Why Waive A Dividend?
For the most part, the shareholders of closely-held corporations and their counterparts in the public realm are subject to the same set of federal income tax rules. However, there are situations within each of these two realms where unique policy or practical considerations dictate the application of different sets of rules.
One such situation involves the declaration of a dividend by a closely-held corporation, and a shareholder’s waiver of his pro rata share thereof.
For example, assume an individual taxpayer owns 65% of the stock of a corporation, relatives of the taxpayer, including his children, own 25% of the stock, and the remaining 10% is owned by key employees of the corporation who are not related to the taxpayer. Due to the necessity of keeping abreast of competition by procuring new equipment, the immediate and long-term working capital requirements of the corporation are such that payments of dividends in large amounts cannot be made. In fact, no dividends have been paid by the corporation since its formation – not an usual circumstance for a close corporation. However, the minority shareholders, most of whom are relatives of the majority shareholder, feel that they are entitled to a proper return on their investment. In order to address this situation, the taxpayer “waives” his rights to any dividends to be declared by the corporation up to a date certain. This permits the distribution of dividends in substantial amounts to the minority shareholders, ostensibly to preserve their goodwill, without depleting the working capital of the corporation.
Upon examination of the above facts, it is likely that the benefits to be afforded the taxpayer’s relatives (including his children) by the waiver of his right to share in the dividend payments was the primary purpose for the waiver. The alleged business purpose to be served, namely, the payment of a larger dividend to minority stockholders, including some who are key employees, to maintain their goodwill is likely incidental. Since the amounts distributed to the minority stockholders do not impair the capital by any greater amount than if distributed pro rata to all shareholders, the waiver should not be considered necessary to protect the working capital of the corporation. Thus, the taxpayer’s waiver of his right to receive his pro rata share of any dividends declared by the corporation, through effecting payment of such pro rata share to his relatives as well as to his employees, should be considered the realization of income by him to the extent of any dividend payments waived. Moreover, the “excess” dividend received by his relatives and key employees should probably be treated as gifts and as compensation, respectively.
Bona Fide Business Purpose?
This is to be contrasted with a situation in which no family or direct business relationship exists between the majority and minority shareholders, and the arrangement is entered into only for bona fide business reasons. In that case, the IRS is likely to hold that the declaration of a dividend did not result in the receipt of income by a shareholder who had waived his right to share in the dividend. In addition, the “excess” dividend paid to the other shareholders is unlikely to be treated as other than a distribution in respect of their shares in the corporation.
A recent IRS ruling [Private Letter Ruling 201636036] illustrates such a situation. Individuals A and B were the beneficiaries and co-trustees of Trust. Prior to Year 1, Trust was the sole shareholder of SmallCo. In Year 1, SmallCo. entered into a merger agreement with BigCo. whereby SmallCo. became a wholly-owned subsidiary of BigCo. (the “Merger”). As consideration for the Merger, Trust exchanged its stock in SmallCo. for ownership of approximately X% of the post-Merger shares of BigCo. stock. The pre-Merger shareholders of BigCo. owned the remaining post-Merger shares of BigCo.
At the time of the Merger, BigCo. owned Note, a subordinated debt instrument related to a prior business venture. As a result of the degree of uncertainty as to the amount of any payment the holder of Note might eventually receive, BigCo. and SmallCo. were not able to agree on a fair market value for Note while negotiating the Merger. In order to proceed with the Merger, the two corporations agreed that for purposes of determining the Merger consideration owed to Trust, the value of Note would be treated as zero (resulting in Trust’s receiving a larger percentage of stock in BigCo.). The parties further agreed that, in the event that BigCo. disposed of Note within three years of the Merger, the proceeds from the disposition would be distributed to all shareholders of BigCo. other than Trust (or related transferees of Trust), and Trust agreed (on behalf of itself and any related transferees) to waive any and all rights to its pro rata share of such a distribution.
Later in Year 1, Trust transferred a portion of its holdings in BigCo. to Partnership, an LLC established for estate planning purposes and taxed as a partnership for federal income tax purposes. Partnership was owned by trusts formed for the benefit of the children of A and B. Partnership, as a related transferee of Trust, acknowledged and agreed to the terms of the Merger related to any distributions from the disposition of Note.
Before the end of Year 1, but after the Merger, BigCo. disposed of Note in a sale, and decided to distribute the proceeds of such sale as a dividend to its shareholders other than Trust and Partnership (the “non-waiving shareholders”).
Income to the Waiving Shareholder?
Gross income means all income received or realized by a taxpayer, from whatever source derived, including dividends. Of course, this may include amounts actually received by the taxpayer — i.e., reduced to the taxpayer’s possession. It may also include income that is not actually reduced to a taxpayer’s possession but that is constructively received by him. Thus, income that is credited to a taxpayer’s account, set apart for him, or otherwise made available so that he may draw upon it at any time, is treated as having been received by him.
A controlling shareholder will sometimes elect not to retain a dividend where the funds distributed are needed in the business of the distributing corporation. In that case, the “waiving” shareholder may elect to be treated as having received the dividend, being taxed thereon, and then returning the dividend amount to the corporation as a capital contribution (presumably in exchange for more stock) or as a loan to the corporation.
But what happens if a shareholder actually gives up his right to receive a dividend?
Generally, a majority shareholder who agrees to waive dividends (rather than simply not keep them) while other shareholders receive theirs does not realize income if there is no family or direct business relationship between the majority and minority shareholders, and the waiver is executed for valid business reasons.
However, the waiver by a majority shareholder of the right to receive a pro rata share of any dividends paid by a corporation will not be recognized for income tax purposes where such dividends are paid to, and redound primarily to the benefit of, his minority shareholder-relatives as increased dividends. In that case, income is realized by the majority shareholder to the extent of the increased distribution to the related shareholders resulting from the waiver.
Or Not? Ruling Conditions
The IRS identified four conditions that had to be satisfied before it would consider issuing a favorable ruling on a proposed waiver of dividends when the waiving and non-waiving shareholders are individuals: (1) a bona fide business reason must exist for the proposed waiver of dividends; (2) the relatives of the waiving shareholder must not be in a position to receive more than 20 percent of the total dividends distributed to the non-waiving shareholders; (3) the ruling will not be effective if any change in stock ownership (other than death) enables non-waiving relatives to receive more than 20 percent of the dividend; and (4) the ruling will not be effective after the third anniversary of the date of the ruling.
The IRS found there was a bona fide business reason for the proposed waiver of dividends described in the above ruling. The waiver was an express condition of the Merger between BigCo. and SmallCo. that would permit the pre-Merger shareholders of BigCo. to obtain the full value of their holdings, and prevent Trust and Partnership from receiving windfall profits from property they did not own.
Trust and Partnership also represented that relatives of their beneficiaries and members were not in a position (as shareholders of BigCo.) to receive, in the aggregate, more than 20 percent of the total dividends attributable to proceeds from the disposition of Note. Trust and Partnership also agreed that any ruling from the IRS would no longer be applicable if any change in the stock ownership of BigCo. enabled non-waiving relatives of the beneficiaries and members of Trust and Partnership to receive more than 20 percent of total dividends attributable to proceeds from the disposition of Note, unless the change occurs because of death. Furthermore, Trust and Partnership agreed that any ruling issued on the waiver of dividends would not be effective for a period longer than three years from the date of the ruling.
On the basis of the foregoing, the IRS concluded that the waiver by Trust and Partnership (in connection with the Merger) of the dividends resulting from the subsequent sale of Note would not result in gross income to either Trust or Partnership.
When advising a closely-held business and its owners in connection with any transaction, it is imperative that the tax adviser be familiar with the personal and business relationships among the owners. It is also important that the adviser understand the business purpose for the transaction, and that he be comfortable in defending its bona fide nature.
The importance of these factors is highlighted in the ruling described above.
Where these relationships have not been considered, and where the transaction at issue is not motivated primarily by a valid business purpose, the tax consequences to the various parties are likely to be other than what they hoped for and, in fact, reported.
I imagine that neither the client-taxpayer nor the adviser will appreciate being surprised.