The Tax Court held that the taxpayers' poor relations with other shareholders of an S corporation did not affect their ownership interest in the corporation, so the taxpayers were required to include their pro rata share of its income and other tax items on their joint return. Further, one of the other shareholder's alleged misappropriation of funds from the S corporation did not give rise to a theft loss deduction for the taxpayers.
Jay Enis was an expert in financing transactions and assisted client businesses with financing purchase orders. He worked in partnership with Jack Burstein through Burstein's merchant banking firm, Strategica Capital Associates. In 2004, the two men came into contact with Mark Ginsburg and his company, NLS.
NLS was a Florida S corporation founded by Ginsburg and his sister, Ricki Robinson. NLS was a diagnostic laboratory supplying blood diagnostic testing to end-stage renal dialysis patients throughout the country. In 2004, Ginsburg sought the help of Enis and Burstein to deal with issues NLS was facing. Ultimately, in September 2006, NLS entered into a Financial Advisory and Business Consulting Agreement (consulting agreement) with Strategica.
Under the consulting agreement, Strategica would, for a payment of $60,000 a month, provide the following services: settling existing liabilities, diversifying the business, and implementing a financial infrastructure. In addition, Strategica group members or their designees would receive 50% of NLS's stock (the Strategica group stock), with Ginsburg and Robinson getting the other 50%. Enis and Burstein agreed that Enis's wife, Sue, would get half of the Strategica group stock.
It was not long, however, before the relationship between Strategica and NLS began to deteriorate. Enis approached Ginsburg concerning certain NLS expenses that Enis believed were personal and unrelated to diagnostic blood testing, money spent on ancillary business ventures, and how Ginsburg treated employees. Enis also took issue with Ginsburg's prioritizing personal financial obligations over those of NLS. However, Ginsburg's financial dealings were never reported to the police, and he was never charged with a crime in connection with them.
At some point in 2009, Ginsburg retaliated by refusing to allow members of Strategica and the Strategica group shareholders to enter NLS's premises. He further instructed NLS's CFO to stop providing financial information to Strategica and the Strategica group shareholders, and, in April 2009, NLS stopped paying Strategica for consulting services.
In August 2009, Strategica sued Ginsburg in state court for breach of the consulting agreement and failure to pay consulting fees and expenses. In February 2010, Ginsburg filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the Southern District of Florida. After the issue had been in litigation for a while, Mrs. Enis sold her interest in NLS for $436,165 in 2014.
The Enises' return
The Enises filed joint returns for 2007 and 2010. On the returns, they did not include any of the income or other items reported to them on Mrs. Enis's NLS Schedule K-1. They also claimed a theft loss deduction in both years, based on Ginsburg's purported use of NLS corporate funds for personal purposes.
The couple attached a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), regarding Mrs. Enis's ownership interest in NLS, to the 2010 return. On the form, the Enises stated that they had not included the amounts reported for the year on Mrs. Enis's Schedule K-1 from NLS because she did not have an ownership interest in NLS. According to the Enises:
The entity and certain shareholders have prevented the taxpayer from exercising their [sic] shareholder rights including: sale of shares, voting on business matters, exercising dominion and control of the ownership interest, or enjoying any economic benefits or other ownership rights. . . . Therefore until legal ownership is resolved by the court, it was improper for the controlling shareholders to issue a Schedule K-1 to the taxpayer, and those amounts are not reported in this return.
The IRS determined deficiencies for 2007 and 2010, claiming that the Enises should have included the amounts from the NLS Schedules K-1 on their returns for both years and that they were not entitled to a theft loss deduction for either year.
The Tax Court's decision
The Tax Court held that Mrs. Enis was the owner of NLS in 2007 and 2010, and the Enises were required to report her pro rata shares of S corporation items of the company's income and other tax items on their returns for both years. The court further held that the couple were not entitled to take a theft loss on their return for either year.
Ownership of NLS: Regarding stock ownership for federal income tax purposes, the Tax Court found that ownership depended on whether the shareholder had beneficial ownership of shares, rather than on whether the shareholder merely had legal title, citing Ragghianti, 71 T.C. 346 (1978), aff'd, 652 F.2d 65 (9th Cir. 1981). The court further found that, under its precedent from Kumar, T.C. Memo. 2013-184, mere interference with a shareholder's participation in the corporation as a result of a poor relationship between the shareholders does not result in the shareholder's being deprived of the economic benefit of the shares or having beneficial ownership of the corporation, unless there is an agreement passing the taxpayer's rights to his or her stock to another shareholder.
In Tax Court, the Enises had identified no agreement or provisions in the corporation's governing articles removing beneficial ownership. Thus, under its precedent, the Tax Court concluded that the poor relationship between the Enises and Ginsburg had not deprived Mrs. Enis of the economic benefit of her NLS shares, which the court noted was proved by the fact that she had actually sold the shares for over $400,000 in 2014. Thus, the court concluded the Enises were required to include Mrs. Enis's pro rata share of NLS's income and other tax items on their joint returns for 2007 and 2010.
Theft loss: Generally, to substantiate a theft loss deduction, a taxpayer must prove both that a theft actually occurred under the law of the relevant state or an applicable federal criminal statute and the amount of the loss. Under Florida law:
A person commits theft if he or she knowingly obtains or uses, or endeavors to obtain or to use, the property of another with intent to, either temporarily or permanently:
(a) Deprive the other person of a right to the property or a benefit from the property.
(b) Appropriate the property to his or her own use or to the use of any person not entitled to the use of the property. [Fla. Stat. §812.014(1)]
The Enises asserted that a theft under Florida law occurs when individuals use corporate funds for personal purposes without the assent or knowledge of other shareholders. However, the court found they had failed to prove that Ginsburg committed a theft under Florida law or applicable federal criminal statutes, because the court could not find that Ginsburg had the requisite intent to commit a theft against NLS solely on the evidence that Ginsburg used corporate funds for personal expenses.
The court observed that Ginsburg concealed neither his loan to NLS nor the subsequent payments made against the loan, and the loan was recorded in the corporation's financial statements and books, which, at least initially, were available to the Strategica group shareholders. Thus, although certain of Ginsburg's actions might have been against the interest of the Strategica group shareholders, and might have violated the shareholders' agreement, they did not constitute a theft for purposes of Sec. 165.
As this case, and others such as Kumar, demonstrate, a taxpayer cannot get out of the tax implications of the ownership of an interest in an S corporation simply because of disputes with another shareholder. Absent an agreement among the shareholders that allows one shareholder to strip the beneficial ownership from another shareholder, or a provision in the corporation's governing articles to that effect, the aggrieved shareholder continues as the beneficial owner of the S corporation shares and is responsible for a pro rata share of the S corporation's income and other tax items.
Enis, T.C. Memo. 2017-222