Rocchio, TC Summary Opinion 2011-58
In a Summary Opinion, the Tax Court has held that a taxpayer had to report his pro rata share of a family-owned S corporation's income on his return even though, due to an ongoing family dispute, he had filed for judicial dissolution of the company and hadn't received income from the entity. However, due to the complexities surrounding the taxation of S corporation shareholders under State law in such a situation, no Code Sec. 6662(a) accuracy-related penalty was imposed.
Background. Under Code Sec. 1366(a)(1), all of an S corporation's items of income, loss, deduction, and credit are passed through to, and taken into account by, the corporation's shareholders in computing their own taxable income. Items are passed through separately if their separate treatment could affect the tax liability of a shareholder. Under Reg. §1.1366-1(a)(1), an S corporation must report, and a shareholder must take into account on his return, his pro rata share of the S corporation's items of income, whether or not distributed.
In the application of Federal tax law, State law controls in determining the nature of the taxpayer's legal interest in property. (U.S. v. National Bank of Commerce, (S Ct 1985) 56 AFTR 2d 85-5210) The Supreme Court has said that to determine State law in the context of a Federal tax case, the State's highest court is the best authority on its own law. If there are no decisions by that court, then federal authorities must apply what they find to be the state law after giving “proper regard” to relevant rulings of other State courts. (Comm. v. Estate of Bosch (S Ct 1967) 387 U.S. 456, 465)
Under New York State law (N.Y. Bus. Corp. Law §1104-a) applicable to the case at hand, holders of shares representing 20% or more of the votes of all outstanding shares of an S corporation could file a petition for dissolution if those in control of the corporation (1) were guilty of illegal, fraudulent, or oppressive actions toward the complaining shareholders, or (2) were wasting the corporation's assets. N.Y. Bus. Corp. Law §1118 provides for an irrevocable election and requires valuation of the shares by the court if the shareholders cannot agree on their fair value. The statute provides that the valuation date is the date before that on which the petition for dissolution was filed.
Facts. Richard Rocchio's parents each owned 50% in Leas-Co Leasing, Inc. (Leas-Co), a New York corporation. After his mother's death in '93, he and each of his three siblings inherited a 12.5% interests in Leas-Co. Sometime around 2000, Rocchio's father remarried. There were disputes within the family, and, as a result, his father became estranged from his children. Rocchio and his siblings received “little to nothing” from the company.
On Oct. 21, 2006, Rocchio and his three siblings filed for judicial dissolution of Leas-Co under N.Y. Business Corporation Law §1104-a (McKinney 2003). On Jan. 9, 2007, Rocchio's father elected to purchase the shares held by Rocchio and his siblings under N.Y. Bus. Corp. Law §1118 (McKinney 2003). However, because the parties couldn't agree on the fair value of the corporation, Rocchio's sale of his shares in Leas-Co to his father was delayed until Aug. 12, 2009, when the litigation on the matter was settled.
Leas-Co's 2007 Form 1120S, U.S. Income Tax Return for an S Corporation, reported $316,635 of ordinary business income. A 2007 Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., reported Rocchio's share of the ordinary business income as $39,579, consistent with his 12.5% interest. Rocchio didn't include this amount on his tax return. On audit, IRS determined that Rocchio should have reported this amount and assessed an accuracy-related penalty under Code Sec. 6662(a) for a substantial understatement of income tax.
Taxpayer's position. Rocchio contended that because his interest in Leas-Co was frozen statutorily and he was no longer entitled to participate in the management of Leas-Co under N.Y. law—as set out in the decision In re Gillman (Audio Den, Ltd.), (Sup. Ct. 1988) N.Y.L.J., Nov. 25, 1988—he wasn't liable for the income tax on his pro rata share of Leas-Co's income for 2007. He further contended that he had no liability because he never received the amount stated on his Schedule K-1 for 2007.
Court's conclusion. The Tax Court ruled that Rocchio had to report his pro rata share of the S corporation's 2007 income on his return. Analyzing N.Y. law, the Tax Court concluded that Rocchio's interest in Leas-Co did not abruptly end upon the filing for judicial dissolution and later election by his father to purchase his shares. On the contrary, Rocchio remained a shareholder in Leas-Co until the sale of his shares was complete in August 2009.
The Tax Court found Rocchio's reliance on In re Gillman (Audio Den, Ltd.), to be misplaced. The court in that case acknowledged that §1118 of N.Y. Bus. Corp. Law, and the remainder of Article 11 of N.Y. Bus. Corp. Law, did not provide guidance regarding the selling of a shareholder's rights to profits and dividends during “the hiatus which separates the filing of the dissolution petition and payment for his shares.” The Tax Court further noted that neither party cited any case from New York State's highest court deciding the narrow legal question at issue, and the Court itself wasn't aware of any such case.
In reaching its conclusion that N.Y.'s highest court would have concluded that Rocchio's status as a shareholder had not terminated, the Tax Court examined several cases. A N.Y. Court of Appeals case held that even when a corporation had been dissolved, the shareholder's interest didn't abruptly end. (Indep. Investor Protective League v. Time, Inc., (N.Y. 1980) 406 N.E.2d 486, 488) The N.Y. Supreme Court, Appellate Division, explained that a shareholder in a corporation remains one until payment was made for the fair value of his shares. (In re Davis, (App. Div. 1991) 571 N.Y.S.2d 234) Further, the U.S. District Court for the Eastern District of New York held that despite the filing for judicial dissolution and the election by the corporation to purchase the shares, the shareholder's interest wasn't put to an abrupt end by the election, and the shareholder remained entitled to the post-election dividend until the sale of the shares. (Stern v. Bambu Sales, Inc. (In re Spielfogel), (E.D.N.Y. 1999) 237 Bankr. 555)
The Tax Court also rejected Rocchio's contention that even if he were a shareholder in 2007, he wasn't liable for the tax on the income of Leas-Co for 2007 because he “never got the money.” Because he was a shareholder in Leas-Co until August 2009, regardless of whether the income from Leas-Co was distributed in 2007, he had to report his pro rata share of Leas-Co's income on his return.
No penalty imposed. The Tax Court held that Rocchio wasn't liable for the Code Sec. 6662(a) accuracy-related penalty. In view of the complexities surrounding the taxation of S corporations and their shareholders and the challenges of divining N.Y. State law, the Court found that Rocchio had reasonable cause to believe that he wasn't a shareholder of Leas-Co in 2007 and he did act in good faith with respect to the underpayment.
References: For taxation of S corporation shareholders, see FTC 2d/FIN ¶D-1761 et seq.; United States Tax Reporter ¶13,664; TaxDesk ¶614,701; TG ¶4771.