A taxpayer who was the president and one of the directors of a state law not-for-profit corporation was not a shareholder in the corporation and could not claim passthrough losses from it as an S corporation shareholder.
Background
Waterfront Fashion Week Inc. (Waterfront) was organized under the Kentucky Nonprofit Corporation Acts as a nonstock, not-for-profit corporation in 2012. The organization was created to put on an event called "Waterfront Fashion Week" (the event) to raise funds to benefit the Waterfront Development Corp., a not-for-profit organization that maintains the Louisville Waterfront Park in Louisville, Ky. The primary individual behind Waterfront was Clinton Deckard, who was its president and one of its three directors.
The event ended up losing money, and Waterfront never made a donation to the Waterfront Development Corp. Because insufficient funds had been raised by an event organizer hired by Waterfront to put on the event, Deckard had assumed complete control over the event and contributed $275,000 to Waterfront (over 85% of its operating costs). Deckard claimed, when he took over control of Waterfront, that he gave up plans to obtain federal tax-exempt status for it and began treating it as a for-profit business he owned.
In 2013, the Kentucky secretary of state administratively dissolved Waterfront for failure to file its 2013 annual report, but it was reinstated as a corporation after a reinstatement application was filed. It was again administratively dissolved for failure to file an annual report in 2014 and was not reinstated after that. Nonetheless, in October 2014, Waterfront made an election to be an S corporation retroactive to the date of its incorporation in 2012. Deckard signed the election form and signed the form's shareholder consent statement that indicated he held a 100% ownership interest in Waterfront.
In 2015, Waterfront filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for its tax years 2012 and 2013, reporting operating losses of $277,967 and $3,239 for 2012 and 2013, respectively. Attached to the Forms 1120S were Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., reporting that Deckard had 100% stock ownership of Waterfront during 2012 and 2013. Later in 2015, Deckard filed Forms 1040, U.S. Individual Income Tax Return, for his tax years 2012 and 2013. He reported passthrough, nonpassive losses from Waterfront of $277,967 and $3,239 for tax years 2012 and 2013, respectively.
The IRS audited Deckard's 2012 and 2013 returns and ultimately issued him a notice of deficiency disallowing his claimed passthrough losses from Waterfront, finding that Waterfront had not made a valid S corporation election or, alternatively, that Deckard was not a shareholder or member of Waterfront for tax years 2012 and 2013.
Deckard challenged the IRS's determination in Tax Court.
The Tax Court's decision
The Tax Court held that Deckard was not entitled to the passthrough losses from Waterfront. It found that Deckard could only deduct the losses if he was a shareholder in Waterfront for purposes of Subchapter S, and the court concluded that as a matter of law he was not.
According to the Tax Court, it was undisputed that Deckard was not a shareholder of record, as Waterfront was not authorized to issue stock and in fact had no shares of stock. Deckard, however, argued that he should be considered Waterfront's sole shareholder because he held exclusive beneficial ownership of the corporation.
Regs. Sec. 1.1361-1(e)(1) "ordinarily" treats as an S corporation shareholder "the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation)." This means that a person is a shareholder on the date S corporation status is elected if the person, if a valid election had been made, would have been required to include the profits earned by the corporation as personal income. In turn, whether a person is required to include the corporation's profits in income depends on whether the person is a beneficial owner of shares entitled to demand the dividends or other distributions of those shares from the nominal owner of the shares. The determination of whether a person is a beneficial owner of corporate shares is based on state law. However, the Tax Court found no case law addressing beneficial ownership in a nonstock, not-for-profit corporation for purposes of Subchapter S.
The Tax Court explained that not-for-profit corporations are not generally considered to have owners because they are prohibited from distributing profits to insiders who are in positions to exercise control, such as members, officers, or directors. Consequently, there is no interest in a not-for-profit corporation equivalent to that of a stockholder in a for-profit corporation who stands to profit from the success of the enterprise.
Looking at the Kentucky Nonprofit Corporation Acts, the Tax Court found that under them, to be a not-for-profit, nonstock corporation, a corporation must meet two requirements: it cannot pay a dividend or distribute any part of its income or profits to its members, directors, or officers; and it cannot issue stock.
Thus, because Waterfront was a nonstock, not-for-profit corporation governed by the Kentucky Nonprofit Corporation Acts, Waterfront had no stock and could not issue any. Consequently, Deckard was not a shareholder under Regs. Sec. 1.1361-1(e)(1) because that provision requires that a person be required to include in income "dividends distributed with respect to . . . stock."
The Tax Court also found that Deckard did not otherwise possess an ownership interest in Waterfront equivalent to that of a shareholder. Because he was the president and a director of Waterfront, the Acts expressly prohibited any income or profit from Waterfront from being distributed to him or inuring to his benefit. This was, the court observed, "fundamentally incompatible with the purpose and operation of subchapter S, which generally taxes an S corporation's income currently at the shareholder level." Furthermore, under the Acts, which required assets to be distributed for exempt purposes under Sec. 501(c)(3) or to a public-purpose entity, Deckard lacked the dissolution rights in Waterfront typical of a shareholder.
Deckard also asserted that the Tax Court should disregard Waterfront's form as a not-for-profit corporation and instead should look to its substance as a for-profit entity. Under Supreme Court precedent, taxpayers are generally bound by the form of the transaction they choose (National Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974)). The court found no reason to depart from this principle because nothing in the record suggested that there was an incongruity between Waterfront's form and its substance. Deckard argued he had mistakenly organized Waterfront as a not-for-profit corporation, but the record suggested that Deckard had purposely formed Waterfront as a not-for-profit corporation so that it could obtain federal tax-exempt status and solicit tax-deductible donations.
Finally, Deckard further argued that because Waterfront never had tax-exempt status for federal tax purposes, it should be regarded as a for-profit. He reasoned that corporations that do not have tax-exempt status are deemed to be for-profit, and for-profit corporations have shareholders. Thus, since Waterfront did not have tax-exempt status, it was a for-profit corporation, and he was its shareholder. The Tax Court summarily dismissed this argument, explaining that it confused federal tax-exempt status with not-for-profit corporation status under state law. Thus, the fact that Waterfront had never received federal tax-exempt status had no bearing on its status as a not-for-profit corporation or Deckard's status as a shareholder of it.
Reflections
Although neither party raised the issue, and the court was not required to address it, the court's opinion included a footnote in which it expressed doubt as to whether, if Deckard was not a shareholder in Waterfront, the court had jurisdiction to determine if Waterfront's S corporation election was valid. The court noted that in a number of cases where an S corporation shareholder was challenging a deficiency notice that included S corporation adjustments, it had held that it has jurisdiction to redetermine those adjustments in a shareholder-level proceeding. However, it had never addressed a case like Deckard's that involved a deficiency notice brought by an individual who was not a shareholder of the entity that the individual claimed was an S corporation.
Deckard, 155 T.C. No. 8 (2020)
