There is nothing like an old proverb to remind you of the obvious. Unfortunately, too many taxpayers need to be reminded all too often. It’s one thing when the reminder comes from the taxpayer’s own advisers – at that point, the taxpayer may still have an opportunity to “correct” his or her actions. It is a very different thing, however, when the reminder comes from the IRS or from a court.

Imagine being the taxpayer to whom the Tax Court directed the following statement:

There is no doubt [a taxpayer] is entitled to benefit from his hard work. However, there is also no doubt that it was [the taxpayer’s] choice to structure the payments in a certain manner. He now must face the tax consequences of his choice, whether contemplated or not.

Corp. was a closely-held C corporation, the issued and outstanding shares of which were owned 85% by Dad (together with Corp., the “Taxpayers”) and 5% each by Mom (together with Dad, the “Shareholders”) and their two daughters, all of whom sat on Corp.’s board of directors and served as corporate officers.

Dad was employed full time as the president and CEO of Corp. In that capacity he had final decision-making and supervisory power over all business matters, including compensation and tax return preparation and approval. As it often happens in small-to-medium size businesses, Dad had to be a jack of all trades and ended up performing the work of three to four individuals.

“It Was A Very Good Year”

Corp. never declared a dividend. The Taxpayers explained that, historically, they kept any excess cash in the business in order to fund its expansion, instead of paying it out as compensation or dividends.

During the tax years at issue, Corp’s business was more profitable than usual. As a result, Dad received not only his base salary, but Corp. also paid him a significant bonus. In fact, his total reported compensation for those years was more than three times his reported salary in prior years. These were also the first years that Corp. had paid bonuses.

 Also during these tax years, Corp. paid for materials and labor in connection with the construction of several structures on land owned by the Shareholders, including a new personal residence for the Shareholders and a barn (the “Barn”). amex corp

The Barn housed Dad’s office, which he used for both business and personal purposes. In addition, the Shareholders used a part of the building to store their personal vehicles and some Corp. vehicles. There was no lease or other written agreement for the use of the Barn between the Shareholders and Corp.

In addition, during the same tax years, Corp. paid and reported on its books as cost of goods sold personal credit card charges on the Shareholders’ behalf. Corp. never recorded these amounts as compensation for Dad and Mom on its books.

Finally, Corp. paid for the purchase of a sports car (“Car”) to which Dad took title in his individual capacity, explaining that this was because Corp.’s business insurance would not permit it to insure the Car. Corp. claimed depreciation deductions for the Car. The Taxpayers, however, did not produce any records or other evidence associated with the alleged business use of the Car. Corp. did not report the amount paid for the car as compensation to Dad.

IRS vs. Taxpayer

According to the IRS, the construction costs of the Shareholders’ house and the Barn, the personal credit card bills, and the purchase of the Car were personal expenses paid by Corp. The IRS argued that these amounts should be treated as a constructive dividend to the Shareholders and, thus, nondeductible to Corp. The IRS also argued that Corp. could not deduct depreciation for the car because it was Dad’s personal property.

The Taxpayers disagreed and petitioned the Tax Court for relief.

The Taxpayers admitted that they “mistakenly” reported the house construction expenses as cost of goods sold, and they conceded that the Corp.’s credit card payments were for personal expenses of the Shareholders.

They argued, however, that the Barn and the Car were capital assets owned by Corp. The Taxpayers contended that the Barn was a storage facility that belonged to Corp., and that any expenses related to that facility should be treated as business-related. They claimed that they used the facility to store Corp.’s vehicles.

However, the IRS pointed out that the Shareholders also used it to store their personal vehicles. Dad had one of his offices in the Barn, and he admitted to using it for both business and personal purposes. The title to the land on which the Barn was constructed belonged to the Shareholders, and the Taxpayers did not introduce any documents containing an agreement between the Shareholders and Corp. as to the use of the land or the ownership of any structures on that land. The only testimony Taxpayers introduced on the subject of the Barn’s ownership was Dad’s, and he did not shed any light on the title to the property or other arrangements with Corp. that would allow the Court to conclude that the Barn was used for legitimate business purposes. Thus, the Taxpayers failed to meet their burden of proof, and the Court concluded that the expenses paid by Corp. to construct the Barn were personal expenses of the Shareholders.

Next, the Taxpayers argued that the Car was an asset that belonged to Corp. and that was used for business purposes, namely, as a means of transportation for Dad between various Corp.   worksites. The IRS argued that because the title to the vehicle was in Dad’s name alone and Taxpayers did not introduce any evidence of the business use of the vehicle such as travel logs detailing date, mileage, and business purpose for the use of the Car, it must be a personal expense of the Shareholders. As a result, the Taxpayers failed to meet the burden of proof to show that Corp. purchased the Car for business purposes.

The Court’s Analysis

Gross income includes all income from whatever source derived unless otherwise specifically excluded. The definition of gross income broadly includes any instance of undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion and control.

The IRS argued that the income the Shareholders received in the form of a “distribution” of corporate property was a constructive dividend. The Taxpayers, in turn, argued that the payments should be treated as compensation to Dad for the prior years of service when he was underpaid. Under both theories, the Shareholders would have been required to include the amounts received as ordinary income for the tax years at issue.

It should be noted, however, that if the Taxpayers prevailed, Corp. may have been able to deduct the amounts paid as an ordinary and necessary business expense, provided the amounts represented reasonable compensation. The Shareholders, however, could potentially have benefited from the lower tax rate on qualified dividend income.  Moreover, dividend treatment would have avoided the imposition of employment taxes.

Compensation?

The Code allows a taxpayer to deduct payments for reasonable compensation for services when incurred as ordinary or necessary business expenses during the taxable year.  Whether amounts are paid as compensation turns on the factual determination of whether the payor intends at the time that the payment is made to compensate the recipient for the services performed. Only if payment is made with the intent to compensate is it deductible as compensation. The relevant time for determining the intent is when the purported compensation payment is made, not when the IRS later challenges the payment’s characterization. The taxpayer bears the burden of proof as to intent to compensate.

According to the Court, the record did not support the Taxpayer’s assertion that Corp. intended the payments for the construction of the house, the Barn, credit card bills, and the Car to be compensation. The only evidence the Taxpayers introduced to prove compensatory intent was Dad’s “self-serving testimony,” as Corp.’s CEO and majority shareholder, that he always intended the payments as compensation for his services in prior years. The Taxpayers did not introduce into evidence any board resolutions that addressed the payment of compensation to Dad. Absent such evidence, the Court could not conclude that Corp. “intended an action not reflected in its corporate documents.”

The Court stated that it did not question Dad’s business decision to keep the money in the business instead of paying himself a higher salary. Because of his efforts, Corp’s business grew substantially—as did his compensation. However, on the record, the Court was convinced that the payments in question were not intended as compensation for services at the time they were made. Dad tacitly approved running the personal expenses at issue through the corporate accounts and recording them as cost of goods sold. Corp. did not report these expenses as compensation either on its books or on its tax return for the years at issue. Nor did Corp.  pay payroll taxes on these amounts. The Shareholders did not report these amounts on their tax return at all, and did not inform their tax preparer that they considered these payments compensation.

It seemed clear, the Court stated, that the Taxpayers played “tax audit roulette” by trying to hide the expense payments and pay as little tax as possible.

Under the circumstances, the Court concluded that Corp. did not intend to compensate Dad for his services at the time it paid the expenses in question. Thus, these amounts were not compensation for prior services that could be deducted by Corp. In addition, Corp. was not entitled to a depreciation deduction for the car because it was Dad’s personal property and the Taxpayers did not introduce any evidence of the business use of the car.

Dividend?

The Court then considered whether the payment by Corp. of the Shareholders’ personal expenses was a constructive dividend. If a distributing corporation has sufficient earnings and profits, the Court stated, the distribution is a dividend, and a shareholder must include it in gross income. [IRC Sec. 301 and 316]. A constructive dividend is a payment or economic benefit conferred by a corporation on one of its shareholders. A constructive dividend may arise through a diversion or conversion of corporate earnings and profits, or through corporate payments to third parties at the direction of shareholders. Whether corporate expenditures constitute a constructive dividend is a question of fact. The amount of the constructive dividend is equal to the fair market value of the benefits received.

In the years at issue, Corp. had sufficient earnings and profits to declare a dividend to its shareholders. Because Dad, as Corp.’s CEO and majority shareholder, had the ultimate control over Corp.’s dealings, he was able to divert corporate funds to pay his personal expenses. Moreover, he approved the payment of those expenses out of the corporate funds. These facts fit squarely into the definition of a constructive dividend.

When Will They Ever Learn?

Every tax adviser has encountered a situation like the one described above. That is because almost every business owner, to some degree, diverts business profits to the payment of a personal, non-business expense. Businesses sometimes pay for personal credit card expenses, residential property taxes, club dues, personal cars, trips, etc. They provide no-show, paying jobs for family members. They over- or under-pay related businesses for services or property.

It is also a fact that many business owners believe that their gambits will never be discovered, especially during a period that has seen Congress basically eviscerate the IRS’s enforcement budget.

Yet, as many tax advisers see every day, taxpayers do get “caught,” whether as a result of traditional IRS audit activity, the analysis of information collected through data mining using new technologies, increased state tax enforcement activity, whistleblowers, or other means.

The guiding principle, as always, should be the following: how would you conduct business with an unrelated third party? Would you charge a reasonable fee and expect to be paid only a reasonable fee? What would you do to determine the reasonableness of a payment? Would you insist that the arrangement between you be properly authorized and memorialized?

Within these parameters, there are many legitimate business and personal goals that a business owner can accomplish without necessarily weakening his or her position vis-à-vis the IRS. One need only ask how.