Thomas v. Thomas ( 1987 )

OPINION

COHEN, Justice.

In this appeal from a judgment dividing the marital estate, we must decide whether the retained earnings of a Subchapter S corporation are marital property subject to division on divorce. We hold that they are not.

The parties were married on November 17, 1968. Appellee filed for divorce in November 1983. Appellant was employed throughout the marriage as an executive with Proctor and Gamble.

Alexandria Coca-Cola Bottling Company Ltd. (hereafter the corporation) was founded in 1906 by appellant’s grandfather. All stock in the corporation is owned by descendants of the founding family. Appellant has been Chairman of the Board since 1973. Between 1976 and 1982, appellant acquired approximately 16% of the stock in the corporation by gift and inheritance. It is undisputed that this stock is his separate property.

The corporation was a “Subchapter S” corporation at all relevant times, 26 U.S.C. sec. 1361, et seq. (1982 & Supp.1984), and its income was treated as personal income of the shareholders for federal income tax purposes. Accordingly, the community estate paid federal income taxes on appellant’s proportionate share of total corporate earnings, whether retained by the corporation or distributed to the shareholders, and the corporation neither owed nor paid federal corporate income tax on its income.

Between 1976 and 1984, the community received dividends of just over $500,000. The record does not disclose whether the community’s federal income tax liabilities arising from the corporation’s income exceeded whatever tax benefits may have arisen from ownership of the corporate stock.

It is undisputed that the corporation did not distribute all of its earnings to the shareholders. In special issue number three, the jury found that $146,000 of retained corporate income earned during the marriage was attributable to appellant’s shares of stock.

The trial court’s judgment provided: [Appellant] shall pay over to [appellee] forthwith (but no later than five (5) calendar days from his receipt thereof) one-half of any sums paid to him by the Coca Cola Bottling Company of Alexandria for his share of the earnings of that company until the sum of Seventy-Three Thousand and No/100 Dollars ($73,000.00) is paid over to [appellee]. [Appellant] is hereby appointed trustee for [appellee] under this provision until all sums due [appellee] have been paid to her and shall be accountable to [appellee] and the Court as trustee. [Appellant] shall notify the company of this award to [appel-lee] and shall take no action which is inconsistent with this Order. [Appellant] shall furnish [appellee] with a full disclosure and accounting of all sums received by him from the company until this portion of the judgment has been satisfied.

Appellant’s third point of error contends that the trial court erred in awarding appel-lee $73,000 because those funds will be appellant’s separate property, if and when he ever receives them.

The parties agree that the $73,000 award was based on special issue three and that it was based upon the trial court’s implied characterization of the retained corporate earnings as community property. Therefore, we must decide whether the corporation’s retained earnings are community property.

It is well established that unless the corporation is a spouse’s alter ego, Vallone v. Vallone, 644 S.W.2d 455 (Tex.1982), a court upon divorce may award only shares of stock, and not corporate assets. McKnight v. McKnight, 543 S.W.2d 863 (Tex.1976). Moreover, a court may not divest a spouse of separate property corporate stock and award it to the other spouse. Cameron v. Cameron, 641 S.W.2d 210 (Tex.1982). Appellee admits that in an ordinary corporation, retained earnings are a corporate asset. They are not marital property, separate or community. Appel-lee contends, however, that retained earnings of a Subchapter S corporation should be treated as community property because the community has paid federal income tax on them. This, she argues, justifies the recognition of a community interest in the retained earnings. We disagree.

Subchapter S status does not determine who owns the corporation’s earnings. It merely provides an alternate method to tax the corporation’s income. A Subchapter S corporation may distribute its income, but, like any other corporation, it is not required to do so. Corporate distributions, regardless of form, are controlled by state law. See Commissioner v. Cohen, 121 F.2d 348 (5th Cir.1941); Tex.Bus.Corp.Act.Ann. arts. 2.38, 2.39, 2.40 (Vernon 1980). The shareholder in a Subchapter S corporation has no greater rights over corporate property than a shareholder in any other corporation.

In Suburban Utility Corp. v. Public Utility Commission, 652 S.W.2d 358 (Tex.1983), a rate case, the court held that a Subchapter S utility could deduct from its income federal taxes paid by its shareholders. Thus in a rate making proceeding governed by state law, the corporation was entitled to the expense deduction, even though the shareholders had paid the taxes. The court recognized that the earnings were owned by the corporation, not by the shareholders. It wrote:

Under Subchapter S...., a corporation may elect a tax status which protects the earnings and profits of the corporation from conventional corporate tax rates. (Emphasis added.)

652 S.W.2d at 363. The court thus recognized that the tax treatment of a Subchap-ter S corporation under federal law would not control the characterization of taxation expense under state law.

Other courts have recognized that Sub-chapter S status does not affect state tax liability. Thus, states may require Sub-chapter S corporations to pay state corporate income tax. Commonwealth v. N.I. Inc., 31 Pa.Commw. 235, 375 A.2d 898 (1977), aff'd, 482 Pa. 261, 393 A.2d 653 (1978); Brown v. Dept. of Revenue, 558 S.W.2d 635 (Ky.Ct.App.1977).

Courts in community property states have unanimously held that corporate earnings remained corporate property until distributed and, therefore, were not divisible on divorce. Hoffmann v. Hoffmann, 676 S.W.2d 817, 827 (Mo.1984); Simplot v. Simplot, 96 Idaho 239, 526 P.2d 844 (1974); Speer v. Speer, 25 Cal.Rptr. 729, 209 Cal. App.2d 233 (Cal.Ct.App.1962); Gapsch v. Gapsch, 76 Idaho 44, 277 P.2d 278 (1954).

We conclude that, while the corporation retained some earnings as “previously taxed income” of the shareholders, the earnings remained the corporation’s exclusive property and never belonged to the appellant or the marital estate.

Appellee next contends that a Subchap-ter S corporation should be treated as a partnership because it is taxed like a partnership. Again, we disagree.

Federal law recognizes that Subchapter S does not convert a corporation to a partnership. United States v. Richardson, 469 F.2d 349 (10th Cir.1972); United States v. Silverman, 359 F.Supp. 1113 (N.D.Ill.1973); Neal v. United States, 313 F.Supp. 393 (C.D.Cal.1970); Wilhelm v. United States, 257 F.Supp. 16 (D.C.Wyo.1966); R.S. Smero, Inc. v. Levine, 51 A.D.2d 273, 381 N.Y.S.2d 337 (1976); Motheral v. Motheral, 514 S.W.2d 475, 477 (Tex.Civ.App—Corpus Christi 1974, writ ref’d n.r. e.), relied on by the appellee, is not to the contrary.

We observe that the marital community benefits from the Subchapter S election. When corporate income is taxed as personal income, the corporation avoids tax liability, and the community avoids having dividends taxed twice, first as corporate income, and then, upon receipt, as personal income. See 26 U.S.C. sec. 1371, et seq. (1982 & Supp.1984); Shores Realty Co. v. United States, 468 F.2d 572 (5th Cir.1972); Brown v. Dept. of Revenue, 558 S.W.2d 635 (Ky.App.1977). By avoiding corporate taxation, the corporation has more money to distribute as dividends. If the corporation has tax credits or losses, these reduce the community’s taxable income. All the while, the corporate veil shields the shareholder from personal liability. Congress intended for shareholders in Subchapter S corporations to enjoy these substantial benefits.

Upholding the trial court's order in this case could lead to undesirable and unpredictable results. It would tend to engraft upon our community property system the manifest complexities of federal tax law. If, by paying taxes, the community acquired an interest in a Subchapter S corporation’s retained earnings, it presumably would also acquire an interest in property purchased with the reinvestment of those earnings. The bright line dividing the corporate estate from the marital estate would be dimmed. Such a result would not bode well for the future of this highly desirable corporate form.

We hold that previously taxed and retained earnings of a Subchapter S corporation are corporate assets, and are neither the community nor the separate property of the shareholder. Accordingly, the order that appellant pay $73,000 to appellee, when and if received as dividends from the corporation, improperly awards property that is not presently owned by the community and that will be appellant’s separate property, if and when it is received. The third point of error is sustained.

In view of our disposition of the third point of error, it is not necessary for us to discuss the first, second, fourth, and fifth points of error.

In points of error six through twelve, appellant contends that the trial court erred in submitting special issues four and five, in which the jury found that the community should be reimbursed $150,-000 because the community estate was used to enhance the value of appellant’s corporate stock. Appellant also asserts that the evidence was factually and legally insufficient to support the jury’s answers.

Based on the jury’s findings, appellant became obligated to reimburse the community estate for $150,000. However, the judgment awarded the community s entire right of reimbursement to appellant. Thus, even if this obligation was erroneously imposed, appellant is not harmed, as long as the judgment eliminates the obligation by awarding it to him. Moreover, .appellant does not contend that he was deprived of any other community property by virtue of his receipt of this specific community asset.

We therefore hold that any error was harmless, unless awarding the right solely to appellant resulted in the overall property division being “so manifestly unjust that it constituted clear abuse of the trial court’s discretion.” See Zisblatt v. Zisblatt, 693 S.W.2d 944, 956 (Tex.App.—Fort Worth 1985, writ dism’d); King v. King, 661 S.W.2d 252 (Tex.App.—Houston [1st Dist.] 1983, no writ). Appellant makes no such contention. Accordingly, points of error six through twelve are overruled.

Insofar as it divides the community estate of the parties, the judgment is reversed, and the cause is remanded to the trial court for a re-division of the community estate.

DUNN, J., concurring and dissenting.

SAM BASS, J., dissenting and concurring.