On September 17, 2020, the Tax Court issued its opinion in Deckard v. Commissioner, 155 T.C. No. 8. The primary issue presented in Deckard was whether as the officer and director of a Kentucky non-stock, non-profit corporation (as constrained by Kentucky law and the company’s articles of incorporation), the taxpayer had an ownership interest in the company equivalent to that of a shareholder for purposes of applying the passthrough loss provisions of subchapter S of the Code.
A Fabulous Plan Gone Awry Because of Kentucky
The road to hell is paved with good intentions. The road to Milan, apparently, passes through Louisville, Kentucky. That is what Clinton Deckard believed when he sunk $275,000 into a Louisville fashion week through his company Waterfront Fashion Week, Inc (“Waterfront”).
The petitioner had been advised to create a nonprofit, tax-exempt entity to conduct the fashion week. He was advised that a tax-exempt entity would encourage sponsors to make tax-deductible contributions, and his attorney never advised that the sponsors might be able to deduct sponsorships as a trade or business expense even if the legal entity lack tax-exempt status. Neither did the hapless attorney advise the petitioner that a nonprofit, tax-exempt corporation formed under the laws of Kentucky could not, in any event, have a shareholder or make distributions.
Waterfront was organized in 2012 as a nonstock, nonprofit corporation under the Kentucky Nonprofit Corporation Act. The articles of incorporation stated that Waterfront “shall be a nonprofit corporation.” The petitioner was Waterfront’s president in one of three directors. Waterfront never applied for recognition of tax-exempt status with the IRS. The fashion week was held from October 17 to October 19, 2012. The fashion event, being held in Kentucky, not quite the Mecca of the fashion world, failed to breakeven.
In 2014, Waterfront mailed to the IRS a Form 2553 (Election by a Small Business Corporation), electing to be treated as an S corporation retroactively as of the date of its incorporation 2012. The petitioner signed the Form 2553 indicating that he had 100% ownership in Waterfront. The company untimely filed its Form 1120S for 2012 and 2013 in January 2015, reporting operating losses of $278,000 in 2012 and $3000 in 2013, respectively. In 2015, the petitioner filed untimely Forms 1040 for 2012 and 2013. On Schedule E, the petitioner reported pass-through, nonpassive losses from Waterfront in the same amount. The IRS issued a notice of deficiency disallowing the reported pass-through losses on the grounds that Waterfront had not made a valid S corporation election and, alternatively, that the petitioner was not a shareholder or member of Waterfront in 2012 or 2013.
S Corporation’s Generally
Subchapter S allows a qualified corporation, with the consent of all its shareholders, to be treated as a passthrough entity for purposes of Federal income tax. Secs. 1361-1366. Consequently, an S corporation, unlike a traditional C corporation, generally pays no Federal income tax.5 Instead, a shareholder of an S corporation must report a pro rata share of the S corporation’s taxable income, losses, deductions, and credits. IRC § 1366(a)(1)(A); Treas. Reg. § 1.1366-1(a); see Gitlitz v. Commissioner, 531 U.S. 206, 209 (2001); Maloof v. Commissioner, 456 F.3d 645, 647 (6th Cir. 2006), aff’g T.C. Memo. 2005-75.
Not a Shareholder of Record
It seems almost elementary that a corporation that is not authorized issue stock, and in fact issued no stock, but not, in any event, have a shareholder of record…there being no shares and all. Nevertheless, the petitioner made a spirited argument in support of his cross-motion for partial summary judgment. He argued that he was the sole decision-maker and had “complete control” over the fashion week. Furthermore, he “abandoned plans” for Waterfront to obtain federal’s tax-exempt status, and he began treating Waterfront as a “for-profit business that [the petitioner] owned entirely.”
Notwithstanding the fact that the petitioner treated Waterfront as a for-profit entity, the fact remained that it was formed under the laws of Kentucky (not just the “laws” of backcountry, Appalachian Kentucky). It is true that the subchapter S regulations provide that “ordinarily, the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation) is considered to be the shareholder of the corporation” Treas. Reg. § 1.1361-1(e)(1).
“The question whether a person was a shareholder on the date of the election to be taxed under subchapter S is equivalent to the question whether, had there been a valid election, he would have been required to report as personal income profits earned by the corporation on that date.” Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 616 (7th Cir. 1995), aff’g in part, rev’g in part on other grounds T.C. Memo. 1994-316. The resolution of this question turns, in turn, on whether the person would have been deemed a beneficial owner of shares in the corporation, entitled therefore to demand from the nominal owner the dividends or any other distributions of earnings on those shares. Id.
Looking at State Law
To answer the question of whether a person is the deemed beneficial owner of corporate stock, the Tax Court looks to state law to determine whether a person is a beneficial owner of corporate shares. Id. at 617 (citing United States v. Nat’l Bank of Commerce, 472 U.S. 713, 722 (1985), Aquilino v. United States, 363 U.S. 509, 513 (1960), and United States v. Denlinger, 982 F.2d 233, 235 (7th Cir. 1992)); accord Pahl v. Commissioner, 150 F.3d 1124, 1129 (9th Cir. 1998), aff’g T.C. Memo. 1996-176; Swenson v. Commissioner, 37 T.C. 124, 131 (1961), rev’d on other grounds, 309 F.2d 672 (8th Cir. 1962). The petitioner provided no authority, and the Tax Court could find no case addressing the beneficial ownership in a nonstock, nonprofit corporation for purposes of subchapter S. This is likely because most of the cases and authorities have held that nonprofit corporations are generally not considered to have owners or shareholders. See, e.g., Farrow v. Saint Francis Med. Ctr., 407 S.W.3d 579, 593 (Mo. 2013).
The reason nonprofit corporations are not generally considered to have owners is that they are prohibited from distributing profits to insiders who are in positions to exercise control, such as members, officers, or directors. See Austin v. Mich. Chamber of Commerce, 494 U.S. 652, 675 n.6 (1990) (Brennan, J., concurring). Consequently, the Tax Court found that there is no interest in a nonprofit corporation equivalent to that of a stockholder in a for-profit corporation who stands to profit from the success of the enterprise.
The prohibition on the distribution of profits is clearly embodied in the Kentucky Nonprofit Corporation Act, which governs the formation, operation, and dissolution of nonstock, nonprofit corporations in Kentucky. As a Kentucky nonstock, nonprofit corporation subject to the provisions of the Act, Waterfront had no stock and could issue no stock. Consequently, petitioner does not fall within the four corners of the regulation which ordinarily treats as an S corporation shareholder the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation). Treas. Reg. § 1.1361-1(e)(1). Furthermore, the petitioner did not otherwise possess an ownership interest in Waterfront equivalent to that of a shareholder, nor did he possess dissolution rights typical of shareholder.
Substance Over Form Argument
You can fault the petitioner for a number of things, including being a serially dilatory filer, but you can’t fault him for being persistent (or, I am guessing, a snappy dresser). The petitioner argued that he intended Waterfront to be a for-profit entity and “objectively operated” the company “consistently with it being a for-profit entity that he owned entirely.” The only fact inconsistent with Waterfront being a for-profit entity, so the petitioner argues, is that it was formed by the attorney as a nonprofit corporation prior to when “the economic realities of the project came to light.” Although, the petitioner admits, he should have changed the corporate documents, he was “mistakenly unaware of these formalities of corporate law.”
Unfortunately for the petitioner, the IRS does not take kindly to the ostrich approach to tax planning. Silly hiding one’s head in the sand and hoping for the best is not likely to prevail on a substance over form argument. Consequently, the Tax Court held that taxpayers are generally bound to the form of the transaction they choose.
Unfortunately for the petitioner, the Supreme Court has likewise held – rather on point, I may add – that although a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not.” Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974). The Second Circuit added a bit of color to the conversation when it noted that it would be “quite intolerable” to “pyramid the existing complexities of tax law” by permitting a rule that the tax should result from the form of the transaction that taxpayers wanted rather than the form that taxpayers actually chose. Television Indus., Inc. v. Commissioner, 284 F.2d 322, 325 (2d Cir. 1960).
In his swansong, the petitioner argues that because Waterfront never again tax-exempt status – which the court notes that Waterfront never, technically, saw – it should be regarded as a for-profit corporation. The Tax Court was less than impressed by the argument, noting that the company’s decision not to seek federal tax-exempt status has “no bearing” on its status as a nonprofit corporation under Kentucky law or on the ownership constraints imposed thereunder. As a consequence of the foregoing, the Tax Court held that the petitioner was not a stockholder of corporation that could not, legally, issue stock.
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Although this appears to be a rather simplistic conclusion, it took 24 pages and the full Tax Court opinion to reach it. Then one realizes that it was Judge Lauber who wrote the opinion, and, though an impressive jurist in his own right, brevity is not his strongest suit…