Despite Embezzlement and Unreceived Distributions, S Corporation Shareholder Must Pay Tax

The Tax Court has ruled that an S corporation shareholder must pay taxes on income he never received, reinforcing a critical tax principle that affects many business owners.

In Maggard, TC Memo 2024-77 (8/7/24), the court ruled that even if other shareholders misuse company funds or fail to distribute earnings, an S corp owner is still responsible for their share of the company’s taxable income.

This case highlights the complexity and risks of S corporation ownership, making it essential for business owners to understand how income taxation works—even when things go wrong.

How S Corporation Taxation Works

Unlike C corporations, which pay corporate taxes and then distribute dividends that are taxed again, an S corporation is a pass-through entity. This means:

1. The S corp itself does not pay taxes. 
2. Shareholders report the corporation’s income on their personal tax returns. 
3. Taxes are due on income allocated to shareholders, whether or not they actually receive it.

For a business to qualify as an S corporation, it must meet the following requirements:

1. Be a domestic corporation
2. Have no more than 100 shareholders
3. Issue only one class of stock
4. Have eligible shareholders (individuals, certain trusts, and estates)
5. Not be an ineligible corporation (such as banks or insurance companies)

However, as this case shows, these tax rules can create problems when business relationships break down.

Case Overview: When an S Corp Owner is Stuck with Phantom Income

The taxpayer in this case was a Silicon Valley chemical engineer who co-founded an engineering consulting firm. Initially structured as a partnership, the company later incorporated as an S corporation, with ownership split evenly between the two founders.

In 2014, one of the original owners sold his shares to two new co-owners, one of whom became the firm’s CEO. Unfortunately, conflicts quickly emerged.

1. The new CEO misappropriated company funds
2. Disproportionate earnings distributions favored the two new co-owners
3. The CEO failed to distribute $165,000 in profits to the taxpayer
4. More than $1 million was allegedly embezzled over four years
5. The CEO stopped filing S corp tax returns after 2014

Even though the taxpayer never received his rightful share of earnings, he was still legally required to report and pay tax on his portion of the S corp’s income.

The Legal Battle: Tax Court’s Harsh Ruling

After years of financial mismanagement, the IRS stepped in and:

1. Issued a notice of tax deficiency to the taxpayer
2. Revoked the S corporation’s status
3. Required the taxpayer to report his share of the income despite not receiving it

At trial, the taxpayer argued that:

1. The misdeeds of his co-owners should disqualify the S corporation’s status
2. The firm effectively had more than one class of stock due to certain debts
3. The missing income should not be taxable to him

However, the Tax Court ruled against him. Despite acknowledging the unfairness of the situation, the court held that:

1. Tax law still required him to report and pay tax on his allocated share of income
2. Misconduct by his co-owners did not change the legal tax obligations of an S corp shareholder

Key Takeaways for S Corporation Owners

This case underscores the risks and responsibilities of S corporation ownership.

1. You must pay taxes on your share of S corp income, even if you never receive it.
2. The IRS does not provide relief for financial disputes between shareholders.
3. If an S corp fails to file returns, shareholders are still responsible for reporting their share of income.
4. Legal disputes with business partners do not shield you from tax liability.

Business owners should protect themselves by:

1. Having strong shareholder agreements that outline how distributions are handled
2. Monitoring financial activity closely to prevent mismanagement
3. Ensuring tax returns are filed properly each year
4. Seeking professional tax guidance to navigate disputes and compliance issues

The IRS does not recognize shareholder disputes as a valid reason to avoid tax obligations, making proactive planning essential.

Final Thoughts: A Costly Lesson in S Corporation Taxation

The Maggard case is a cautionary tale for S corp owners who assume that their tax obligations depend on actually receiving distributions.

The IRS and Tax Court have made it clear: if you’re an S corp shareholder, you’re on the hook for taxes—whether you get the money or not.

For those considering S corporation status, understanding these risks can help prevent costly surprises down the road.

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