K-1 Found to Be In Error, S Corporation Had to Deduct All Payments on Employment Agreement in Year Paid for Terminated Employee

In the second Winter case (T.C. Memo. 2010-287) Judge Holmes was put in an unusual position—being assigned to decide issues that he had previously indicated the Court had no jurisdiction to decide (Winter v. Commissioner, 135 TC No. 12).  So he begins his opinion by noting:

“I would have held that the Court lacks jurisdiction over these questions, but my colleagues, in a reviewed opinion, assured me, the parties, and the rest of the audience for our opinions that we did have jurisdiction in Winter v. Commissioner.”

But given the assignment, Judge Holmes now wrestled with a case involving a shareholder employee of an S corporation who had a falling out with the corporation.  The case becomes truly unusual because now the employee is arguing that the S Corporation return should have included additional deductions, forcing the Court to have to look through to the corporation’s return to come to a conclusion in the matter.

In 2002 Mr. Winter received $5.5 million from the corporation that related to his employment agreement.  However, in 2003 the corporation, asserting that Mr. Winter was terminated for cause, brought action to recover the portion of the compensation that represented the amount that would have been due for periods after Mr. Winter was terminated and stopped performing services.

As well, Mr. Winter claimed never to have received a K-1 from the S corporation, but computed his share of income based on financial reports of entity.  A major difference between the financial reporting and the tax return was that the corporation deducted only $1.1 million of the $5.5 million, that portion applicable to 2002.  Mr. Winter, now being shown the K-1, disputed the corporation’s tax reporting, claiming the amount was a payment on a disputed liability, deductible under IRC §461(f).

The IRS countered that this could not be a disputed liability because no dispute existed at the time the corporation paid the amount due.  However, Judge Holmes notes that the IRS’s own regulations have an example where a vendor paid for product only to later find it was defective.  The regulations held in that case the original payment was a payment of a contested liability.  Judge Holmes held that the key was whether the amount was disputed at year end.

The Judge noted that if Mr. Winter had not been discharged for cause, the additional $4 million would have payable to him as damages under the contract. For purposes of applying the four tests for recognition under §461(f), the amount paid had to treated as if it was paid for what Mr. Winter alleged—the payout of his contract.  If it had been paid to settle the balance due on Mr. Winter’s contract, it would be in the nature of a severance payment.  Since there was no future benefit the payor would receive, the amount would have been deductible in 2002 absent the dispute.  Since the payor had turned over the cash to Mr. Winter, the amount was properly deductible in 2002—thus, Mr. Winter was correct that his Schedule K-1 was in error and should have reported a loss rather than the income shown.

The fact the S Corporation did not claim the loss isn’t relevant—as Judge Holmes noted, “unless the Code explicitly allows a taxpayer to make an election, each of his expenses has a proper year for its deduction.”  Therefore, 2002 was the only year in which that deduction could be claimed—it’s not an optional claim.

However the Court did not agree with Mr. Winter’s argument that he only needed to recognize the $1.1 million, treating the additional $4 million of income as a loan.  The Court found that Mr. Winter had not been given a “loan” but rather had unfettered use of the funds, subject to a contingent repayment obligation.  Thus he was required to recognize the entire payment in 2002.  If he later needed to repay the loan, he would receive a deduction in the year of repayment.

The Court also didn’t accept Mr. Winter’s claim that he should not be held subject to a negligence penalty for not attempting to obtain his K-1 or filing a Form 8082 since he had not hired professional help to prepare his return.  The Court found that Mr. Winter was financially sophisticated enough to understand that tax and financial reporting income are often very different, admitted he knew a Form 8082 (flagging an inconsistent treatment) should have been filed, and that while hiring a professional wouldn’t automatically protect a taxpayer from a negligence penalty, failing to hire one in this case was not going to be accepted as an excuse for failure to handle the matter properly.

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