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William Ellis, CPA
William Ellis, CPA, CPA
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Experience:  Over 15 years of experience in public accounting
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I am a 1/3rd shareholder in an S-Corporation but I am not employed

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I am a 1/3rd shareholder in an S-Corporation but I am not employed by the corporation. My brother and a third party are the other shareholders and are employed by the business. The company has a YTD profit of about $470K and the other two shareholders have given themselves additional payroll AND a distribution of $150K each. I always thought that such distributions had be approved by ALL shareholders effected and that they should be equal no matter whether the shareholder was employed or actively engaged in the the day to day business of the company. What is the correct answer to this situation? Please send your answer to this email address:XXX@XXXXXX.XXX. Thank you.
Submitted: 1 year ago.
Category: Tax
Expert:  PDtax replied 1 year ago.

PDtax :

Welcome to the site. I'm PDtax, and will be helping you today.

PDtax :

The rule you refer to is disproportionate distributions, and did they create a second class of stock, which would soil the s election. That is often interpreted strictly by advisors, who would immediately agree with you that the S corp has been damaged. A review of the facts and law is appropriate here.

PDtax :

S corps can and do have unequal distributions to some shareholders. The test under law is do they create a second class of stock (do your shares confer unto you more rights than my shares). The facts dictate.

PDtax :

Treas. Reg. Section 1.1361-1(l)(2)(i) provides guidance on whether the disproportionate distribution is indicative of multiple classes of stock.

The test is based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions). A disproportionate distribution will not be treated as creating a second class of stock, provided the underlying stock provides both A and B with identical rights to the distribution.

PDtax :

If, for example, the other shareholders received salaries for services, and you didn't, the facts support your not getting a salary (you don't work for the entity). If they decided to pay out cash you did not get an option to receive, that could be a problem. As long as you have the right to distributions (even if you elect not to receive cash), then you are still ok.

PDtax :

A review of the corporate agreement, stockholders agreements, if any, that outline the distribution rights is vital here. PLRNNN-NN-NNNNis another source of insight on the matter. IRS determined in this letter that disproportionate distributions did not create a second class of stock. The taxpayer making that request was trying to repair prior disproportionate distributions, and would have had to make additional disproportionate distributions to do so.

PDtax :

The best answer I can give after that discussion is to look at your facts carefully. You may indeed have a problem, but if your equity account has continued to grow proportionately with the other shareholders, you will have options for cash distributions or sale of the shares that will make you whole.

PDtax :

Thanks for asking at Just Answer. I'm PDtax.

Customer:

Thank you PDtax- I believe you have given me solid information so that I can proceed with what I need to do and have the grounds on which to state my case.

PDtax :

Then please rate my response, which closes out your question (and processes payment). PDtax

Expert:  William Ellis, CPA replied 1 year ago.

Hello and thank you for allowing us at Just Answer to assist you. Though I agree with PD about the second class of stock, you need to separate the salary from the distributions.

 

I agree with you that salaries of this magnitude certainly should be agreed upon by all significant shareholders, and this agreement should be recorded with all other important corporate decisions. Since this salary is an expense, it affects the net income required to be reported and taxed to each of the shareholders.

 

Regarding the disproportionate distributions, simply making them can put the S-Corp election in jeopardy. This rule can be circumvented if the entity is an LLC that elected S-Corp status, but LLCs do lose their status because of this. The easiest way to correct this is to classify the disproportionate portions of the distributions as loans to shareholders. This should be officially recorded in the corporate records with a period to either pay the amounts back or withhold future earnings to satisfy the loans. The loans should also have a stated interest rate included meaning the S-Corp should be showing some interest income for the year, unless the amounts are immediately paid back.

 

I hope this helps,

 

Bill

William Ellis, CPA, CPA
Category: Tax
Satisfied Customers: 296
Experience: Over 15 years of experience in public accounting
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William Ellis, CPA
William Ellis, CPA
Tax Professional
296 Satisfied Customers
Over 15 years of experience in public accounting