Disproportionate Distributions in an S-Corp; Innocent Spouse Relief

Jones v. Commissioner, T.C. Memo. 2010-112 (2010).

The issues for decision are: (1) Whether petitioner’s former husband’s distributive share of the income of two pass-through entities is includable in their joint income for the year at issue . . . .

 

Mr. Jones is a 45-percent shareholder of Hadley & Pech, Inc. (Hadley & Pech), an aviation management company that is an S corporation, and a 50-percent owner of Archipelago Aviation, LLC (Archipelago), a limited liability company that charters aircraft and is taxed as a partnership. Roger Sutton (Mr. Sutton), who was a friend of Mr. Jones’, owns the remaining 55 percent of Hadley & Pech and 50 percent of Archipelago.  (3).

 

For 2005 Hadley & Pech and Archipelago had $101,927 and $212,298 of ordinary net business income, respectively. Mr. Jones’ shares of that income, as Mr. Sutton eventually reported to the Internal Revenue Service (IRS) on the Schedules K-1, were $45,867 and $106,149, respectively. Hadley & Pech’s cash distributions for 2005 consisted of $115,000 to Mr. Sutton and $10,000 to Mr. Jones, while Archipelago did not make any distributions for 2005.  (4).

 

Although Mr. Jones received only a $10,000 cash distribution from Hadley & Pech in 2005, as a shareholder he was required to recognize his 45-percent share of the S corporation’s income even though it was not distributed. (7).

 

Archipelago reported ordinary net business income of $212,298 on its partnership return but did not make distribution to Mr. Sutton or Mr. Jones during 2005.  As a 50-percent partner, Mr. Jones is required to recognize and report $106,149, his share of the partnership income even though it was not distributed to the partners. (9).

This is an unfortunate, but correct, outcome for Mr. & Mrs. Jones.  Pass-through entities, such as partnerships and S-corporations, are double-edge swords for the unwary.  On the one hand, distributions of cash from the entity are generally not taxed.  But on the other hand, the partner's/shareholder's share of net income is taxable, EVEN IF NO DISTRIBUTIONS WERE MADE.

There were two more decisions for the court to decide: innocent spouse relief, and accuracy-related penalty.  Ms. Jones won the first and lost the second.

Comments

[S Slotfeldt]

I strongly agree with you that flow-through entities such as partnerships and s-corporations are double edged swords for the unwary. The IRS is increasingly focusing in on small businesses owners who don't pay themselves a reasonable salary

[Tax Attorney]

Wonderful post, i appreciate reading things that are informative from fellow practitioners