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Tomseth v. United States

United States District Court, D. Oregon, Eugene Division

September 27, 2019

TOMSETH, et al., Plaintiffs,

          OPINION & ORDER


         Husband and wife plaintiffs Matthew Tomseth and Diana Tomseth ("Plaintiffs") sued the United States for a $2, 304, 799 tax refund, plus statutory interest. They allege that the United States collected these taxes based on an incorrect interpretation of certain tax provisions that governed the shareholder distributions Plaintiffs received from three Les Schwab tire companies. The parties have filed a joint stipulation of facts and cross motions for summary judgment. For the following reasons, the United States' motion is granted in part and denied in part, and Plaintiffs' motion is denied as moot.


         Plaintiffs are shareholders in three family-owned Les Schwab Tire corporations: Les Schwab Warehouse Center, Inc. ("LS Warehouse"), Les Schwab Tire Centers of Washington, Inc. ("LS Washington"), and Les Schwab Tire Centers of Portland, Inc. ("LS Portland") (collectively, the "Corporations"). Throughout their history, these Les Schwab tire companies toggled between operating as S-corps and C-corps to use each designation's tax benefits.

         S-corps generally pay a single level of tax because their shareholders can elect to make the corporation a pass-through entity for tax purposes. This allows the S-corp to pass its income directly to its shareholders on a pro rata basis, which the shareholders would then record on their individual tax returns. By contrast, C-corps are often said to be subject to "double-taxation" because their income is first taxed at the C-corp entity level and again at a shareholder's ordinary income tax rate if earnings are distributed as dividends.

         S-corps sometimes retain their taxed earnings instead of distributing them to their shareholders. 26 U.S, C. § 1368(e) requires these taxed but undistributed earnings to be kept in a separate accumulated adjustments account ("AAA"). But the IRC also allows corporations to toggle between S-corp and C-corp designations so an issue about the status of these taxed but undistributed AAA funds naturally arises. Section 1371(e) provides a partial answer to this issue. It allows for an S-corp's AAA balance to be distributed tax-free even after it becomes a C-corp as long as the distribution happens within a one-year post-termination transition period ("PTTP"). See 26 U.S.C. § 1371(e). In short, it allows distributions up to the value of the AAA balance to escape dividend treatment under subchapter C.

         But what if the corporation doesn't distribute all of its AAA within the PTTP; can it distribute the remaining AAA funds tax-free once the corporation reverts to an S-corp? The parties answer this question differently.

         Plaintiffs argue that the old AAA balance is still accessible once the C-corp reverts to an S-corp. They interpret the PTTP provisions as placing a temporary bar on accessing the old AAA tax-free only while the corporation remains a C-corp. But once the corporation elects to be an S-corp again, the S-corp can tap back into its old AAA funds and distribute them tax-free. The United States argues that PTTP expiration equals AAA expiration: once the PTTP expires, the old AAA earnings are no longer available for tax-free distribution even if the corporation reverts to an S-corp. In that case, the United States argues that the AAA balance resets to zero after a new S election.

         This differing interpretation of the status of AAA funds after the expiration of the PTTP has led to this dispute between the parties. In 2013, Plaintiffs received $9, 326, 545 in distributions from all three corporations, which the IRS characterized as taxable dividends: $4, 313, 419 from LS Warehouse, $850, 941 from LS Washington, and $4, 162, 185 from LS Portland. The Corporations were C-corps at the time of the distributions and the distributions were within the PTTP. In previous years, however, they had twice operated as S-corps and calculated their AAA funds at the beginning of their most recent S-election as the sum of the AAA balances during these two S-periods.

         Their history of corporate metamorphosis is dizzying. LS Warehouse was incorporated as a C-corp in 1958. In 1987, LS Warehouse elected to be an S-corp for the first time (the "First S-Period"). It then reelected to be taxed as a C-corp in December 1993. As of December 31, 1993, LS Warehouse had a balance in its AAA of $51, 627, 736 and distributed $26, 743, 007 to its shareholders during its PTTP, leaving $24, 884, 729 of undistributed AAA. LS Warehouse continued as a C-corp from 1994 through 2008 and reelected to be an S-corp on January 1, 2009 (the "Second S-Period"). It then carried over the First S-Period's AAA and added it to the new 2009 AAA balance at the start of the Second S-Period. At the end of 2012, considering solely the AAA funds generated during its Second S-Period, LS Warehouse had a AAA balance of $17, 563, 554. But in 2013, LS Warehouse again reelected to become a C-corp and distributed $42, 443, 028-roughly the sum of its First and Second S-Period AAA balances-to its shareholders, of which Plaintiffs received $7, 356, 905. The IRS determined that $4, 313, 419 of the $7, 356, 905 was a taxable dividend rather than a tax-free AAA distribution.

         LS Washington followed the same pattern of corporate changes as LS Warehouse. It was incorporated on April 12, 1968 and operated as a C-corp from inception until it elected to be classified as an S-corp on August 1, 1987 (the "First S-Period"). LS Washington continued operating as an S-corp from August 1, 1987 through December 31, 1991, when it reverted to a C-corp. As of December 31, 1991, LS Washington had a balance in its AAA of $19, 862, 658. During its PTTP in 1992, LS Washington distributed $10, 225, 694 to its shareholders. LS Washington operated as a C-corp from January 1, 1992 through December 31, 2008, and then reverted to an S-corp on January 1, 2009 (the "Second S-Period"). It then operated as an S-corp until December 31, 2012, at which time it elected to be a C-corp again. During its Second S-Period, LS Washington had accumulated a AAA of $15, 104, 172. It then distributed $24, 692, 889-roughly the sum of its First and Second S-Period AAA balances-to its shareholders during its 2013 PTTP, of which Plaintiffs received $2, 180, 376. The IRS determined that $850, 941 of the $2, 180, 376 was a taxable dividend rather than a tax-free distribution.

         Finally, there is LS Portland. It was initially incorporated as a C-corp in 1973 and first elected to be an S-corp from 1987 through 1993 (the "First S-Period") when it revoked its S status and reverted to a C-corp. It had a AAA balance of $56, 645, 199 at the end of its First S-Period and distributed $31, 916, 781 of it during its 1994 PTTP while operating as a C-corp. This left $22, 728, 418 of undistributed AAA. In 2004, however, LS Portland re-elected to become an S-crop (the "Second S-period") and assumed it could carry over the old AAA from the First S-period and calculated its starting AAA balance as $22, 728, 418. It then distributed $1, 968, 878 to its shareholders as a tax-free distribution in 2005. This lowered the old AAA balance to $20, 759, 540. It further accumulated $21, 950, 729 of new AAA during its Second S- Period between 2004 and 2012. It re-elected to become a C-corp in 2013 and distributed $4, 162, 185 of its old AAA (out of the remaining $20, 759, 540) to Plaintiffs.

         Plaintiffs believed that none of the 2013 distributions were taxable dividends because the distributions were already taxed when the Corporations were operating as S-corps. They initially calculated their 2013 tax liability under the United States' theory of the case. That is, their complaint suggests that they knew that the IRS may treat the Corporations' distributions as taxable so they included "disclosure statements with the relevant tax returns stating that [they believed] that the distributions from the Corporations' old AAA were nontaxable and [that they] intended to file claims for refund." Compl. at 6.

         In April 2015, Plaintiffs filed a form 1040X and claimed a refund for the taxes paid under the theory that AAA never expires and was available for tax-free distribution once the Corporations began their Second S-Periods. Although the IRS first issued them a refund for $2, 298, 368, it then determined that the refund was issued mistakenly based on a 2014 IRS Chief Counsel Advice Memorandum (the "2014 Memorandum") after conducting an audit of Plaintiffs' tax returns. The 2014 Memorandum concluded that after the PTTP, undistributed AAA would not be available for distribution once a corporation re-elected to become an S-corp. Because Plaintiffs' claimed refund was inconsistent with the 2014 Memorandum, the IRS demanded payment of the $2, 298, 368.

         Additionally, during the same audit, the IRS discovered that in 2005 LS Portland had another tax deficiency and now wants to tax an additional $357, 488 of Plaintiffs' income. The United States claims that LS Portland started its Second S-period in 2004 with a AAA balance of $0. As a result, it didn't have sufficient AAA funds to make its 2005 distribution of $1, 968, 878 tax-free. Although the United States doesn't explain its calculation, it claims that $1, 783, 025 of the $1, 968, 878 that LS Portland distributed in 2005 was taxable.

         But the United States ran into a statute of limitations problem because the tax deficiencies stem from LS Portland's 2005 distribution. The United States concedes that "it was too late to assess the tax that should have been reported and paid for in 2005 [in 2013]." It thus reduced the AAA balance to a negative balance of ($1, 968, 878) in 2005. That negative balance was carried forward to reduce the new AAA available in 2013 and therefore made $1, 783, 025 of the distributions in 2013 taxable to LS Portland's shareholders, with $357, 488 being Plaintiffs' pro rata share.

         In July 2017, the IRS issued an audit report that added $9, 684, 033 of taxable qualified dividends to Plaintiffs' taxable income. Plaintiffs paid the tax attributable to these qualified dividends in August 2017 but filed for a refund. The IRS rejected their refund request two months later and Plaintiffs filed a complaint for refund in this Court in December 2017. The parties have filed a Joint Stipulation of Facts and cross motions for summary judgment. Plaintiffs have only moved for summary judgment on the statutory interpretation issue while the United States has moved for summary judgment on both the statutory interpretation issue and the statute of limitations issue. The parties also requested oral argument, which was held earlier this year.


         Summary judgment is proper when "there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law." Fed. H. Civ. P. 56(a). A dispute is genuine only if there is sufficient evidence for a reasonable fact finder to find for the non-moving party, and material only if the fact may affect the outcome of the case. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248-49 (1986). In this analysis, the Court draws all reasonable inferences in the light most favorable to the non-moving party. Johnson v. Rancho Santiago Cmty. Coll. Dist, 623 F.3d 1011, 1018 (9th Cir. 2010). Unsupported conjecture or conclusory statements, however, cannot defeat summary judgment. Surrell v. Cal. Water Serv. Co., 518 F.3d 1097, 1103 (9th Cir. 2008).


         There are two issues before me: (i) whether under the relevant statutory language a corporation that doesn't distribute all of its AAA within the PTTP can still distribute its remaining AAA balance tax-free if it reelects to become an S-corp, and (ii) whether the statute of limitations bars the United States from.collecting tax on certain improperly distributed AAA funds by LS Portland in 2005. The parties agree that there are no disputes of material fact and the only issues here are disputes of law. See Joint Stipulation of Facts (doc. 19).

         I. Undistributed AAA and the PTTP

         Plaintiffs argue that any AAA funds that were not distributed to shareholders during the PTTP are still distributable on a tax-free basis if a corporation becomes an S-corp sometime in the future. Plaintiffs' position centers on four core arguments. First, they argue that their interpretation of the AAA and PTTP provisions is supported by the relevant statutory texts: §§ 1368(e), 1371, and 1377. Second, they argue that their interpretation is supported by the relevant legislative history. Third, they argue that the United States' position has the added disadvantage of being inconsistent with § 1371(f) of the Tax Cuts and Jobs Act, which Congress passed in 2017. Finally, they argue that the Court should not give persuasive weight to the IRS opinion and tax treatises relied on by the United States.

         A. The ...

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