Do Disproportionate Distributions Terminate a Company’s S Status?
The Maggard v. Commissioner Tax Court Opinion
S Corporations are required to have one class of stock. In this article, the author discusses the recent Maggard v. Commissioner U.S. Tax Court opinion and addresses whether a disproportionate distribution violates the one class of stock requirement.
In any financial analysis of a company, we must consider potential tax liabilities. Since many small businesses operate as S corporations, the possibility of their S status being terminated retroactively can be a major concern.
One potential way to intentionally or unintentionally terminate S status is to violate the requirement that the company have only one class of stock.
Internal Revenue Code section 1361(b)(1)(D) allows a corporation to be an S corporation only if it has no more than one class of stock. Differences in common-stock voting rights may not violate that rule according to Code section 1361(c)(4). However, could disproportionate distributions among the shareholders create varying classes of stock? If so, could the payment of unreasonable compensation to one shareholder lead to that result if the Internal Revenue Service reclassed the excessive portion of the pay as a distribution?
The Tax Court recently addressed this issue in Maggard v. Comm., T.C. Memo. 2024-77.
In this case, the Tax Court focused on Treas. Reg. section 1.1361-1(l)(1) which says, “[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.” The Court went on to say that the “regulation also tells us to determine whether stock confers identical rights to distributions and liquidation proceeds based on the corporation’s governing provisions.” These documents could include a corporate charter, articles of incorporation, and/or bylaws.
The Court referred to Rev. Proc. 2022-19 which says, “the IRS will not treat any disproportionate distributions made by a corporation as violating the one class of stock requirement of section 1361(b)(1)(D) so long as the governing provisions of the corporation provide for identical distribution and liquidation rights.”
The Court sympathized with the individual who had complained about other shareholders who he said had made unauthorized and grossly unequal distributions to themselves. However, the Court concluded that the Code and regulations had not been violated since nothing had authorized or formally created a second class of stock.
The Court ruled that the regulation’s language and case law (Mowry v. Commissioner, 116 T.C.M. (CCH) 55 (2008),) led it to hold that disproportionate distributions alone do not change a company’s S corporation status. Although the unauthorized distributions in this case had been hidden from Mr. Maggard, the company’s governing documents still allowed only one class of stock. And, although the distributions were substantial, those distributions had not been memorialized by formal amendments to the company’s governing documents. Without such memorialization, there was no real change to that company’s single class of stock. And this means that, under Treasury Regulation § 1.1361-1(l)(2), the Court could not revoke the company’s S status due to its disproportionate distributions.
Stephen Kirkland, CPA, CMC, CFF, is a compensation consultant and expert witness at Atlantic Executive Consulting, LLC. He serves as an expert witness in cases involving potentially unreasonable compensation.
Mr. Kirkland may be contacted at (803) 724-1414 or through ReasonableComp.biz, at Stephen.Kirkland@AECG.biz.
