRS bears the initial burden of producing evidence linking the taxpayer with the receipt of funds before the general presumption of correctness attaches to a determination. Once the IRS meets this burden of production, the Court explained, the burden of persuasion remains with the taxpayer to prove that the IRS’s deficiency calculations were arbitrary or erroneous.
Corp failed to file income tax returns or to maintain adequate books and records for the years in issue. The IRS obtained banking records and conducted bank deposits analyses to determine the company’s net income. Bank deposits are prima facie evidence of income, the Court stated, and the “bank deposits method” was an acceptable method of computing unreported income.
The Court found that the IRS satisfied the burden of production with respect to the unreported income items at issue.
 https://www.law.cornell.edu/uscode/text/26/1361 .
 Reg. Sec. 1.1361-1(l). https://www.law.cornell.edu/cfr/text/26/1.1361-1.
 When Taxpayer and Bro were still on good terms, they should have agreed that Corp would make regular tax distributions, at least annually.
 The reference to “outstanding” shares is important; an S corporation’s certificate of incorporation may authorize the issuance of a preferred class of stock, but so long as such preferred class has not been issued and remains outstanding, the “S” election will remain in effect.
 For example, gift tax.