In a recent Tax Court opinion, the Court granted the IRS’ motion for summary judgment holding that a state law Nonprofit corporation could not election to be treated as S corporation for federal income tax purposes.[1] Clinton Deckard attempted to make an S election for Waterfront Fashion Week, Inc., a Nonprofit corporation organized under the laws of Kentucky (“Waterfront”). In doing so, he also attempted to deduct losses from Waterfront on his personal income tax return. However, the Court disagreed and granted the IRS’ motion for summary judgment disposing of the issue without trial.
Facts
Waterfront was formed on May 8, 2012 as a Kentucky Nonprofit corporation under the Kentucky Nonprofit Corporations Act (the “Act”). The Articles of Incorporation for Waterfront (the “Articles”) provided that the organization was to be “a Nonprofit corporation organized for all lawful charitable purposes…[with] the primary mission…to raise money for the conservation and maintenance of the Waterfront Park located in Louisville, Kentucky.” The Articles also provided that the organization was “exclusively for charitable and educational purposes” referencing Section 501(c)(3) of the Internal Revenue Code[2]. The Articles also contained the standard language found in most, if not all, Nonprofit corporations which provides that “no part of the net earnings of the organization shall inure to the benefit of, or be distributable to its directors, officers or other private persons.”
The Articles also provided that Waterfront was not to have members. Clinton Deckard and two other individuals were appointed as the directors of Waterfront. The Articles required a two-thirds vote of the directors to dissolve the entity.
In 2013, the Secretary of State of Kentucky administratively dissolved Waterfront for failure to file its annual report. The report was filed and Waterfront was reinstated. In 2014, Waterfront was again administratively dissolved for failure to file its annual report. This time, Waterfront did not reinstate and instead remained dissolved.
On October 28, 2014, Waterfront filed Form 2553 with the IRS electing to be taxed as an S corporation retroactive to the date of formation.[3] On the Form 2553, which requires shareholder consent, Deckard indicated he owned 100% of the shares in Waterfront. Waterfront filed its 2012 and 2013 Form 1120-S returns in January of 2015, both untimely. The returns reported losses of $277,967 and $3,239 respectively, and issued Forms K-1 for such losses to Deckard. In May of 2015, Deckard filed his Form 1040 returns for 2012 and 2013, both untimely and both claiming the losses flowed through from Waterfront. The IRS denied the losses on the grounds that the S-election was invalid, and alternatively, that Deckard was not a shareholder of Waterfront.
Analysis
The Court began its analysis discussing summary judgement, which is meant to expedite litigation and avoid unnecessary trials.[4] Pursuant to Tax Court Rule 121(b), the Court may grant summary judgment when there is no genuine issue as to any material fact. The moving party, in this case, the IRS, had the burden of proving this.
Next, the Court discussed its S corporation analysis. Corporations may make an S-election only with the consent of all shareholders.[5] Thus, from the Court’s perspective, the issue turned on whether Deckard was a shareholder of Waterfront. In its analysis, the Court noted several important factors it considered in its analysis, the first two being negative for Deckard and the latter three being in his favor:
- Deckard was not a shareholder of record;
- Waterfront was not authorized to issue stock and there was no evidence as to the issuance ofany stock;
- Deckard was the sole decision maker for Waterfront;
- After failing to attract sponsors, Waterfront abandoned its plans to run as a Nonprofit and Deckard began running Waterfront as a for profit business; and
- Waterfront never sought tax-exempt status from the IRS.
Pursuant to Treas. Reg. §1.1361-1(e)(1), under ordinary circumstances, the person who would include dividends in gross income were the entity a C corporation is the shareholder. If the person is the beneficial owner of the shares, then he or she may be considered a shareholder for S corporation purposes.[6] Ultimately, the issue turned on state law to determine whether Deckard was the beneficial owner of Waterfront and could therefore be considered a shareholder under the Cabintaxi analysis.
Citing numerous law review articles as well as a case out of Missouri, the Court concluded that Nonprofit corporations generally do not have shareholders, are not owned by third-parties, whether individuals or entities, and there is no interest in a Nonprofit corporation akin to that of a stockholder of a for-profit corporation.
Moving on to the Act, the Court noted that the prohibition on the distribution of profits to an individual was clearly prohibited. The Act defines a Nonprofit corporation as “as corporation no part of the income or profit of which is distributable to its members, directors, or officers.”[7] Further, Waterfront’s Articles themselves prohibited such distributions.
The Court also emphasized certain facts that indicated Deckard was not a shareholder since he did not possess standard shareholder rights. Deckard had no ownership, no rights to profit as discussed above, did not have dissolution rights a shareholder would typically have, and had no right to assets of Waterfront upon dissolution.
Deckard countered these arguments with the fact that, while he initially intended that Waterfront to be a Nonprofit corporation and obtain tax-exempt status from the IRS, he abandoned that plan sometime in August of 2012, assumed complete control, and attempted to make a profit from Waterfront. Deckard argued that the concept of “substance over form” should be applied to this case, and while the form may have been that Waterfront was a state law Nonprofit corporation, the substance of what was taking place was that it was being run for profit. We previously discussed the “substance over form” doctrine here as applied in another case where the taxpayer attempted to reclassify transactions, and unfortunately as Deckard found out and the article is titled, this doctrine is “No Friend of the Taxpayer”
In rebuffing these arguments, the Court noted that control of the corporation was still vested in the board of directors, of which Deckard only had 1 of 3 votes. Further the Court addressed the “substance over form” argument with a classic quote from the United States Supreme Court, “while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choices, whether contemplated or not.”[8] Waterfront established itself as a Nonprofit corporation with the all the rights and obligations of a Nonprofit corporation under the Act, and Waterfront was bound by its decision.
The last issued argued by Deckard was that Waterfront was not tax-exempt by the IRS, and thus it should be regarded as a for-profit corporation for federal income tax purposes. However, the Court opined that the decision to not seek tax-exempt status had no bearing on its status as a Nonprofit corporation under the Act or on the ownership, or lack thereof, under the Act.
Conclusion
In the end, the Court analyzed the issue thoroughly and ultimately concluded there was not even a dispute as to whether Deckard was a shareholder of Waterfront. He was not and accordingly, summary judgment was appropriate. There was no reason for the Court to discuss any alternative arguments made by the IRS or get into any issues on the untimeliness of the election and tax returns in this case.
S corporations are subject to their own set of special requirements which are found in Sections 1361 through 1366. In addition to the special requirements of making the S election itself, numerous other special restrictions are imposed on S corporations that are not imposed on C corporations or partnerships. It is not uncommon to see a case or Private Letter Ruling addressing inadvertent violations of the rules whereby the S corporation status was accidentally terminated and the taxpayer suffered disastrous consequences, or would have but for the IRS issuing a favorable, but no doubt expensive, Private Letter Ruling.[9] It is important to seek competent tax advice any time you are structuring a business, but even more so when dealing with S corporations due to the stringent technical requirements imposed by Sections 1361 through 1366. When Deckard abandoned his plans to run Waterfront as a nonprofit in August of 2012, it’s quite possible he could have converted to a for profit corporation and the results might be much different.
[1] Deckard v. Commissioner, 155 TC 8 (2020).
[2] All references to a Section or § are to a Section or Section so the Internal Revenue Code.
[3] In general, pursuant to § 1362(b)(1), an S election will only be effective retroactively if made within three months and fifteen days of the start of the taxable year. However, Revenue Ruling 2013-30 provides grounds for relief for a late election. This issue was not raised by the IRS and thus not discussed by the Court.
[4] Fl. Peach Corp. v. Commissioner, 90 TC 678 (1988).
[5] §1362(a)(2).
[6] Cabintaxi Corp. v. Commissioner, 63 F.3d.614 (7thCir. 1995).
[7] Ky. Rev. Stat. Ann. Sec. 273.161(1).
[8] Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 US 134 (1974).
[9] For some recent examples, see PLRs 201935010, 201936005, 201930023.
