Taproot Admin. Servs., Inc. v. Comm'r

• Citation: 109 A.F.T.R.2d 2012,12 Cal. Daily Op. Serv. 3334,2012 Daily Journal D.A.R. 3759,679 F.3d 1109
• Decision Date: 21 March 2012
• Docket Number: No. 10–70892.,10–70892.
• Parties: TAPROOT ADMINISTRATIVE SERVICES, INC., Petitioner–Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)

679 F.3d 1109

109 A.F.T.R.2d 2012-1446

12 Cal. Daily Op. Serv. 3334

2012 Daily Journal D.A.R. 3759

TAPROOT ADMINISTRATIVE SERVICES, INC., Petitioner–Appellant,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.

No. 10–70892.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Nov. 9, 2011.

Filed March 21, 2012.

Steven R. Mather (argued), Kajan Mather and Barish, Beverly Hills, CA, for the petitioner-appellant.

John A. DiCicco, Acting Assistant Attorney General; Richard Farber and John A. Dudeck (argued), Attorneys; U.S. Department of Justice, Tax Division, Washington, D.C., for the respondent-appellee.

Appeal from a Decision of the United States Tax Court. Tax Ct. No. 15396–07.

Before: MARY M. SCHROEDER and STEPHEN REINHARDT, Circuit Judges, and HENRY E. HUDSON, District Judge.^*

OPINION

HUDSON, District Judge:

Under the Internal Revenue Code, certain eligible corporations may elect S corporation status, thereby acting as pass-through entities for federal taxation purposes. The rules governing eligibility to elect S corporation status restrict various attributes those corporations may have, including the number of shareholders, the classes of stock issued, and the types of shareholders. The single question presented is whether a corporate taxpayer is ineligible for S corporation status, and therefore must be taxed as a C corporation, because its sole shareholder is a custodial Roth Individual Retirement Account (Roth IRA). Taproot Administrative Services, Inc. (Taproot) contends that a Roth IRA cannot be distinguished from its individual owner under a reasonable interpretation of the governing statute. Adhering to this construction, Taproot thus argues that it satisfies the S corporation requirements. For the reasons that follow, we disagree with Taproot and affirm the decision of the Tax Court.

I.

Qualifying small business corporations may affirmatively elect S corporation status for federal income tax purposes. I.R.C. §§ 1361(a), 1362(a)(1) (2006). Under I.R.C. §§ 1363(a) and 1366(a)(1)(A), an S corporation's “profits pass through directly to its shareholders on a pro rata basis and are reported on the shareholders' individual tax returns.” Gitlitz v. Comm'r, 531 U.S. 206, 209, 121 S.Ct. 701, 148 L.Ed.2d 613 (2001) (citing I.R.C. § 1366(a)(1)(A)). In this way, an S corporation serves as a conduit through which income flows to its shareholders. Id. (“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.”); see also Bufferd v. Comm'r, 506 U.S. 523, 525, 113 S.Ct. 927, 122 L.Ed.2d 306 (1993).

To receive such favorable tax treatment under the statute, a small business corporation must first meet all of the eligibility requirements before electing S corporation status.¹ Eligibility turns on three characteristics: (1) the number of shareholders, (2) the class of stock, and (3) the types of shareholders. I.R.C. § 1361(b).² In pertinent part, the statute limits eligible types of shareholders to domestic individuals, estates, certain trusts, and certain tax-exempt entities. I.R.C. § 1361(b)(1)(B), (c)(2), (c)(6). As of the 2003 tax year, § 1361(c)(2)(A) permitted the following trusts to be eligible 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.³

Taxpayer Paul Di Mundo (Di Mundo) incorporated Taproot Administrative Services, Inc. in the state of Nevada on October 2, 2002. Taproot elected S corporation status effective as of the date of incorporation and filed its 2003 tax return on a Form 1120S, U.S. Income Tax Return for an S Corporation. On January 2, 2003, Taproot issued all outstanding shares of its stock to a custodial Roth IRA account held at the First Trust Co. of Onaga, in Onaga, Kansas, for the benefit of Di Mundo.⁴ The custodial Roth IRA ⁵ account remained Taproot's sole shareholder during the 2003 tax year. According to its 2003 tax return, Taproot earned a total income of $322,420. Taproot reported total deductions of $320,191, resulting in a net ordinary income of $2,229. Taproot also reported interest income totaling $8,549.

On April 10, 2007, the Commissioner of the Internal Revenue Service (I.R.S.) issued a notice of deficiency to Taproot for the 2003 tax year. Among other findings,⁶ the Commissioner determined that a Roth IRA did not qualify as an eligible shareholder of an S corporation. Consequently, Taproot was deemed taxable as a C corporation for the 2003 tax year.

II.

In response to the Commissioner's notice of deficiency, Taproot filed a petition with the U.S. Tax Court arguing that the individual beneficiary of a custodial account also qualifying as a Roth IRA should be considered the shareholder for purposes of the S corporation statute, or, in the alternative, a Roth IRA should be treated as a grantor trust pursuant to § 1361(c)(2)(A). Specifically, Taproot contended that as the sole beneficiary of the Di Mundo Roth IRA, Di Mundo should be considered the shareholder and, thus a qualifying individual for the purposes of the statute. According to Taproot, Di Mundo's eligibility as such is governed by § 1.1361–1(e)(1) of the Treasury Regulations. In relevant part, the regulation provides that “[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 for purposes of [the S corporation statute].” Treas. Reg. § 1.1361–1(e)(1). Taproot further supported this conclusion by citing Revenue Ruling 66–266, 1966–2 C.B. 356, and I.R.S. Priv. Ltr. Rul. 86–05–028 (Nov. 4, 1985) for the propositions that S corporation stock held in a custodial account for a disabled person or by a custodian under the Uniform Gifts to Minors Act, respectively, should be treated as held by the disabled person or child individually.

In the alternative, Taproot argued that a Roth IRA should be classified as a grantor trust, which qualifies as an eligible S corporation shareholder. Specifically, § 1361(c)(2)(A)(i) extends shareholder eligibility to any grantor trust ⁷ “all of which is treated ... as owned by an individual who is a citizen or resident of the United States.”

The Tax Court rejected Taproot's arguments, holding that a Roth IRA could not be an S corporation shareholder under the eligibility rules in place during 2003. As a result, Taproot was ineligible for S corporation status in 2003 and was therefore a C corporation for federal income tax purposes. In articulating its reasoning, the Tax Court first acknowledged that “no statute or regulation in effect during 2003 explicitly prohibited a traditional or Roth IRA from owning S corporation stock.” Taproot Admin. Serv. v. Comm'r, 133 T.C. 202, 208 (2009). The Tax Court then identified Revenue Ruling 92–73, as providing the only guiding legal authority on the issue. Id. Examining this ruling, in which the Commissioner held that a trust that qualifies as an IRA is not a permitted shareholder of an S corporation, the Tax Court concluded that the underlying rationale was sound and comported with the apparent intent of Congress, thus providing a compelling reason for its decision. The Tax Court was also mindful that under Taproot's theory of statutory construction, Di Mundo would avoid virtually all taxation on his S corporation profits.

In determining the requisite deference owed to a revenue ruling, the Tax Court noted that it was not bound by the official interpretations of the I.R.S., which “are published for the information and guidance of taxpayers, I.R.S. officials, and others concerned.” Id. (quoting Treas. Reg. § 601.601(d)(2)(i)(a)). Rather, “applying the standard enunciated by the Supreme Court in Skidmore v. Swift & Co., 323 U.S. 134, 140, 65 S.Ct. 161, 89 L.Ed. 124 (1944), the weight (if any) that [the court must] afford them depends upon their persuasiveness and the consistency of the Commissioner's position over time.” Id. at 208–09.

Extending Skidmore deference to Revenue Ruling 92–73, the Tax Court found the ruling to “sensibly distinguish[ ] IRAs from grantor trusts.” Id. at 210. In making that determination, the Tax Court relied in part on the rationale of Revenue Ruling 92–73, stating that:

[T]raditional IRAs are not eligible S corporation shareholders because the beneficiary of a traditional IRA is not taxed currently on the IRA's share of the S corporation's income whereas the beneficiaries of the permissible S corporation shareholder trusts listed in section 1361(c)(2)(A) are taxed currently on the trust's share of such income.

Id. The Tax Court also noted the functional difference between IRAs and grantor trusts. Governed by distinct code sections, traditional and Roth IRAs exist separately from their owners for federal taxation purposes, while grantor trusts do not.⁸

Turning to the second factor set forth in Skidmore, the Tax Court also found that the Commissioner had applied the revenue ruling consistently. In particular, the Tax Court cited the Commissioner's uniform citation to Revenue Ruling 92–73 in private letter rulings addressing automatic terminations of S corporation status upon stock acquisition by IRAs. Id.

Finally, the Tax Court shifted its attention to the legislative intent behind the S corporation statute, finding the only available...