This was originally published on PAOO on August 23rd, 2010.
I've known some people who mangle common expressions without realizing it. "He wants everything handed to him on a silver spoon." "She'll just have to fish or get off the pot." I don't think I do it myself very often. If I mangle a common expression, its on purpose. So I am well aware that the expression is "Six of one - half a dozen of the other". I owe the modification to a friend of mine, who I will gladly credit, if he should claim priority. (I checked with my friend Alan Jacobs. He doesn't remember coining the phrase, but he grants it was characteristic.) He thought "Six of one - half a dozen of the other" was a stupid expression like the oxymoronic "same difference". By using the even stupider "Six of one - a dozen of the other", he made you pay attention.
In general, a corporation is a tax paying entity. Individuals who realize income from corporations either as dividends or from gains on selling interests in corporations are taxed on that income. Profit from an activity can thus be taxed twice before it goes to the ultimate beneficiary of the profit. Used to be if you didn't like that you could just do business as an individual and have unlimited liability or in a partnership where at least one person had unlimited liability. That was a long time ago, though.
Skipping over much history there are two ways in which you can have an entity that provides a liability shield without being subject to double taxation, as some loosely term it. One is to for a corporation make an S election, which requires the consent of all the shareholders. The other is to form a Limited Liability Company (LLC). You can elect to have your LLC treated as a corporation, but absent that election the LLC will be treated as a partnership, if it has more than one owner, or it will be disregarded, for income tax purposes, if it has a single owner.
There, are, however, many difference between the taxation of S Corporations and LLC's, which are treated as partnerships. Generally speaking the partnership form is much more flexible than that of the S Corporation. There is a perception that partnerships are much more complicated than S Corporations. This is mainly due to people taking advantage of the flexibility of the partnership form to do more complicated things. An example of a significant difference is that partners (read LLC members) have basis in their share of the partnership's liabilities, where as S Corporation shareholders do not even if they have personally guaranteed them. So if you had a shopping mall owned by an S corporation that refinanced and used the proceeds to make a distribution, the shareholders might have to recognize gain on the distribution. It is unlikely that LLC members would. These differences will be a persistent theme in this blog as various developments illustrate them.
PLR 20107019 was issued on April 30, 2010 making it still reasonably fresh. It concerns one of the things that make S Corporations appear simpler than entities treated as partnerships. That is the single class of stock rule. An S Corporation can have more than one class of stock. There might be for, example, be voting and non-voting stock. The stock must, however, have identical rights with respect to current and liquidating distributions. Entities taxed as partnership can split the pie up any way that they want. The complexity comes in from the regulations that require that allocations of taxable income reasonably relate to the economic deal. The single class of stock rule makes S corporations a bad choice for deals in which money investors are to get their original investment and a preferred return.
The thing that is scary about S Corporations is that if you screw up badly enough you no longer have a flow through entity. Screw up a non-corporate entity and you are talking more about moving the income or losses around among the different parties, not creating a whole new layer of taxation. The PLR comes out of that type of concern. I had originally considered titling the article "Possible Triumph of Common Sense".
The shareholders of S corporations and partners in partnerships (which includes most LLC members) are taxed on the entity's income regardless of whether it is distributed. Other than in very closely held situations, this creates a business problem. A non-controlling owner has to be concerned that they won't have the cash to pay the taxes that the entity creates for them. This is typically dealt with by having an agreement by the entity to make tax distributions. Generally the distribution is some sort of formula. Certainly in the case of an S corporation it could not be the exact amount of each shareholders federal and state tax, since this amount is unlikely to work out exactly on a per share basis. For example, if you distributed more to a shareholder who happened to live in California, you would probably be violating the single class of stock rule.
PLR 20107019 has a unique wrinkle though. Its tax distribution plan is based on making distributions in proportion to ownership at the time that the taxable income is generated rather than based on ownership when the distribution is declared.
If X's taxable income is increased or its creditable foreign taxes are decreased after X's original return for a particular taxable year is filed, the Stockholder's Agreement allows X to make a distribution to its shareholders, in accordance with their respective interests in X's taxable income or loss for that period, with respect to the deficiency resulting from such increase or decrease within a reasonable time after the amount of the increase or decrease becomes final (the Discretionary Payment Provision). The Discretionary Payment Provision is intended to allow X to assist its shareholders in paying their additional tax liability resulting from adjustments to X's originally filed tax returns.
So imagine that in 2009 X had shown no taxable income and then you sold your stock in early 2010. Sometime in 2012 X settles an audit and you get a corrected K-1 for $20,000. X will then declare a special distribution some of which will go to you even though you have not been a shareholder for over two years.
The IRS ruled that this special plan did not violate the single class of stock rule. Advisers to substantial S Corporations may want to take a look at this ruling as might owners of minority interests in S Corporations.