Question

Research Problem 1. Glow and Bro organized an S corporation and intended to have only one class of stock. They agreed that all distributions should be proportional to their stock ownership. During 2019, Bro withdrew large sums of money from the S corporation without Glow’s knowledge. Glow’s share of pass-through income was $500,000 on the Schedule K–1, but he only received $30,000 of cash distributions. The S corporation became bankrupt. The IRS determined that the two owners did not receive distributions that were proportional to their ownership, but it taxed Glow (who is in the 37% tax bracket) on the $500,000.

Glow argued that a second class of stock was created: these substantially disproportionate distributions appear to create a preference in distribution, creating a second class of stock. Thus, the election was terminated, the entity was a C corporation, and Glow should be taxed only on the $30,000 distribution, taxed as a dividend because the entity was a C corporation. Glow also argued that the S corporation should take a theft loss deduction for Bro’s withdrawals.

You are the U.S. Tax Court judge hearing the dispute. What are the proper Federal income tax results? Elaborate.

Answer 1