IRS Attempts to Impose Accumulated Earnings Tax After Inadvertent Termination

IRS Attempts to Impose Accumulated Earnings Tax After "Inadvertent Termination"

February 26, 2004

Why would a decision on accumulated earnings have an impact on Subchapter S? Are you up to speed on the importance of S corporation shareholder agreements?

Sponsored by Bisk Education, Inc.

This article, from Bisk Education's Monthly Audio Report: Tax News and Developments (February 2004), features an in-depth discussion between E. Lynn Nichols, CPA and Dr. William (Bill) Raby, Ph.D., CPA. It was found in the AICPA CPA2Biz section and is leader article to attract new subscriptions.

Advanced Delivery & Chemical Systems Nevada Inc.;

T.C. Memo. 2003-250;

IRC §§532,533 and 537.

Executive Summary: In Advanced Delivery & Chemical Systems Nevada Inc., the Tax Court refused to accept the IRS' argument that the shareholders of an S corporation that was inadvertently terminated were "tax sensitive" and had deliberately attempted to avoid the accumulated earnings tax. Bill Raby and Lynn Nichols explain why the corporation did not just seek relief from inadvertent termination and avoid the litigation altogether.

Learning Objective:Upon completion of this segment, the user should understand the importance of S corporation shareholder agreements.

At first glance, you might think a decision on accumulated earnings would have nothing to do with Subchapter S. After all, one of the reasons we make S elections is to avoid such Subchapter C unpleasantness. The reason we call this case to your attention is that the corporation thought it was an S corporation, and was surprised to learn that because a minority shareholder had transferred his shares to a partnership, the S election was terminated. That meant a lot of very sophisticated tax planning was for naught, and the company had unexpected exposure to tax on excess accumulated earnings. The case is presented with lots of facts that have nothing to do with what we see as the central issue: one shareholder; acting alone and in ignorance of the consequences can cause a lot of grief for an S corporation. Another issue that came up in the IRS audit was the assertion that because the corporation had engaged in complex tax planning, it was "tax sensitive" and "tax motivated" and justified an assumption that the corporation intended to avoid the accumulated earnings tax. Tax Court Judge Stephen Swift disagreed with the government on this issue, but it certainly added an unusual twist to the case. We asked Bill Raby why the corporation did not just seek relief from inadvertent termination and avoid the litigation altogether.

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Dr. Raby
I don't really know the answer to that, but bear in mind that this corporation that entered into a merger after this occurred. You had some changes that were taking place, and the question of inadvertent termination would have probably required, I think, the consent of the shareholder who did the inadvertent termination, and maybe some admissions on his part. I get the impression that there was a little ill feeling involved between the bulk of these shareholders and this one shareholder.

Mr. Nichols
It's possible that the shareholder, who initiated the terminating event, did so perfectly aware of what was going on, so there was no "inadvertent termination."

Dr. Raby
Inadvertent from the corporation's point of view.

Mr. Nichols
[That] is the whole issue here. A restrictive S corporation shareholders' agreement would have made this whole thing unnecessary.

Dr. Raby
That is a standard stock thing when you are forming a new [corporation] or making a new election. The problem that you have is often people don't think of the shareholder's agreement until you're down the road always. We have one situation like that now where the stock is somewhat widely dispersed and not in the hands, even, of the original holders of the stock. There are maybe 40 different shareholders out there, and there still is no shareholders' agreement because it is almost impossible to get these people to agree on anything. Each one of them hires his own lawyer, [who] wants changes made, and that isn't acceptable to that person. Finally, the controlling shareholder throws up his hands in disgust and says, Let's forget about; we'll take our chances. Shareholders' agreements [are] an absolute necessity, and if you don't suggest it to the client who is making an S election, especially if it's at a point where it's easy to implement, you probably, I would say, are close to being guilty of malpractice. Here, of course, if there had been a shareholders' agreement, there never would have been a problem. The problem arose because you had been operating as an S corporation, obviously without regard to any impact of dividend policy on shareholder taxes, because the dividend policy of the S corporation does not impact the shareholder taxes.

Mr. Nichols
But this corporation had previously accumulated C corporation earnings and profits.

Dr. Raby
That's true, and that complicates things very much. In this particular case, when they terminated their election, they didn't know the election was terminated for quite some time, so they did nothing that would have insulated them against the possibility of a penalty tax. It would have been relatively easy to have cleaned out the earnings, because you have this one-year period following the termination, but they didn't even know that they had a termination.

Mr. Nichols
They could have made an election to treat the distributions as being first from earnings and profits.

Dr. Raby
Right.

Mr. Nichols
There are two things as we talk about S corporation shareholder agreements. Shareholder agreements tend to be fairly standard, but in an S corporation there are two things in particular that you need to have. Number one, all the shareholders need to agree that they will join in any election that is desired by the owners of the majority of the shares, because some S corporation elections require 100-percent consent. The other provision you need, which is relevant to our topic in this item, is that you need to restrict the ability of a shareholder to transfer shares without approval of the corporation's counsel. Other than that, the S corporation shareholder agreement is a fairly standard deal.

Dr. Raby
In an S corporation, you can so set it up that the stock is being held by a voting trustee, and get rid of some of the little problems that may come up, including the problem of transferability. As long as that stock is in that voting trust, you can't transfer anything; at the most, you could try to assign your beneficial interest in the trust. That is extremely important. There are checklists, I think most of the standard tax-help things; PPC has an S corporation several volume manual that has a pretty good checklist on this type of thing.

Mr. Nichols
The AICPA Tax Division provides you each year with checklists.

Dr. Raby
Yes, but not on the shareholder agreement, I don't think. But the PPC thing does, I believe, provide that. In this particular case, of course, the inadvertence and lack of knowledge was actually a weapon in the litigation on behalf of the corporation.

Mr. Nichols
That's a whole other issue, the fact that you are tax savvy makes you more vulnerable to IRS assertions of intent? That's a new one.

Dr. Raby
These shareholders were tax-sophisticated people, and the IRS attorney was arguing that the very fact that they were tax-sophisticated led to the conclusion that the failure to pay dividends must be for the purpose of avoiding tax on the shareholders. Under the provisions that you were talking about, IRC §531, etc., that is kind of the ultimate question, what was your intent? The court [made] a very clear and very precise statement: "[The] legitimate misunderstanding of petitioner's management with regard to petitioner's subchapter S status and the single level tax applicable thereto runs counter to respondent's argument that avoidance of the shareholder level tax with respect to petitioner's retained earnings constituted the reason such earnings were retained and not distributed." [The S corporation shareholders] didn't even know they were saving anybody any taxes by not paying these dividends.

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