Opinion ID: 768669
Heading Depth: 2
Heading Rank: 2

Heading: The Legal Status of Beneficial Shareholders

Text: 104 It is a fundamental axiom, applicable even in the criminal context, that tax consequences flow from the substance rather than the form of a transaction, and that control over property, rather than documentary title marks the real owner for federal tax purposes. United States v. Schmidt, 935 F.2d 1440 (4th Cir. 1991) (collecting cases); see United States v. Atkins, 869 F.2d 135, 140 (2d Cir. 1989); United States v. Ingredient Technology Corp., 698 F.2d 88, 95 (2d Cir. 1983). My colleagues suggest that this axiom is inapplicable here. It seems to be their perception that there is no statute which obliged Pirro to report Boyle as a beneficial owner on DPC's returns. I cannot agree. 105 The majority overlooks 26 U.S.C. § 6037(a), the very statute which required Pirro to file DPC's return in the first place. As already noted, § 6037(a) imposes its reporting obligations with respect to all persons owning stock in the corporation, a category it equates with shareholders. Neither § 6037(a) itself, nor the accompanying regulations and IRS instructions, even suggest that the terms persons owning stock in the corporation, and shareholders are somehow confined to ownership interests that are officially recorded on the corporation's books. And while it is also true that these statutes and regulation did not explicitly state in 1992 that those terms include the beneficial owners of stock, I fail to see why the absence of such an explicit definition should confer a license for the willful concealment alleged here. The prohibition against vagueness in criminal tax proceedings has never been read to prohibit prosecutions under statutes which a reviewing court believes could have been drafted with greater precision. United States v. Herrera, 584 F.2d 1137, 1149 (2d Cir. 1978). All the Due Process Clause requires is that the law give sufficient warnings that men may conduct themselves so as to avoid that which is forbidden, and thus not lull the potential defendant into a false sense of security, giving him no reason even to suspect that his conduct might be within its scope. Ingredient Technology Corp., 698 F.2d at 97 (quoting Herrera, 584 F.2d at 1149). Here, Pirro had the requisite fair warning, not only from the text of § 6037(a), but from the case law, a governing revenue ruling, and applicable regulations. 106 The issue of shareholder status in Subchapter S corporations is not a new one. Speca v. Commissioner, 630 F.2d 554, 556 (7th Cir. 1980). As already noted, an initial election to become an S Corporation is valid, only if all persons who are shareholders . . . on the day on which such election is made consent to such an election. 26 U.S.C. § 1362(a)(2). Although the issue of who is a shareholder for purposes of determining whether there has been a valid initial election has been litigated many times, it has been resolved by the courts consistently. Every court that has addressed the issue has concluded that a beneficial shareholder of an S Corporation's stock is indeed that Corporation's shareholder. 107 The seminal opinion is Hoffman v. Commissioner, 47 T.C. 218 (1966), aff'd on basis of tax court opinion, 391 F.2d 930 (5th Cir. 1968). In that case, a shareholder in an S Corporation sold her stock to the taxpayer but continued to hold it in escrow (i.e., she remained the shareholder of record) to ensure payment of the purchase price. The purchaser-taxpayer consented to a Subchapter S election, but the former owner and still shareholder of record did not. The Tax Court held that her consent was unnecessary. According to the court, beneficial ownership of the stock, as opposed to technical legal title thereto, is the critical factor in determining who is a shareholder. Applying this principle, the court then concluded that regardless of who had naked title, the shares were really owned by [the purchaser-taxpayer] and were merely pledged as collateral. This was so, because it was the purchaser-taxpayer of the Corporation who was to enjoy all the fruits of the enterprise, whereas the shareholder of record plainly could not have been taxed on the Corporation's undistributed earnings. Id. at 234. 108 The cases following Hoffman are legion. See e.g., Cabintaxi v. Commissioner, 63 F.3d 614, 616 (7th Cir. 1995) (individuals who are not shareholders of record, are nevertheless shareholders for purposes of Subchapter S if they are beneficial owners under applicable state law); Pahl v. Commissioner, 150 F.3d 1124, 1228 1129 (9th Cir. 1998) (lawyer who joined law firm organized as S Corporation but withdrew without paying for shares was properly treated as shareholder for S Corporation tax purposes and thus required to report pro rata share of profits because he held a beneficial shareholder's interest in the corporation); Wilson v. Commissioner, 560 F.2d 687, 689 (5th Cir. 1977) ([T]he term 'shareholders' must mean those who bear the tax consequences of the election . . . . Because beneficial ownership of stock, not mere record ownership or other formal indicia, determines who bears those tax consequences, beneficial ownership also provides the standard for determining who must consent to the Subchapter S election.); Kean v. Commissioner, 469 F.2d 1183, 1189 (9th Cir. 1972) ('shareholders' who must file a consent are not necessarily 'shareholders of record' but rather beneficial owners of shares who would have to include in gross income dividends distributed with respect to the stock of the corporation); Lafayette Dist., Inc. v. United States, 397 F.Supp. 719, 724 (W.D. La. 1975) (Traditionally, courts have looked to the beneficial owner in order to ascertain who has the tax liability); Dannenberg v. Commissioner, 73 T.C. 370, 390 (1979) (It is well established that for purposes of determining who is a shareholder under the provisions of subchapter S, beneficial ownership of the stock rather than technical legal title is controlling.); Ragghianit v. Commisioner, 71 T.C. 346, 349 (1978) (By now it is well settled that record ownership of stock, standing alone, is not determinative in answering the question as to who is required to include in gross income any dividends attributable to such stock. Rather, beneficial ownership is the controlling factor.); CHM Co. v. Commissioner, 68 T.C. 31, 37 (1977) (in deciding who is a shareholder for subch. S purposes, we look to the beneficial ownership of the stock.); Hook v. Commissioner, 58 T.C. 267, 273 (1972) ([B]eneficial ownership, as opposed to technical legal title, is determinative . . . .). 109 Also relying on Hoffman, the IRS itself advised as far back as 1970 that: 110 [F]or purposes of determining who is a shareholder under the provisions of Subchapter S of the Code, beneficial ownership of the stock rather than technical legal title is controlling. Accordingly, it is held that the taxpayer who is the stockholder of record but does not own the beneficial interest in a share of stock of a small business corporation is not a shareholder for the purposes of the provisions of Subchapter S of the Code . . . . 111 IRS Revenue Ruling 70 615, 1970 2 C.B. 169, 1970 WL 20547 (relying on Hoffman, 47 T.C. 218). In this Circuit, this Revenue Ruling is entitled to great deference. Texasgulf, Inc. & Subs. v. Commissioner, 172 F.3d 209, 217 (2d Cir. 1999) (citations omitted). Indeed, it is presumed to 'have the force of legal precedent unless unreasonable or inconsistent with the provisions of the Internal Revenue Code.' Gillespie v. United States, 23 F.3d 36, 39 (2d Cir. 1994) (quoting Salomon, Inc. v. United States, 976 F.2d 837, 841 (2d Cir. 1992) (citing Amato v. Western Union International, Inc., 773 F.2d 1402, 1411 (2d Cir. 1985)). 112 The rule that beneficial owners of an S Corporation's stock are its shareholders is obviously neither unreasonable nor inconsistent with the purposes and provisions of the Tax Code. Indeed, while I am the first to concede that the federal tax laws are often esoteric, I cannot imagine that reasonable people would really have any difficulty understanding the rule that the beneficial owners of an S Corporation's stock are in fact persons owning stock in the corporation. 26 U.S.C. § 6037(a). 113 The rationales for that rule are self-evident. At a threshold level, it prevents an obvious end run around the rule that an S Corporation can have no more than 35 (now 75) shareholders. More fundamentally, it serves the purpose of requiring S Corporations to list for the IRS the actual recipients of beneficial income from the Corporation's shares. In this latter respect, the beneficial ownership rule is entirely consistent with the basic congressional purpose [in enacting Subchapter S] to tax only those who actually receive dividends paid by the corporation. Kean, 469 F.2d at 1186 (quoting Hoffman, 47 T.C. at 233). 114 Finally, for much of the history of Subchapter S, the IRS's regulations have explicitly explained that: 115 Ordinarily, the person who would have to include in gross income dividends distributed with respect to the stock of the corporation . . . is considered to be the shareholder of the corporation . . . . For example, . . . [t]he person for whom stock of a corporation is held by a nominee, guardian, custodian, or an agent is considered to be the shareholder of the corporation. 116 26 C.F.R. § 1.1361-1(e) (1995). It is true that this regulation was proposed in 1986, but did not actually get formally adopted until 1995. It is equally true that its predecessor statute - § 1.1371-1(d) containing almost exactly the same language - was withdrawn pursuant to the 1982 Subchapter S Revision Act, see Pub. L. 97-364, 96 Stat. 1669 (1982). Nevertheless, I fail to see how the suspension of a regulation, which is obviously merely reflective of (rather than the source for) applicable law, somehow grants taxpayers license to hugger-mugger about the real shareholders of their companies. 117