Cohen v. State, Dept. of Revenue
| Decision Date | 16 April 1979 |
| Docket Number | No. 27878,27878 |
| Parties | Alvin L. COHEN and Geraldine R. Cohen, Plaintiffs-Appellees, v. STATE of Colorado, DEPARTMENT OF REVENUE, and Joseph F. Dolan, ExecutiveDirector of Department of Revenue, Defendants-Appellants. |
| Court | Colorado Supreme Court |
Isaacson, Rosenbaum, Spiegleman & Friedman, P. C., Stanton D. Rosenbaum, Barry J. Goldstein, Denver, for plaintiffs-appellees.
J. D. MacFarlane, Atty. Gen., David W. Robbins, Deputy Atty. Gen., Edward G. Donovan Sol. Gen., Stephen H. Kaplan, Asst. Atty. Gen., Denver, for defendants-appellants.
After notice of deficiency, assessment and a hearing, the Executive Director of the Department of Revenue determined that the appellees-taxpayers were liable for a surtax on their respective shares of 1974 income of the subchapter S corporation in which they were shareholders. On review the district court concluded that the taxpayers' proportionate shares of the subchapter S corporation's income were not dividends for surtax purposes. The trial court held regulations 138-1-6(1) and 138-1-36 invalid because these regulations attempted to broaden the definition of "dividends" beyond the scope intended by the General Assembly in enacting section 39-22-106(1), C.R.S.1973. We affirm.
Taxpayers Alvin and Geraldine Cohen, husband and wife, are Colorado residents and majority stockholders of a Colorado corporation, the Al Cohen Construction Company. In 1974, Mr. Cohen owned 102 shares representing 51 per cent of the corporation's outstanding stock, and Mrs. Cohen owned 78 shares, representing 39 per cent of the outstanding stock. The stockholders elected tax treatment under Subchapter S of the Internal Revenue Code of 1954, sections 1371-1379.
The Cohens, on their 1974 federal and Colorado joint income tax returns, reported their respective shares of the Al Cohen Construction Company earnings for its fiscal year ending June 30, 1974, in substantial amounts proportionate to their respective percentages of stock ownership. They paid federal and Colorado income taxes on these amounts. In addition to paying taxes on his proportionate share of the corporation's undistributed 1974 earnings, Mr. Cohen also reported and paid tax on a salary paid to him by the corporation during 1974. However, the taxpayers did not pay any Colorado surtax on their respective shares of the corporation's 1974 earnings.
Less than two and one-half months after the end of the corporation's 1974 fiscal year, and in compliance with I.R.C. Section 1375(f), the subchapter S corporation distributed substantial sums of money to both Mr. and Mrs. Cohen.
The appellant Department of Revenue contends that a shareholder's proportionate share of the income earned by a subchapter S corporation constitutes dividends subject to the Colorado surtax. Section 39-22-106(1), C.R.S.1973. The Department of Revenue has promulgated regulations to this effect. Regulation 138-1-6(1), effective January 1, 1973, states in pertinent part:
"The terms 'interest' and 'dividends' . . . as used in (section 39-22-106(1)) include . . . the stockholder's share of the taxable income of an electing small business corporation (except that portion treated as long-term capital gain) whether or not such income was distributed during the taxable year of the corporation which ends with or within the taxable year of the shareholder . . . ."
Regulation 138-1-36, also effective January 1, 1973, provides:
"The shareholders of a 'subchapter S' corporation shall report their share of the subchapter S corporation income as subject to both the Colorado normal tax and (except for that portion treated as a long-term capital gain) the Colorado surtax . . . ."
In 1958 Congress adopted Subchapter S of the Internal Revenue Code (sections 1371-1379), to enable small businesses to choose the most desirable form of business organization for their circumstances without having the choice dictated by tax considerations. S.Rpt. No. 1983, 85th Cong., 2d Sess. (1958), U.S.Code Cong. & Admin.News 1958, p. 4791. These provisions enable electing small business corporations to qualify for the non-tax advantages of incorporation such as continuity of existence, insulation from personal liability, and ease of transferability of ownership, without the concomitant "double taxation" of corporate earnings. The general scheme is to tax the income earned by a corporation electing subchapter S treatment only once, at the shareholder level. See 7 Mertens, Law of Federal Income Taxation § 41B.01 (1976); Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders § 6.02 (3d ed. 1971). This scheme, of course, contrasts with the normal pattern of imposing a tax on the corporation's profits, payable by the corporation, and an additional tax on dividends distributed by the corporation, payable by the individual shareholders.
The central mechanism of the subchapter S structure is the taxation of each shareholder for a proportionate share of the corporate income earned during the corporation's tax year. I.R.C. § 1373(a). The corporate income is treated as having been "passed through" to the shareholders regardless of whether in fact it is distributed. To each shareholder is attributed a portion of the corporation's taxable income proportionate to his or her share of the total stock, and each shareholder is taxed accordingly.
Except for long-term capital gains, the corporate income attributed to shareholders does not retain the character it had at the corporate level. I.R.C. § 1375(a). Because income earned by a subchapter S corporation is not taxed at the corporate level, the shareholders to whom it is attributed are not entitled to claim a dividends-received exclsuion. I.R.C. § 1375(b).
As a result of Subchapter S, the shareholders report the corporation's income, whether or not distributed, as if it were their personal income and the federal tax at the corporate level is eliminated. See 7 Mertens, supra at § 41B.26-35; Bittker & Eustice, supra at § 6.05.
The Colorado General Assembly has adopted the Subchapter S scheme and has exempted from the state's corporate income tax small business corporations electing Subchapter S tax treatment. Section 39-22-302, C.R.S.1973. The Colorado Department of Revenue, however, has attempted to apply the dividend surtax against each shareholder's proportionate share of income earned by subchapter S corporations. This has been accomplished, not by amending subsection 39-22-106(1), the surtax statute, which was enacted in 1937 (21 years before there were subchapter S corporations), but by the Department of Revenue's adopting regulations. That statute imposes a surtax on the portion of gross income which exceeds $5,000 and "consists of or is derived from dividends and interest . . . ." Thus the question is whether income attributed to the shareholders of a subchapter S corporation constitutes dividends subject to surtax under this...
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