Taxpayer Unable to Prove Basis in Stock, Has Taxable Gain on Distributions

A taxpayer who was unable to establish the basis of his stock in an S corporation found himself stuck with paying tax on distributions from the corporation in the case of Power et ux. v. Commissioner, T.C. Memo. 2016-157.

The taxpayer was the sole shareholder of an S corporation which operated a real estate brokerage firm.  The Court described his accounting systems and methods as follows:

In 2007 Power Realty had two employees and used Paychex as its third-party payroll provider. Debbie Berger, a secretary who is not a certified public accountant (C.P.A.), kept and maintained the books and records for Power Realty. In 2011 Power Realty let Ms. Berger go and downsized to a smaller office suite on Hosbrook Road in Cincinnati, Ohio. For the taxable years 2007-11 Mr. Power maintained “Itemized Profit and Loss” and “Transactions by Account” documents for Power Realty. Mr. Power has no formal training in tax or accounting.

While the court does not say so explicitly, the titles of the documents Mr. Power maintained suggests he was using the personal finance software Quicken to handle the record-keeping for his business.

Mr. Power did employ tax professionals to prepare his tax returns as described below:

Power Realty filed Forms 1120S, U.S. Income Tax Return for an S-Corporation, for the taxable years 1993-2011, which were prepared by either Attorney C. Christopher Muth or C.P.A. Andrew J. Bucher. When Mr. Muth prepared returns, Mr. Power would typically provide him with one or two sheets of paper with handwritten income and expense categories and corresponding amounts. Mr. Power would provide underlying documentation to Mr. Muth “[o]ccasionally, but not very frequently.” The record does not establish whether Mr. Power followed a similar protocol for tax returns that Mr. Bucher prepared.

As well, the Court noted that Mr. Power was not drawing a salary from the corporation for his services, noting:

Power Realty compensated Mr. Power through distributions rather than wages or salary. However, Power Realty did not report any distributions to Mr. Power on its Forms 1120S for the taxable years 2007-11. Mr. Power used funds from Power Realty to pay personal living expenses of petitioners for each of the taxable years 2007-11. Furthermore, during the taxable years 2007-11 Power Realty claimed deductions on its Forms 1120S for certain personal living expenses of Mr. Power.

The corporation made distributions to the taxpayer “of $359,860 for 2007; $60,173 for 2008; $221,829 for 2010; and $189,447 for 2011.”  The IRS determined that the taxpayer had zero basis in his S corporation as of January 1, 2007.  Mr. Power claimed he had a basis of $510,216 as of January `1, 2007 and no distributions in excess of basis were made.

The problem the taxpayer faced was that he bore the burden of proving his basis—and the records he had did not provide reasonable evidence of the existence of the claimed basis.

First, the calculation that was provided was not one that had been maintained over the years but rather an attempt at reconstruction of basis undertaken due to the Court case:

Mr. Power did not maintain a basis schedule for his Power Realty stock. To establish Mr. Power's basis in his Power Realty stock, petitioners offered Power Realty's Forms 1120S for the taxable years 1993-2011 and a reconstructed stock basis chart attached as an appendix to their posttrial brief.

Generally a taxpayer should maintain a record of his/her basis in the corporation on an ongoing basis in order to determine each year if distributions are in excess of basis from the S corporation.  So, at this point, the taxpayer would seem to have, at best, “lucked” into not having a taxable distribution since the reconstructed basis seems to have been just enough to allow him to escape tax.

However, the Court did not find the information the taxpayer provided in support of this reconstruction to be adequate to support the calculation of basis:

To begin with, the Forms 1120S do not include sufficient information for us to establish Mr. Power's basis in Power Realty. See Fehlhaber v. Commissioner, 94 T.C. 863, 869 (1990), aff'd, 954 F.2d 653 (11th Cir. 1992). It is also unclear how petitioners calculated Mr. Power's stock basis in Power Realty using Forms 1120S given that Power Realty's income and expenses were improperly divided between Mr. Power's Schedules C and Power Realty's Forms 1120S. Further, petitioners stipulate that Mr. Power was compensated by Power Realty through distributions (not wages or salary) and that petitioners used Power Realty's checking account to pay substantial personal expenses during the taxable years 2007-11. On the basis of the record before us, petitioners have not established that Mr. Power had basis in Power Realty stock or that he did not receive distributions from Power Realty as respondent determined in the notices of deficiency. Accordingly, we conclude that Mr. Power's adjusted stock basis in Power Realty was zero and that he received distributions from Power Realty as respondent determined in the notices of deficiency.

While this is clearly a “bad facts” case that most likely made the Court even more skeptical than it normally would be, fundamentally taxpayers must be aware that proving basis in S stock (or a partnership interest) does involve being able, if necessary, to reach back into the past to provide information to support the calculation—and that may need to be more than just copies of the original returns or K-1s, especially if the years under exam uncovers problems that may be reasonably be suspected to have also taken place in those earlier years.