The taxpayer who did not receive his proportionate share of distributions due to embezzlement contended that the disproportionate distributions violated the one class of stock rule of §1361(b)(1)(D), and argued that the corporation’s S status should have been terminated, requiring all the corporation’s income to be reported on Form 1120 and the tax paid by the corporation. The Tax Court cited Reg. §1.1361-1(l)(1), which states “[A] corporation is 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” and held that the disproportionate distributions among the shareholders were irrelevant. Shareholder rights are defined by the governing documents of the corporation, not the actual practices of the shareholders. This decision aligns with IRS guidance in Rev. Proc. 2022-19, 2022-41 IRB 282, which the court referenced.

Thank goodness the judge did not side with the taxpayer, albeit an unfortunate outcome for the taxpayer in this specific case because he was required to report his share of S corporation income, notwithstanding the misappropriation by the other shareholders. Given the widespread occurrence of disproportionate distributions, many of which are inadvertent and corrected within a relatively short period of time, a contrary holding could potentially jeopardize the S corporation status of numerous corporations.

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The latest flow-through developments and many other flow-through planning transactions will be discussed in detail at our 2024 Tax Forum programs that begin this fall, and we expect spirited discussion during our live Q&A sessions. Register now to ensure your spot at your preferred program.

See a summary of the anticipated topics to be covered at the 2024 Tax Planning Forum and at the 2024 Fundamentals of Flow-Through Seminar.

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