Taproot Admin. Servs., Inc. v. Comm'r of Internal Revenu

• Decision Date: 29 September 2009
• Docket Number: No. 15396–07.,15396–07.
• Citation: 133 T.C. 202,133 T.C. No. 9
• Parties: TAPROOT ADMINISTRATIVE SERVICES, INC., Petitioner v. COMMISSIONER of INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

133 T.C. 202

133 T.C. No. 9

TAPROOT ADMINISTRATIVE SERVICES, INC., Petitioner

v.COMMISSIONER of INTERNAL REVENUE, Respondent.

No. 15396–07.

United States Tax Court.

Sept. 29, 2009.

R determined that P is ineligible for S corporation status in 2003 because its shareholder was a Roth individual retirement account (Roth IRA). As a consequence, R determined that P is taxable as a C corporation for 2003.

Held: The Roth IRA is not an eligible S corporation shareholder. P is taxable as a C corporation for 2003.

Steven R. Mather and Kenneth M. Barish, for petitioner.

David W. Sorensen, for respondent.

OPINION

WHERRY, Judge.

This case, which involves a petition for redetermination of a deficiency for petitioner's 2003 tax year, is before the Court on respondent's October 23, 2008, motion for partial summary judgment. See Rule 121(a).¹ Respondent argues that petitioner is not eligible for S corporation status during 2003 because it had an ineligible shareholder—a Roth individual retirement account (Roth IRA)—during that year. Petitioner counters that a Roth IRA is an eligible S corporation shareholder and that petitioner's S corporation status remained intact. For the reasons discussed below, we agree with respondent.

Background

Petitioner is a Nevada corporation that elected S corporation status and filed its 2003 tax return on a Form 1120S, U.S. Income Tax Return for an S Corporation.² Petitioner's sole shareholder during 2003 was a custodial Roth IRA account for the benefit of Paul DiMundo.³

Respondent issued petitioner a notice of deficiency on April 10, 2007. Respondent made various determinations, including that petitioner is taxable as a C corporation for 2003 because it had an ineligible shareholder. Petitioner filed a petition with this Court on July 6, 2007. Respondent moved for partial summary judgment on the issues of whether petitioner is eligible for S corporation status for Federal tax purposes for 2003 and, if not, whether petitioner is treated as a C corporation for that year. Petitioner contests that motion.

Discussion

A. Summary Judgment

Rule 121(a) allows a party to move “for a summary adjudication in the moving party's favor upon all or any part of the legal issues in controversy.” Summary judgment is appropriate “if the pleadings, answers to interrogatories, depositions, admissions, and any other acceptable materials, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law.” Rule 121(b). Facts are viewed in the light most favorable to the nonmoving party. Dahlstrom v. Commissioner, 85 T.C. 812, 821, 1985 WL 15413 (1985). The moving party bears the burden of demonstrating that no genuine issue of material fact exists and that the moving party is entitled to judgment as a matter of law. Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520, 1992 WL 88529 (1992), affd. 17 F.3d 965 (7th Cir.1994). The Court has considered the pleadings and other materials of record and concludes that there is no genuine justiciable issue of material fact. Whether a Roth IRA is an eligible S corporation shareholder is a legal question appropriate for decision by summary judgment.

B. S Corporations: Shareholder Eligibility

An S corporation is not generally subject to Federal income taxes. Sec. 1363(a).⁴ Like a partnership, it is a conduit through which income flows to its shareholders. See Gitlitz v. Commissioner, 531 U.S. 206, 209, 121 S.Ct. 701, 148 L.Ed.2d 613 (2001) (“Subchapter S allows shareholders of qualified corporations to elect a ‘pass-through’ taxation system under which income is subjected to only one level of taxation.”).

A qualifying “small business corporation” must affirmatively elect S corporation status in order to be treated as an S corporation for Federal income tax purposes. Secs. 1361(a), 1362(a)(1). That S election terminates automatically and immediately if any of the eligibility rules is violated. Sec. 1362(d)(2). For example, if an ineligible shareholder acquires stock in an S corporation, the S corporation's S election terminates on the date on which the ineligible shareholder acquired the stock. Sec. 1362(d)(2)(B); sec. 1.1362–2(b)(2), Income Tax Regs. If we agree with respondent that a Roth IRA is an ineligible S corporation shareholder, then petitioner was not an S corporation during 2003 and should be taxed as a C corporation for that year.

The S corporation eligibility rules, which focus on both the corporate and shareholder levels, are quite elaborate. Among those rules are detailed shareholder eligibility requirements that restrict the number and type of eligible S corporation shareholders. In general, S corporation shareholder eligibility is limited to domestic individuals, estates, certain trusts, and certain exempt organizations. See sec. 1361(b)(1)(B), (c)(2), (6). Section 1361(c)(2)(A) prescribed, as of the tax year at issue, the types of trusts that are eligible S corporation shareholders:

(2) Certain trusts permitted as shareholders.—

(A) In general.—For purposes of subsection (b)(1)(B), the following trusts may be shareholders:

(i) A trust all of which is treated (under subpart E of part I of subchapter J of this chapter) as owned by an individual who is a citizen or resident of the United States.

(ii) A trust which was described in clause (i) immediately before the death of the deemed owner and which continues in existence after such death, but only for the 2–year period beginning on the day of the deemed owner's death.

(iii) A trust with respect to stock transferred to it pursuant to the terms of a will, but only for the 2–year period beginning on the day on which such stock is transferred to it.

(iv) A trust created primarily to exercise the voting power of stock transferred to it.

(v) An electing small business trust.

The list of eligible S corporation shareholders has been anything but static. When subchapter S was first added to the Internal Revenue Code in 1958, the only permissible S corporation shareholders were domestic individuals and estates. In the Tax Reform Act of 1976, Pub.L. 94–455, sec. 902(c)(2)(A), 90 Stat. 1609, Congress amended subchapter S to allow certain trusts to own S corporation stock. In the Small Business Job Protection Act of 1996, Pub.L. 104–188, sec. 1316(a), 110 Stat. 1785, Congress amended section 1361(b)(1)(B) and added section 1361(c)(6) to permit certain tax-exempt organizations to own S corporation stock.⁵ Although it took effect after the tax year at issue, a more recent and more relevant congressional amendment permits a bank to make an S corporation election where the bank's stock is held in a trust that qualifies as an IRA or a Roth IRA. See sec. 1361(c)(2)(A)(vi).⁶

C. IRAs⁷

Provisions for traditional IRAs were enacted into the Internal Revenue Code as part of the Employee Retirement Income Security Act of 1974, Pub.L. 93–406, sec.2002(b), 88 Stat. 959. The IRA provisions were designed “to create a system whereby employees not covered by qualified retirement plans would have the opportunity to set aside at least some retirement savings on a tax-sheltered basis.” Campbell v. Commissioner, 108 T.C. 54, 63, 1997 WL 65944 (1997). The basic tax characteristics of a traditional IRA are (1) deductible contributions, (2) the accrual of tax-free earnings (except with respect to section 511 unrelated business income), and (3) the inclusion of distributions in gross income.⁸ See secs. 219(a), 408(a), (d)(1), (e).

Roth IRAs are of more recent vintage, having been created as part of the Taxpayer Relief Act of 1997, Pub.L. 105–34, sec. 302, 111 Stat. 825, to further encourage individual savings. The basic tax characteristics of a Roth IRA are (1) nondeductible contributions, (2) the accrual of tax-free earnings, and (3) the exclusion of qualified distributions from gross income. See sec. 408A(a), (c)(1), (d)(1) and (2)(A).⁹

Section 408(a) provides in pertinent part that “the term ‘individual retirement account’ means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries”. However, IRAs and Roth IRAs can assume another legal form. They can be custodial accounts. In that case, they must be treated as trusts in order to qualify as IRAs. See sec. 408(h). In other words, a custodial account IRA must be treated as a trust in order for it to qualify as an IRA under section 408.

D. Parties' Arguments

Petitioner has two arguments. First, petitioner argues that “a custodial account qualifying as an IRA also meets the qualifications to be a shareholder of an S corporation.” According to petitioner, the beneficiary of the custodial account—in this case, Mr. DiMundo—should be considered the shareholder for purposes of section 1361. In support of that argument, petitioner cites section 1.1361–1(e)(1), Income Tax Regs., which provides that “The 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 for purposes of this paragraph (e) and paragraphs (f) and (g) of this section.” Petitioner also cites Rev. Rul. 66–266, 1966–2 C.B. 356, and Priv. Ltr. Rul. (PLR) 86–05–028 (Nov. 4, 1985)¹⁰ for the proposition that S corporation stock held in a custodial account for a disabled person or by a custodian under the Uniform Gifts to Minors Act is treated as held by the disabled person or child. Petitioner's other argument is that an IRA is a grantor trust that qualifies as an S corporation shareholder under section 1361(c)(2)(A)(i), which provides that eligible S corporation shareholders include “A trust all of which is treated (under subpart E of part I of subchapter J of this chapter) as owned by an individual who is a citizen or resident of the United States.”¹¹

Respondent argues that “an IRA custodial account is very different” from the custodial accounts that were the subjects of the revenue ruling and the...