Second Circuit Affirms Taxpayer's Part Ownership of S Corporation

(Parker Tax Publishing March 2026)

The Second Circuit affirmed the Tax Court and held that a taxpayer who formed an S corporation with her husband, but later stopped receiving distributions from the company after divorcing him, was nevertheless liable for tax on capital gains and rental income realized by the S corporation. The court found that the taxpayer never abandoned her interest in the S corporation and that the government was not precluded by two earlier bankruptcy proceedings from arguing that she was a part owner because no final judgment on the issue of the company's ownership was ever issued in the bankruptcy proceedings. Veeraswamy v. Comm'r, 2026 PTC 27 (2d Cir. 2026).

Background

Karen Veeraswamy married her husband, Velappan, in 1990. They started a family and raised two children. The couple also started a business, Ashand Enterprises, Inc. (Ashand) in 2000. They elected to make it an S corporation under Code Sec. 1362(a). When Ashand was incorporated, Velappan and Karen each owned 100 shares of the business.

Velappan started Ashand as a vehicle for trading tech stocks. After the dotcom bubble burst, he pivoted to real estate. Through Ashand, Velappan and Karen bought a building on Ward Avenue in The Bronx in 2005. The property had about 70 tenants. Velappan served as Ashand's president and ran the business. Karen was the company's secretary and treasurer. She helped open the corporate bank accounts, worked in its office, and collected rent from the tenants. Both spouses served on Ashand's board of directors.

In 2011, Karen filed for divorce after enduring years of abuse and infidelity by Velappan. However, she still helped with Ashand's books and sent out eviction notices. Velappan began to isolate his wife from the business, taking her off Ashand's bank accounts and attempting to limit her access to the office. In the divorce, Velappan argued that Ashand was not a marital asset because Karen was no longer involved with the company. Karen apparently took that to mean she was no longer a shareholder in Ashand. She also began to file her tax returns as married filing separately.

Ashand's and Velappan's Bankruptcies

In 2013, after Ashand fell behind on its mortgage payments, Velappan filed for chapter 11 bankruptcy protection on its behalf. Velappan represented to the bankruptcy court that he was Ashand's sole owner. Karen filed a proof of claim for domestic support. She did not claim she was co-owner of Ashand, only that she was entitled to support by way of her marriage to Ashand's purported sole owner, Velappan. The bankruptcy court denied Karen's claim, though it continued to let her participate in the case.

The bankruptcy moved quickly, and in 2014 the trustee put the Ward Avenue property up for sale. The property ultimately fetched $7.6 million, more than enough to pay Ashand's debts and leave a nearly $2 million surplus even after expenses. Karen was not listed as an equity holder entitled to a portion of the surplus. Nowhere in her proof of claim did she assert that she was a co-owner of Ashand because at this point she did not believe that she was a shareholder in Ashand. But because Karen remained a party in Ashand's bankruptcy, the bankruptcy court - even though it denied her claim for domestic support - ordered that the surplus be put into an escrow account controlled by Karen's attorney until a resolution of the divorce proceedings.

Ashand's bankruptcy case ended with a final decree in early 2015. The court stated that the decree "shall not be construed as to settle any issues as to the propriety of payments by the Debtor as between the Debtor's equity holders or parties in interest."

Velappan also filed for bankruptcy in 2018. Karen filed a proof of claim was for the domestic support that Velappan still owed her. A year into the bankruptcy, in February 2019, Velappan died. The divorce case was now moot, and the court appointed Karen as the administrator of her late husband's estate. As she began sorting things out, Karen discovered corporate documents in a basement that showed she had remained a 50-percent shareholder in Ashand. Velappan had lied to the courts, to creditors, and to her.

Karen submitted an amended proof of claim in Velappan's bankruptcy. In addition to the previous claim for domestic support, Karen sought $950,000 as an equity distribution from Ashand's sale of the Ward Avenue building. She specifically asserted that she was a 50-percent shareholder of Ashand. In the end, the trustee in Velappan's bankruptcy negotiated a settlement with Karen. In 2022, the court approved a final settlement. Karen received $486,038 to satisfy her equity claim and $480,000 in domestic support. Karen did not report either figure in her 2022 tax return, and she did not file a return for her 2014 tax year.

IRS Audit of Ashand

Even before Velappan died, the IRS began an audit of Ashand for the 2014 tax year. This audit ended in 2017 but was reopened in 2022 after the revenue agent received the bankruptcy court filings in which Karen claimed she owned half of Ashand. The IRS determined that Ashand received nearly $400,000 in rental income in 2014 and realized a $1.9 million capital gain from the sale of the Ward Avenue building.

Karen had not filed a 2014 tax return, so the IRS prepared a substitute return using calculations and assumptions derived from Ashand's bankruptcy filings. Since Ashand was an S corporation, the IRS assigned half of Ashand's net rental income and half its capital gain to Karen. The IRS also asserted penalties against Karen for failure to timely file and pay.

Karen challenged the notice of deficiency in the Tax Court. She argued that she had abandoned her interest in Ashand. She also contended that the bankruptcy proceedings established that Velappan was Ashand's sole owner and that the IRS was therefore precluded from treating her as a part owner of the company. Specifically, Karen contended that in its attempts in Velappan's bankruptcy to prevent the distribution of Ashand's surplus to her, the IRS had already argued that she was not an owner of Ashand, and was therefore estopped from saying otherwise in this case.

Tax Court's Decision

In Veeraswamy v. Comm'r, T.C. Memo. 2024-83, the Tax Court held, based on the corporate records, tax returns, bankruptcy exhibits, and family-court exhibits that Karen was a half-owner of Ashand in 2014. In the court's view, Karen never abandoned her interest in Ashand because she took no affirmative act to relinquish her interest and actively pursued her interest in the bankruptcy proceedings. In addition, the Tax Court found that the IRS was not precluded from arguing her ownership because no final judgment was issued regarding the ownership of Ashand in either bankruptcy proceeding. The Tax Court also affirmed the additions to tax under Code Sec. 6651(a)(1) for failing to timely file and pay tax after finding that Karen did not have reasonable cause.

Karen appealed to the Second Circuit. She argued that the Tax Court improperly found that she was a part owner of Ashand in 2014 and improperly imposed penalties under Code Sec. 6651(a). She asserted that Velappan likely altered the ownership structure of Ashand to make himself the sole shareholder. She also renewed her argument that Ashand's bankruptcy confirmation plan precluded the IRS from arguing that she was a part owner of the company.

Second Circuit's Analysis

In a summary order, the Second Circuit affirmed the Tax Court. The Second Circuit found that Karen failed to demonstrate that she had abandoned her interest in Ashand and she submitted no evidence of such abandonment in the Tax Court proceedings. The court pointed out that Karen's own admissions supported the Tax Court's conclusion that she was part owner of Ashand through at least 2014. The court noted that, in particular, Karen responded to the trustee's attempt to obtain turnover of the escrow funds in Velappan's bankruptcy by repeatedly asserting that she was "50 percent equity shareholder of Ashand Enterprises, Inc." and was thus entitled to some or all of the escrow funds. The court found that Karen provided no evidence to support her assertion that Velappan altered Ashand's ownership structure. The court also agreed with the Tax Court that the IRS was not precluded from arguing that Karen was a part owner of Ashand since there was no earlier final judgment on the merits as to Ashand's ownership.

Finally, the Second Circuit upheld the assessment of penalties after finding that, although Karen said she spoke to an accountant about her tax obligations, the accountant never advised her that she had no obligation to file a tax return. Because she did not rely on the accountant's advice in failing to file, the Second Circuit concluded that the Tax Court did not err in finding she did not have reasonable cause.

For a discussion of determining stock ownership of an S corporation, see Parker Tax ¶31,935. For a discussion of the doctrine of collateral estoppel, see Parker Tax ¶263,550. For a discussion of delinquency penalties, see Parker Tax ¶262,105.

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