In the last several weeks, I have seen a number of examples of what are commonly referred to as “constructive dividends,” including a corporation’s satisfaction of the personal expenses of its shareholders.
Unlike a regular dividend distribution, a constructive dividend does not involve the formal declaration of a dividend by the corporation, followed by the payment of such dividend to each of the corporation’s shareholders in accordance with their relative stock ownership.
Rather, a constructive dividend may arise as a result of a transaction between a shareholder and the corporation – for example, a loan, lease, sale, or compensation arrangement – in which the amount of the consideration paid to the shareholder by the corporation exceeds the fair market value of the consideration provided by the shareholder to the corporation. Thus, a below-market lease of corporate property to a shareholder may generate a constructive dividend, as may a corporation’s bargain sale of property, or its payment of excessive compensation to a shareholder.
A constructive dividend may also arise as a result of a transaction between a corporation and a third party with which a shareholder of the corporation has some sort of relationship. In these situations, the corporation does not make a direct payment of cash to the shareholder, but the corporation’s funds are still expended in a way that bestows a direct benefit upon the shareholder. For example, when a corporation satisfies a personal obligation of a shareholder, or provides a below-market loan to another entity owned by the shareholder, it has likely paid a constructive dividend to the shareholder, at least where the corporation has no expectation of repayment.
Close Corps Beware
By its very nature, the occurrence of a constructive dividend is, generally speaking, limited to closely-held corporations. For this reason, when examining the tax returns of such a corporation, the IRS will, as a matter of course, inquire into the arm’s-length nature of any transaction between the corporation and any of its shareholders, and it will inquire as to the business purpose behind certain expenditures by the corporation.
Accordingly, it will behoove the shareholders of a closely-held corporation to familiarize themselves with the types of transactions that the IRS looks for, and with their tax consequences should the IRS successfully recharacterize them, at least in part, as constructive dividends.
The shareholders of a closely-held corporation also must be attuned to various threshold issues – including who the actual obligor is in respect of a payment made by the corporation – the resolution of which may determine the risk of a constructive dividend. For example, is the shareholder required to reimburse the corporation as to a particular payment?
In one recent decision, the court examined an “arrangement” between a shareholder (Taxpayer) and his wholly-owned corporation (Corp.) under which the corporation paid many of the shareholder’s personal expenses, and the shareholder then reimbursed the corporation.
During 2004 and part of 2005, Taxpayer maintained a checking account (Account) at Bank.
Corp. maintained a ledger account on its books to keep track of Taxpayer’s non-Corp. expenditures. To generate a ledger entry, Taxpayer would instruct Corp. to issue a check for a non-Corp. item, or he would charge a non-Corp. item to his Corp. credit card. Taxpayer would then instruct Corp. to charge the item back to his Corp. ledger account.
During the years in issue, various non-Corp. expenses were charged to Taxpayer’s ledger account, including various charitable contributions.
Corp.’s creditors required Corp. to ensure that all ledger accounts were paid off each month, and Taxpayer accordingly wrote checks drawn on Account to pay off his ledger at the end of each month. However, at the end of several months during the years in issue, Taxpayer had insufficient funds in Account to clear the checks drawn on Account. In those months, Taxpayer caused Corp. to (1) transfer sufficient funds from Corp. to Account to cover the check(s) drawn on Account; (2) record the charge on his Corp. ledger account; and (3) then cash the check(s) drawn on Account.
The Court as Solomon
Taxpayer claimed significant charitable contribution deductions on his Forms 1040 for 2004 and 2005, but the IRS disallowed these because it determined that the contributions were made by Corp.
Generally, a taxpayer bears the burden of proving that he is entitled to any claimed deduction, including one for a charitable contribution.
The Court acknowledged that a taxpayer’s charitable contribution may be effected through the efforts of an agent acting for the taxpayer-donor.
Taxpayer contended that he properly deducted the charitable contributions at issue because he bore the economic burden of the charitable contributions that were charged to his Corp. ledger account and, therefore, Corp. paid the amounts in question as Taxpayer’s agent.
The IRS countered that Corp., and not Taxpayer, bore the economic burden of the charitable contributions, and that Taxpayer did not show that Corp. acted as his agent.
According to the IRS, Taxpayer used a circular flow of funds to ensure that he did not bear the economic burden of the contributions. In particular, the IRS contended that Taxpayer would regularly (1) issue checks from Account at the end of the month to pay off his ledger; (2) advance sufficient funds from Corp. to Account at the beginning of the next month to cover the check drawn on Account ; and then (3) cause Corp. to cash the check from Account.
The Court rejected the IRS’s argument as too broad, stating that it failed to recognize that Taxpayer, at certain times during the years at issue, fully paid his Corp. ledger account balances with his own funds. The record showed that the alleged circular flow of funds of which the IRS respondent complained did not become a regular pattern until the second half of 2005. Moreover, the record showed that Taxpayer paid his Corp. ledger account balances as of December 31, 2004, and June 30, 2005, without the benefit of any advances from Corp. to cover the payments. Because Taxpayer’s Corp. ledger account balances were fully paid off at the end of December, 2004 and June, 2005 without an advance to cover those months’ payments, any previous advances were necessarily paid off. Accordingly, the Court concluded that Corp. did not bear the economic burden of the charitable contributions charged to Taxpayer’s Corp. ledger account before July, 2005.
The Court reached a different conclusion, however, with respect to the charitable contributions made from Taxpayer’s Corp. ledger account after June, 2005. From July, 2005 through at least November, 2005, Taxpayer caused Corp. to advance funds to Account to cover the checks drawn on that account to pay off his Corp. ledger balance for those months. This circular flow of funds resulted in Corp’s assumption of most, if not all, of the economic burden of the charitable contributions charged to Taxpayer’s Corp. ledger account after June, 2005.
Moreover, Taxpayer failed to prove what portion, if any, of the charitable contributions made after June, 2005 Taxpayer effectively paid with his own funds and not funds advanced by Corp. Taxpayer also failed to introduce any credible evidence that his Corp. ledger account balance at the end of 2005 represented bona fide indebtedness owing to Corp. Therefore, the Court concluded that Taxpayer failed to carry his burden of showing that he, and not Corp., bore the economic burden of the charitable contributions at issue that were made after June, 2005.
The IRS contended further that Taxpayer had not shown that Corp. acted as his agent in making the charitable contributions at issue. It noted that although an agency relationship does not require a written agreement, there still must be evidence that the agent assented to the undertaking. However, Taxpayer credibly testified that he directed Corp. employees to make the charitable contributions on his behalf. Moreover, his testimony was corroborated by the testimony of Corp. employees, and by the introduction of the ledger itself into evidence.
The Court recognized that by agreeing to act as Taxpayer’s agent in making the charitable contributions at issue, Corp. also agreed to advance the contributed amounts to Taxpayer – amounts that Taxpayer was expected to repay. Therefore, the Court found that Corp. acted as an agent of Taxpayer when it made the charitable contributions at issue.
Accordingly, the Court concluded that Taxpayer was entitled to deduct the charitable contributions at issue that were charged to Taxpayer’s Corp. ledger account before July, 2005 – Taxpayer bore the economic burden for these payments. It also sustained the IRS’s disallowance of the charitable contribution deductions at issue that were charged to Taxpayer’s ledger account after June, 2005, finding that these deductions properly belonged to Corp.
But what if Taxpayer had been obligated – for example, pursuant to a pledge – to make the charitable contributions at issue after June, 2005? Because Corp. assumed the burden for the contribution, and Taxpayer was not required to repay the amount of the contribution to Corp., Taxpayer would have been treated as having received a constructive distribution from Corp. that may have been treated and taxed as a dividend. The overall tax benefit that Taxpayer may have expected to achieve as a result of the contribution would have been reduced.
With some planning, however, and with the recognition of the risk of a constructive distribution by Corp., Taxpayer could have arranged for a bona fide loan from Corp.
Unfortunately, too many taxpayers fail to recognize the distinction between themselves and their closely-held corporation. They direct the corporation to pay all manner of personal expenses, including cars, utilities, credit cards, vacations, clubs, meals, and other items. The corporation then fails to reflect these payments as distributions or as compensation to the shareholders, and many even go one step further and claim these expenditures as business deductions against the corporation’s revenues.
Pigs get slaughtered? You can count on it.