In our last post, we indicated that the business owner’s guiding principles in evaluating any transaction in which he or she may engage with the business should be the following:
– Would an unrelated third party have entered the transaction on comparable terms?
– Is the taxpayer’s behavior consistent with what one would expect from a third-party?
However, one area in which these principles may not be as strictly applied, at least in some circumstances, involves the provision of services by the business.
In a recent decision, the Tax Court considered whether the sole shareholder of a corporation received a constructive dividend when the corporation provided services to the shareholder at cost; i.e., without charging the shareholder an amount equal to the corporation’s customary profit margin.
The corporation was a construction company specializing in housing projects. The taxpayer, who was its president and sole shareholder, constructed his own home. To keep track of the construction costs, the taxpayer caused the corporation to open a “cost plus” job account on its books, though the taxpayer acted as his own general contractor. During the construction, the corporation paid the taxpayer’s subcontractors and vendors directly, and its own crew framed the home. The taxpayer reimbursed the corporation for all amounts paid to the subcontractors, and also reimbursed it for its labor and overhead costs. However, the corporation did not charge the taxpayer its customary profit margin of 6% to 7%.
The IRS argued that this “forgone profit” represented a dividend payment by the corporation to the taxpayer-shareholder.
According to the Code, a dividend is any distribution of property that a corporation makes to its shareholders out of its accumulated or current earnings and profits. “Property” includes money and other property; under some circumstances, the courts have held that it also includes the provision of services by a corporation to its shareholders.
A “constructive” dividend arises where “a corporation confers an economic benefit on a shareholder without the expectation of repayment, . . . even though neither the corporation nor the shareholder intended a dividend.” The key factor in finding that there is a constructive dividend is that “the corporation has conferred a benefit on the shareholder in order to distribute available earnings and profits without expectation of repayment.” However, not every corporate expenditure that “incidentally confers economic benefit on a shareholder is a constructive dividend.”
According to the Court, where a corporation constructively distributes property to a shareholder, the constructive dividend received by the shareholder is ordinarily measured by the fair market value of the benefit conferred. Where the fair market value cannot be reliably ascertained, or where there is evidence that fair market value is an inappropriate measurement, the constructive dividend can be measured by the cost to the corporation of the benefit conferred.
The IRS asserted that the proper measure of a “service-based” constructive dividend was equal to the cost of the services provided to the shareholder by a corporation plus the corporation’s customary profit margin.
The Court disagreed, pointing out that, while it had previously held that the amount expended by a corporation for its shareholders constituted a constructive dividend, it had never held that the dividend included an amount corresponding to the foregone profit. It went on to state that in order to find a dividend, one must first find that there has been a distribution of property to the shareholder that reduces the corporation’s current or accumulated earnings and profits; there must be a finding, it said, that “corporate assets are diverted to or for the benefit of a shareholder” in order to distribute available earnings and profits without expectation of repayment.
The Court contrasted the provision of services to a shareholder at cost with the bargain sale of property to a shareholder. The former scenario, the Court said, does not result in the “diversion of corporate assets or the distribution of its earnings and profits,” while in the latter scenario, the shareholder receives a benefit equal to the excess of the fair market value of the property over the sale price because the property being sold is an asset of the corporation and its sale for less than fair market value diverts to the shareholder actual value otherwise available to the corporation. Similarly, the Court went on, where a corporation provides a shareholder with the use of corporate property and the shareholder does not fully and reasonably reimburse the corporation for its use, the shareholder has received a constructive dividend equal to the fair market value of the use of the property. (The Court did not discuss corporation-to-shareholder loans, but the same reasoning applies; in fact, the Code specifically addresses this scenario in the imputed interest rules of Sec. 7872.) However, the Court noted, the incidental or insignificant use of corporate property may not justify a finding of a constructive dividend.
In the present case, the Court found that the corporation maintained its corporate infrastructure and workforce for business purposes. It concluded that the shareholder’s “use” of the corporation during the construction of his home was at most incidental to those purposes.
The Court also found that the taxpayer had used the corporation as a conduit in paying subcontractors and vendors and that he obtained some “limited services” from corporate employees. He fully reimbursed the corporation for all costs associated with those services, and the corporation did not divert actual value otherwise available to it by failing to apply its usual profit margin. Accordingly, it held that the taxpayer did not receive a constructive dividend.
How much comfort can one derive from the above decision? It seems clear that, if the taxpayer had not reimbursed the corporation for its costs (both direct and overhead), a constructive dividend would have been found. The decision also suggests that, if properly structured, a shareholder’s use of corporate services may not lead to a constructive dividend. The key to the Court’s decision was that no transfer of corporate property was deemed to occur, and this conclusion seems to have been based, in no small part, on its finding that the taxpayer’s use of the corporation’s services was “incidental or insignificant” and that the services provided were “limited” – none of these terms provides a bright-line standard. Thus, before a shareholder decides to use the services of its own corporation, it would behoove him or her to first consider the nature, extent and cost of the services to be rendered, and then to structure the arrangement appropriately.