The call usually starts with a Schedule K-1. A minority owner of a California S corporation sees a six-figure share of the company’s profit allocated to him, and he has not received a dollar of it. The owners who run the company have been paying themselves and keeping him away from the books. He still owes federal and California tax on his share.
Two August 2026 rulings bear on his position. The Ninth Circuit’s affirmance in Maggard limits his tax arguments, and the Eleventh Circuit’s Owoc decision matters if the company ends up in bankruptcy.
Why does an S corporation shareholder owe tax on money he never received?
Under 26 U.S.C. § 1366(a), each shareholder reports his pro rata share of the corporation’s income, cash or no cash. Quoting Moore v. United States, 602 U.S. 572 (2024), the Ninth Circuit’s Maggard disposition said shareholders are taxed “even if the entity has not distributed any money or property to them.” The company owes him a K-1 under 26 U.S.C. § 6037(b), but nothing obliges the insiders to send cash for the tax. That gap is phantom income.
Can lopsided distributions end the S election?
A shut-out owner often argues the insiders now hold a better class of stock, which 26 U.S.C. § 1361(b)(1)(D) forbids. Maggard v. Commissioner, T.C. Memo. 2024-77, rejected that theory. James Maggard owned 40 percent of Schricker Engineering Group, an engineering company in California, while the other owners took outsized distributions and froze him out. Judge Holmes held the S election survived for 2014 through 2016. Under Treas. Reg. § 1.1361-1(l)(2)(i), identical rights are judged by the “governing provisions” (articles, bylaws, state law and binding agreements), and distributions that differ in timing or amount do not create a second class.
The Ninth Circuit affirmed in Maggard v. Commissioner, No. 25-4131 (9th Cir. Aug. 26, 2026), an unpublished memorandum that is not precedent except as Ninth Circuit Rule 36-3 allows. It is brief, but it comes from the court that hears California’s Tax Court appeals. Termination is not a lever here; the fix has to come from corporate law.
How does California tax the same income?
California follows the federal election under Cal. Rev. & Tax. Code § 23800 and section 23801(a) but still taxes the entity. Section 23802 imposes a 1.5 percent tax on the S corporation’s net income and keeps the $800 minimum franchise tax of section 23153. The company files Form 100S and gives each owner a Schedule K-1 (100S). Section 17087.5 carries Subchapter S into the personal income tax, and section 17041(a) taxes a resident’s entire taxable income, so an owner in Rancho Cucamonga or Elk Grove pays California tax on his whole share. (An earlier post looks at how California taxed one S corporation’s division sale.)
What does this look like for a 30 percent owner in Fontana?
In an illustrative case, Dan owns 30 percent of a Fontana trucking company organized as a California S corporation, and two brothers own the rest and run it. In 2025 the company earns $900,000. The brothers take $560,000 in distributions, which means Dan’s pro rata share would have been $240,000. He gets nothing.
Each of Dan’s K-1s shows $270,000. At an assumed combined federal and California rate of 35 percent, he owes about $94,500, while the company pays $13,500 of California tax at 1.5 percent. Under 26 U.S.C. § 1367(a)(1), his basis rises by $270,000 with no distributions to reduce it, taking him from $50,000 to $320,000.
What can a frozen-out shareholder do under the California Corporations Code?
Start with records. Cal. Corp. Code § 1601 lets any shareholder inspect the books, records and minutes on written demand for a purpose tied to his shareholder interests, and the bylaws cannot restrict it. Section 1501(c) lets a 5 percent holder demand interim financial statements. Those are the records I test a K-1 against.
In Jones v. H.F. Ahmanson & Co., 1 Cal. 3d 93 (1969), the California Supreme Court held that controlling shareholders may not use their power “to benefit themselves alone or in a manner detrimental to the minority.” Uneven distributions can support a direct claim for Dan’s loss. Harm to the company, like inflated insider pay, goes derivatively under Corp. Code § 800, which requires a pleaded demand on the board or a reason for skipping it.
Section 1800(b)(4) permits involuntary dissolution for persistent and pervasive fraud, mismanagement or abuse of authority, or persistent unfairness toward shareholders, and section 1800(b)(5) adds a ground for corporations with 35 or fewer shareholders when liquidation is reasonably necessary to protect the complaining owner. Standing normally takes 33 1/3 percent, but section 1800(a)(2) leaves out shares of anyone who personally took part in the (b)(4) conduct, so if both brothers did, Dan holds every share that counts. Under Corp. Code § 2000, the company or the 50 percent holders can avoid dissolution by buying his shares at fair value, usually as of the filing date, with court-appointed appraisers if the sides disagree.
Are you being taxed on S corporation profits the other owners are keeping? Each year of delay adds another K-1 you pay on, and a section 2000 buyout is usually valued as of the day the dissolution suit is filed. An attorney who is also a CPA can trace the money and build the corporate case together.
What should a California shareholder agreement say about taxes?
Most of this is preventable. A shareholder agreement should require a yearly tax distribution, paid before estimated tax deadlines, equal to allocated income times one assumed rate, per share to every owner. Treating every share alike keeps it within the governing-provisions test; paying some owners more per share would invite the second-class problem. I also add a put right if tax distributions are missed and a deadlock clause that ends in a buy-sell. The firm drafts these in its shareholder agreement and S corporation planning work.
What happens to the S election if the corporation files bankruptcy?
When a Chapter 7 trustee sells fully depreciated trucks, the gain passes through to shareholders while creditors get the cash. The fix is revocation. Under 26 U.S.C. § 1362(d)(1)(B), that takes consent from holders of “more than one-half of the shares,” and Treas. Reg. § 1.1362-6(a)(3) has the corporation file the statement. A revocation filed by the 15th day of the third month of the year relates back to January 1.
In re Majestic Star Casino, LLC, 716 F.3d 736 (3d Cir. 2013), held that pass-through status is not estate property, and Owoc v. Liquidating Trustee, No. 24-14048 (11th Cir. Aug. 10, 2026), agreed, reasoning that the election is controlled by the shareholders rather than the company.
California is different. In Parker v. Saunders (In re Bakersfield Westar, Inc.), 226 B.R. 227 (B.A.P. 9th Cir. 1998), the owners of a California ambulance company revoked its election about a month before bankruptcy. The Ninth Circuit Bankruptcy Appellate Panel held that the right to revoke was the corporation’s property and that the trustee could avoid the revocation under 11 U.S.C. § 548. Majestic Star criticized that reasoning, but I have found no Ninth Circuit decision resolving the conflict.
So here, revoking before filing invites a fraudulent transfer claim, and revoking after invites a stay fight. Document majority consent and, once a case is open, ask the bankruptcy court for an order before the statement goes in, as Owoc did. Dan cannot revoke alone. The brothers, though, now bear 70 percent of the phantom gain and may well cooperate.
How should a shareholder read the K-1 and handle tax he cannot pay?
As a CPA, I reconcile the K-1 to the money. If it shows distributions he never received or income the financials do not support, he can report what he believes is right and flag the difference on IRS Form 8082, as section 6037(c) allows.
If the company fails, Dan’s $320,000 basis becomes a worthless-stock loss under 26 U.S.C. § 165(g). That is a capital loss, and section 1211(b) limits its yearly use to capital gains plus $3,000 unless qualifying stock lets section 1244 treat up to $50,000 a year ($100,000 joint) as ordinary.
For California tax he cannot pay, R&TC § 19008(b) requires the FTB to grant an installment agreement on $25,000 or less of tax, payable within five years, if he has filed his returns and cannot pay in full. Larger balances go through the FTB’s installment agreement or offer in compromise programs, and the FTB says it delays collection during temporary hardship.
| Option | Who can use it | What it gets him |
|---|---|---|
| Records demand (Corp. Code § 1601) | Any shareholder | Records to test the K-1 |
| Fiduciary claim (Jones) | Harmed minority owner | Damages for missed distributions |
| Dissolution (Corp. Code § 1800) | 33 1/3 percent, excluding wrongdoers’ shares | Buyout leverage under section 2000 |
| Second-class-stock theory (Maggard) | Any shareholder | Fails if governing provisions are equal |
| Revocation (IRC § 1362(d)(1)(B)) | Majority of shares outstanding | Stops pass-through; Bakersfield Westar risk |
Frequently Asked Questions
Do I have to pay tax on S corporation income I never received?
Yes. Federal law taxes each shareholder on his pro rata share of S corporation income whether or not it is distributed, and California taxes residents on the same share. The undistributed income does raise your stock basis. The fix is to pursue the missing distributions under corporate law and arrange payment with the IRS and FTB.
Does an S corporation lose its status if the other owners take bigger distributions?
Generally no. In Maggard v. Commissioner, the Tax Court ruled that unequal distributions do not violate the single-class rule when the articles, bylaws and binding agreements give every share identical rights, and the Ninth Circuit affirmed in an unpublished August 2026 memorandum. The distributions can still support a fiduciary duty claim.
Can a 30 percent shareholder sue to dissolve a California corporation?
Possibly. Corporations Code section 1800 generally requires holders of 33 1/3 percent to sue, but shares held by people who personally took part in the alleged misconduct are not counted. If the controlling owners are the wrongdoers, a 30 percent owner may qualify, though the company can usually buy him out at fair value instead.
Does California tax S corporation income twice?
Partly. The corporation pays a 1.5 percent tax on its net income, subject to the $800 minimum franchise tax, and files Form 100S. Each resident shareholder also pays personal income tax on his full Schedule K-1 (100S) share. That is less than C corporation double taxation, but federal law has no similar entity tax.
Can shareholders revoke the S election after the company files bankruptcy?
The Third and Eleventh Circuits allow it because shareholders, not the estate, control the election. California is less settled because a 1998 Ninth Circuit Bankruptcy Appellate Panel decision let a trustee attack a revocation as a transfer of the corporation’s property. Revocation needs majority shareholder consent, and a bankruptcy court order first is prudent.
How North Star Law Firm Can Help
North Star Law Firm represents minority owners and closely held companies across California, including the Inland Empire and the Sacramento area, in shareholder disputes, buyouts and the tax fallout that comes with them. The firm reviews and drafts shareholder agreements, advises on S corporation elections and revocations, works out installment agreements with the IRS and FTB, and counsels owners whose companies are headed into Chapter 7 or Chapter 11. Phillip Zagotti is a California attorney and a CPA, admitted to the U.S. Bankruptcy Court for the Central District of California, and he represents taxpayers before the IRS, the Franchise Tax Board, the Office of Tax Appeals and the U.S. Tax Court.
If you are paying tax on profits you are not receiving, contact North Star Law Firm or schedule a consultation.