Fifth Circuit: Tax Court Did Not Err in Finding S Corp Election Was Not Terminated

Holding:

In this dispute relating to a deficiency determination, the U.S. Court of Appeals for the Fifth Circuit has ruled that the Tax Court was correct in affirming the Internal Revenue Service’s (“IRS”) assessment of deficiency against appellant Linda K. Minton. The Fifth Circuit held that that an agreement to provide monthly contributions from Long Preferred Products, Inc. (“LPPI”), a family-owned company with S-corporation status, to Minton’s parents did not create a second class of stock that caused their company to lose its S-corporation status. According to the Fifth Circuit, the burden of proof of showing that such contributions constituted a creation of second class of LPPI stock falls on Minton, who failed to carry such burden. Minton’s only evidence was her own testimony and LPPI’s distribution records from 1993 to 1998. This evidence demonstrated only that the parents received monthly distributions from LPPI. In this regard, Minton owed taxes on her share of LPPI’s income that she failed to pay. The Fifth Circuit therefore affirmed the Tax Court’s judgment.

Detailed Summary:

In her appeal from the Tax Court, Minton argued that a transaction among her, her parents, and her brother, all of whom were shareholders of LPPI, created a second class of stock thereby terminating the company’s status as a small business corporation. The Tax Court determined that the transaction did not create a second class of stock, and sustained the deficiency assessed against Minton.

LPPI is a family-owned janitorial and paper-supply company. Julian E. Long (“Julian”) and his wife Alma Long started LPPI in the 1950s and incorporated the business in 1976. Soon after its incorporation, LPPI sought and received S-corp treatment.

At the time, Julian and Alma were the sole owners of LPPI’s one hundred outstanding shares. As Julian and Alma aged, their children, Julian W. “Dooksie” Long (“Dooksie”) and Linda Minton, gradually took control of the company.

In 1986, Minton and Dooksie each supposedly purchased nineteen shares from their parents. Minton asserted that in exchange for these shares Alma and Julian received monthly distributions from LPP. Julian and Alma initially received $4,000 per month, but the amount was reduced to $2,000 when Alma died in 1990. There were no executed documents reflecting any of these transactions.

By 1996, through purchase, gift, and bequest, Julian and Alma had relinquished all of their shares to the children, and Minton and Dooksie each owned a 50% interest in LPPI. In 1997, a dispute arose. Minton and Dooksie determined that one would have to buy the other out. When the negotiations broke down, Julian and Dooksie attempted to squeeze Minton out. Minton then sued in Louisiana state court to establish her 50% ownership.

In the course of litigation, Minton’s counsel concluded that, based on an audio recording that was discovered, the monthly distributions to Julian and Alma constituted a preferential distribution of LPPI’s income, not a purchase payment for their stock by Minton and Dooksie. Minton’s counsel thus concluded that this preferential distribution created a second class of stock and automatically terminated LPPI’s S-corp status.

If LPPI’s S-Corp election was terminated, goes the thinking of Minton’s counsel, then LPPI was no longer a pass-through entity. Minton therefore personally owed no taxes on LPPI’s profits, but only owed taxes on money actually distributed to her by the company.

Upon her counsel’s recommendation, Minton did not report her share of LPPI income on her 1998 tax return, and filed amended returns for 1996 and 1997.

Soon thereafter, a revenue agent conducted an investigation and concluded that the monthly distributions did not evidence a second class of stock. Thus, LPPI was still an S-corp, and Minton owed taxes on her share of the income. The IRS assessed a deficiency of $165,366. Minton petitioned the Tax Court for a redetermination.

The Tax Court however ruled against Minton. It ruled that Minton failed to prove that the 1986 transaction constituted a binding agreement providing Julian and Alma disproportionate distribution rights.

Specifically, the Tax Court found that there was no evidence that the directors of LPPI took any formal corporate action sufficient to bind the company in a manner that affected distribution and liquidation rights of the S Corp.

Alternatively, the Tax Court found that, even if the 1986 transaction constituted a “binding agreement,” Minton failed to establish that the distributions were payments to Julian and Alma qua shareholders.

On appeal, the Fifth Circuit affirmed, stating that the Tax Court did not err in concluding that Minton failed to discharge her burden of proving that the 1986 transaction constituted the creation of a second class of LPPI stock.

Like the Louisiana state court and the Tax Court, the Fifth Court also found that there was very little evidence from which to discern the nature and form of the transaction.

According to the Fifth Circuit, this factor worked against Minton, who has the burden of proof. Minton’s only evidence was her own testimony and LPPI’s distribution records from 1993 to 1998. This evidence demonstrated only that the parents received monthly distributions from LPPI.  The Fifth Circuit wrote that the parties could have implemented a transfer of the shares from the parents to the children resulting in a fixed monthly payment to the parents in any number of ways.

The Fifth Circuit agreed with the Tax Court’s conclusion that the evidence as a whole suggested that it was more probable that the transaction was structured in a way that neither formally nor legally bound LPP.

“To be sure, Minton’s testimony in the Louisiana litigation suggested that she and Dooksie purchased the shares directly and the monthly payments by LPPI were simply made on their behalf,” the Tax Court wrote.

Finding no error in the Tax Court’s conclusion that Minton failed to carry her burden of proof, the Fifth Circuit accordingly upheld the Tax Court’s decision.

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