The Tax Court determined that Clinton Deckard did not own shares in Waterfront Fashion Week, Inc., and, as such, the corporation could not make a late S election. Mr Decker was barred from claiming losses from that corporation on his personal return.[1]

The taxpayer had formed Waterfront Fashion Week, Inc. as a nonprofit corporation under Kentucky law in May of 2012. The purpose of the corporation was explained in the opinion as follows:

Waterfront produced an event called Waterfront Fashion Week that was held at the Louisville Waterfront Park from October 17 to 19, 2012. This event was marketed as benefiting Waterfront Development Corp., a nonprofit organization that maintains the Louisville Waterfront Park. The event failed, however, to break even. Consequently, Waterfront made no cash charitable contribution to Waterfront Development Corp. The record does not reflect that Waterfront engaged in any other activity at any relevant time.[2]

Not only did Waterfront not generate earnings to be donated to Waterfront Development Corp., Mr. Deckard made significant transfers to the entity while trying to make a go of the event. As it became clear that Waterfront was never going to be able to have a successful event and recoup those losses, Mr. Deckard took the following actions:

On October 28, 2014, Waterfront mailed to the IRS Form 2553, Election by a Small Business Corporation. The Form 2553 indicated that Waterfront was electing to be an S corporation retroactively as of the date of its incorporation, May 8, 2012.4 Petitioner signed the Form 2553 in his capacity as Waterfront's president. Petitioner also signed the Form 2553 shareholder's consent statement, indicating that he held a 100% ownership interest acquired on May 8, 2012.

On January 13, 2015, Waterfront filed untimely Forms 1120S, U.S. Income Tax Return for an S Corporation, for its taxable years 2012 and 2013, reporting operating losses of $277,967 and $3,239 for 2012 and 2013, respectively. Attached to the Forms 1120S were Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., reporting that petitioner had 100% stock ownership of Waterfront during 2012 and 2013.

On May 12, 2015, petitioner filed untimely Forms 1040, U.S. Individual Income Tax Return, for his taxable years 2012 and 2013. On the Schedules E, Supplemental Income and Loss, attached to these returns, petitioner reported passthrough, nonpassive losses from Waterfront of $277,967 and $3,239 for taxable years 2012 and 2013, respectively.[3]

While the IRS argued both that the corporation hadn’t made a valid S election and that Mr. Deckard was not a shareholder, the Tax Court disposed of the case by looking solely at the issue of whether Mr. Deckard was a shareholder, finding he was not a shareholder.

A Kentucky Nonprofit Corporation Cannot Have a Shareholder for S Corporation Purposes

The taxpayer claimed that the facts of the case indicate that even though Kentucky law may not allow for shareholders in a nonprofit corporation, he would be a shareholder for federal tax purposes due to the beneficial interest he had in the corporation:

Petitioner’s declaration in support of his cross-motion for partial summary judgment asserts, among other things: that on or about July 22, 2011, he hired Extraordinary Events, an unrelated event-planning business, to coordinate Waterfront Fashion Week; that on May 3, 2012, he hired Attorney D. Kevin Ryan to advise him on the creation of a legal entity to conduct Waterfront Fashion Week because Extraordinary Events had advised petitioner that a tax-exempt entity would encourage sponsors to make tax-deductible contributions to the legal entity; that Attorney Ryan never advised petitioner that sponsors might be able to deduct sponsorships as trade or business expenses even if the legal entity lacked tax-exempt status; that on May 8, 2012, Attorney Ryan formed Waterfront under the Act; that during 2012 and 2013 petitioner was president of Waterfront and its “sole decision maker”; that on or about August 10, 2012, he terminated the agreement with Extraordinary Events because it had failed to recruit enough sponsors or raise enough contributions to fund Waterfront Fashion Week; that he then assumed “complete control” over planning Waterfront Fashion Week, “abandoned plans” for Waterfront to obtain Federal tax-exempt status, and began treating Waterfront as a “for-profit business that I owned entirely”; and that in August 2012 he made over $275,000 of contributions to Waterfront representing over 85% of the total cost of Waterfront Fashion Week.[4]

As the IRS did not specifically dispute these facts, the Tax Court assumed they were true—but, even so, it found Mr. Deckard was not a beneficial shareholder.

The Court found that, in determining if the shareholder had a beneficial interest that made him a shareholder for Subchapter S purposes, the Court would need to look at the following:

The subchapter S regulations provide: “Ordinarily, the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation) is considered to be the shareholder of the corporation.” Sec. 1.1361-1(e)(1), Income Tax Regs. Citing this regulation, one court has observed that “the question whether a person was a shareholder on the date of the election to be taxed under Subchapter S is equivalent to the question whether, had there been a valid election, he would have been required to report as personal income profits earned by the corporation on that date.” Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 616 (7th Cir. 1995), aff’g in part, rev’g in part on other grounds T.C. Memo. 1994-316. The resolution of this question depends on whether the person “would have been deemed a beneficial owner of shares in the corporation, entitled therefore to demand from the nominal owner the dividends or any other distributions of earnings on those shares.” Id.[5]

The opinion notes that nonprofit corporations are generally prohibited from distributing profits to insiders who exercise control—such as Mr. Deckard. And, specifically, the Kentucky law under which the corporation was formed contains just such a prohibition:

The prohibition on the distribution of profits is clearly embodied in the Act, which governs the formation, operation, and dissolution of nonstock, nonprofit corporations in Kentucky. A corporation subject to the provisions of the Act must possess two important characteristics. First, the corporation must be “nonprofit”. Ky. Rev. Stat. Ann. sec. 273.161(1). A “[n]onprofit corporation” is defined as a corporation no part of the income or profit of which is distributable to its members, directors, and officers. Id. sec. 273.161(3). Consistent with this definition, the Act expressly prohibits a nonprofit corporation from paying a dividend or distributing any part of its income or profits to its members, directors, or officers. Id. sec. 273.237. Second, the corporation “shall not have or issue shares of stock.” Id.[6]

The Court found that:

Under Kentucky law, the corporation had no stock and could issue no stock;
Mr. Deckard, being unable under the law to have any of the profit of the corporation distributed to him or inure to his benefit, did not possess a beneficial interest equivalent to the holding of stock; and
Due to similar restrictions, Mr. Deckard could not receive any assets on liquidation of the corporation.[7]

The Court found that his assertion that he took full control of the entity did not change the issue—it was still organized as a Kentucky nonprofit corporation and had articles of incorporation in accordance with that law that continued to bar Mr. Deckman from receiving distributions:

Petitioner asserts that in August 2012 he “assumed complete control over the planning of the fashion week event” and began “treating * * * [it] as a for-profit business”. Even assuming that this is true, any such actions would not give rise to ownership rights in Waterfront greater than those afforded by the Act and Waterfront’s articles of incorporation. Control over Waterfront was vested in its three directors, as fiduciaries entrusted with the duties and powers imposed upon them by the Act and the articles of incorporation. See Ky. Rev. Stat. Ann. sec. 273.215(1); Ballard v. 1400 Willow Council of Co-Owners, Inc., 430 S.W.3d 229, 241 (Ky. 2013).[8]

Substance Over Form

As we have noted previously in prior articles, the party that establishes the form of a transaction will generally be barred from arguing that the chosen form doesn’t comport with reality. Nevertheless, Mr. Deckard attempted to argue substance over form—that even if the form would bar him from being a beneficial shareholder, the substance of the transactions meant he was a shareholder for federal tax purposes.

Invoking the doctrine of substance over form, petitioner urges that we should disregard Waterfront’s form as a nonprofit corporation and instead should regard it, in substance, as a for-profit entity. He asserts that he intended Waterfront to be a for-profit entity and “objectively operated” it “consistently with it being a for-profit entity that he owned entirely.” He urges that “the only fact inconsistent with Waterfront * * * being a for-profit entity is that an attorney formed * * * [it] as a nonprofit corporation prior to when the economic realities of the project came to light.” He states that although he “should have sought to change Waterfront[’s] * * * corporate documents to reflect” these changed plans, he was “mistakenly unaware of these formalities of corporate law” and so treated Waterfront “like he was the sole owner in every practical sense.”[9]

The Court notes that taxpayers are almost always bound by the form for the transaction they selected, but that even if that wasn’t the case the substance of this transaction was in line with its form:

Nothing in the record suggests that Waterfront’s form did not respect its substance. To the contrary, the record shows that in May 2012 Waterfront was purposefully organized as a nonprofit corporation, upon an attorney’s advice, with the expectation that it would seek tax-exempt status so as to facilitate tax-deductible gifts. Its corporate existence as a nonprofit corporation began when its articles of incorporation were filed on May 8, 2012. See Ky. Rev. Stat. Ann. sec. 273.2531. It was not until several months later that petitioner changed course, abandoned plans to obtain Federal tax-exempt status for Waterfront, and “assumed control”. Any such actions after Waterfront’s organization had no effect upon its status as a nonprofit corporation under the Act. Indeed, the parties have stipulated that at all relevant times Waterfront existed under the provisions of the Act.[10]

Lack of Federal Tax-Exempt Status

Finally, Mr. Deckard argued that since the corporation never sought tax-exempt status under the IRC, it should be treated as a for-profit corporation. But the Court finds that Mr. Deckard is confusing federal and state law—whether a corporation is nonprofit under state law, and thus bound by the state’s rules for such an entity, does not depend on the corporation obtaining federal tax-exempt status:

Petitioner’s argument confuses Federal tax-exempt status with status as a nonprofit corporation under State law. As noted, at all relevant times Waterfront was subject to the provisions of the Act. The decision not to seek Federal tax-exempt status for Waterfront has no bearing on its status as a nonprofit corporation under the Act or on the ownership constraints imposed thereunder.[11]

[1] Deckard v. Commissioner, 155 TC No. 8, September 17, 2020, https://www.ustaxcourt.gov/UstcInOp2/OpinionViewer.aspx?ID=12322 (retrieved September 18, 2020)

[2] Deckard v. Commissioner, 155 TC No. 8, p. 6

[3] Deckard v. Commissioner, 155 TC No. 8, pp. 7-8

[4] Deckard v. Commissioner, 155 TC No. 8, pp. 10-11

[5] Deckard v. Commissioner, 155 TC No. 8, pp. 11-12

[6] Deckard v. Commissioner, 155 TC No. 8, pp. 16-17

[7] Deckard v. Commissioner, 155 TC No. 8, pp. 18-19

[8] Deckard v. Commissioner, 155 TC No. 8, p. 20

[9] Deckard v. Commissioner, 155 TC No. 8, pp. 20-21

[10] Deckard v. Commissioner, 155 TC No. 8, p. 22

[11] Deckard v. Commissioner, 155 TC No. 8, p. 23