The distinction could be important when transferring your company interests
A recent Ohio Fourth District Court of Appeals decision raises an issue for pass-through entity (PTE) owners. The decision involves a divorce where the husband and wife were owners in an S Corporation. But it has implications for any occurrence where a current PTE owner transfers his or her interest to someone else.
In this particular situation, under the terms of their divorce, the husband was to buy out the wife’s 60% ownership in the S Corp. A provision in the divorce decree stipulated the husband was solely responsible for any indebtedness of the company, holding the wife harmless. The court’s interpretation of how this provision relates to tax liability has caught the attention of savvy tax professionals.
The wife initiated the law suit
The wife brought the case before the courts, asking for reimbursement for Federal, Ohio and West Virginia taxes as a result of her final K-1 from the Company. She sued because no disbursements for taxes were distributed to her by the S Corporation, and she maintained it is standard practice for companies who utilize pass-through taxation to pay the personal tax obligations of their “owners” (emphasis added).
The Lawrence County Trial Court, in adopting the decision of a Magistrate, awarded the wife reimbursement of her taxes incurred on the income reported on her final K-1.
The husband appealed, and lost
The husband’s appeal was brought before The Ohio Fourth District Court of Appeals, who upheld the tax reimbursement. The court looked at the company’s past practice of distributing tax payments as proof the wife was entitled to expect the S Corp to distribute monies sufficient to pay those taxes associated with the income.
The court considered the ambiguity of the provision in the divorce decree and connected it with the courts’ understanding of Ohio S Corporation law: that the profits, and therefore debts (emphasis added), of the S Corp belong to the individuals, not the S Corp.
As such, due to the way the provision in the divorce decree was drafted and the historic practice of distributing tax payments from the S Corp, the debt was deemed the responsibility of the S Corp and as such, the husband.
The take-away for PTE owners
It is common practice for PTE owners to distribute payments for the owner’s tax liabilities from the PTE. This case illustrates an unintended consequence from that practice. By distributing tax payments from the PTE, the owners are effectively making the PTE legally responsible for the owners’ tax payments.
While this case illustrates the consequences resulting from a divorce, it easily translates to any situation where a current owner transfers his or her interest to someone else. It’s especially relevant when the transfer occurs between a transferor and transferee whose relationship is strained.
It would be smart to be sure that agreements effectuating the transfer of ownership interest in a PTE are scrubbed to eliminate ambiguous provisions regarding the transfer. What may at first blush look to be a simple or well understood provision could trigger litigation if one party to the transaction interprets the provision one way and the other party differently.
In the above case, the provision in the divorce should have spelled out exactly what liabilities the company was responsible for, or it should have excluded taxes as a liability for which the wife would be held harmless.
Further resources for understanding C corps and S corps: