You need to be extremely careful on how you get in business with. You might end up being liable for ghost income, funds stolen from your partners and many other issues.
In the Maggard v. Commissioner, (TC Memo 2024-77), James Maggard co-founded an engineering consulting partnership, the initial co-partner left buying him out, and then, got on board two individuals LL, an old family friend, giving 40% ownership as CEO and another person, WJ, giving 20% ownership as Secretary.
The new CEO and new Secretary colluded to inflate expenses and reimbursements, plus making disproportionate distributions. Also, LL stopped filing 1120S tax returns and sending K1 information to Maggard. Note that Maggard was cut off any business information, he called the IRS whistleblower office and filed the whistleblower form (the IRS did not pursue any investigation) and there was litigation among the shareholders with a settlement in 2018 selling his stock to LL.
Even if Maggard was a victim, he was responsible based on the current tax laws as it was still deemed a S corporation even if he claimed that the unauthorized and disproportionate distributions to the other shareholders caused the corporation to have multiple classes of stock losing the S Corporation status. The Court ruled that Maggard had to pay taxes on over $784k of the S Corporation income as no governing document authorized those disproportionate distributions.
Also, this is a good time to remind the reader that you should avoid having your spouse, if possible, as partner in your business. If there is economic benefit from the business activity, they could potentially go after your marital or joint assets. For more details on this topic, a more extensive discussion with a lawyer might be a good idea.
Another case that got a similar result was Veeraswamy v. Commissioner, (TC Memo 2024-83). In this case between husband and wife owners of the corporation, Veeraswamy seemed involved in the operation of the apartment building. Even if she was abused by her spouse and filed a divorce in 2011, she was still on the hook due to the initial registration as 50% shareholder and remaining a shareholder until 2014 as there was no transfer of shares or similar document. The corporation filed for bankruptcy in 2013 and sold the apartment building in 2014 so the IRS deemed her liable for the 50% of the net profits of the rental and capital gain from the sale in 2014 (she did not file a 2014 tax return and the IRS prepared a substitute return). In this case, the spouse was still liable even if was abused, and divorced the other shareholder before, but there was no documentation of leaving the business or selling / transferring those shares as part of the divorce agreement.
These two cases show how having bad partners/shareholders and being a potential victim of their schemes will not save you from being liable for the tax bill.
Link Law (This post includes both cases) – Termination of Status as S Corporation Shareholder
Link Parker Tax Publishing – S Shareholder Is Taxed on Income Stolen from Company by CFO and Corporate Secretary
Link Taishoff Law – CAN’T LOSE YOUR ‘S’
