Locked Out S Corporation Shareholder Still Taxable


In a recent Tax Court case, a 40% shareholder of an S corporation medical practice was locked out of the office and the practice by the 60% shareholder. Nonetheless, at the end of the tax year, the S corporation issued a Form K-1 to the 40% shareholder allocating to him $215,920 of business income and $2,344 of interest income.

The 40% shareholder sought to disallow the allocation of income to him, since he could not participate in the business. His theory was that by reason of the lockout, he ceased to be the beneficial owner of the shares. Points should be given for the creative theory, even though it was not successful.

A taxpayer is the beneficial owner of property if the taxpayer controls the property or has the economic benefit of the property. The Tax Court found that the 40% shareholder still retained beneficial ownership since there was no agreement transferring any rights to the stock, and the 40% shareholder still retained his economic rights as a shareholder.

What could the 40% shareholder have done here? One thought is that he could have transferred his shares to a nonqualified shareholder (such as a nongrantor trust), thus terminating the S election of the company. Some shareholder agreements restrict such transfers, but in the scope of the wider controversy or in the absence of such a restriction, this may have solved his problem. However, in this case under applicable state law, perhaps the shares could not be transferred to someone other than a licensed professional.

Kumar v. Commissioner, TC Memo 2013-184

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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