In a recent Tax Court case, Maggard v. Commissioner, the court ruled that unauthorized, disproportionate distributions within an S corporation did not terminate its S corporation status, highlighting the importance of proper documentation and governance for business owners.
S Corporations and Classes of Stock
One of the key requirements for a corporation to qualify for maintaining an S election to allow for pass through taxation is that there can only be a single class of stock and that all distributions and allocations of income of an S corporation must be made on a pro rata basis. If this requirement is ever violated, then generally the S corporation’s S election is terminated and the company immediately becomes a C corporation subject to corporate level taxation and potential double taxation to shareholders.
S Corporation Court Decision
In the recent tax court decision of James J Maggard V Commissioner (TC Memo 2024-77) the tax court ruled that a second class of stock wasn’t created when one shareholder embezzled funds for his own benefit without paying matching distributions to the other shareholders. In this case, the S election was not terminated and the court concluded that in the absence of an agreement between shareholders to disproportionately make distributions, the shareholders rights to distributions provided in the corporation’s governing documents would control whether a second class of stock exists or not, regardless of the actions of the individuals.
How to Proceed
This decision can provide some comfort to S corporation taxpayers who may have inadvertently made disproportionate distributions to one or more shareholders at any point in time and intend to correct the imbalance. If a corporations S election is ever terminated voluntarily or not there is normally a five year waiting period before it can re-elect subchapter S status.
By Ben Hubbell
Partner
