When a C corporation pays expenses for its shareholder, the payment can be subject to income tax for the shareholder as a constructive dividend. One defense is that the expenses for the C corporation were legitimate. Does the taxpayer have to prove the amount of the expenses or does the IRS? The Combs v. Commissioner, T.C. Memo. 2019-96, case presents an opportunity to consider this issue.
Facts & Procedural History
The taxpayer is a comedian and motivational speaker. He operated through a C corporation, with the earnings from his gigs paid into the C corporation. The C corporation then transferred income and assets to various trusts. The trusts paid the taxpayer’s personal expenses.
The IRS audited the taxpayer’s return and concluded that the payments from the C corporation to the trusts were constructive dividends to the taxpayer. The IRS made the adjustment to the taxpayer’s return and it disallowed the C corporations expenses.
The C corporation’s and it’s disallowed expenses were not before the court. The taxpayer just filed a petition to litigate the case in tax court to review the constructive dividends. As explained below, this created a procedural challenge for the taxpayer as the court didn’t have full access to the C corporation expenses in reviewing the constructive dividend issue.
About Dividends and Tax on Dividends
A dividend is a transfer from a corporation to its shareholder. The term “dividend” refers to amounts paid to the shareholder out of the corporation’s “earnings and profits.” This is just a tax term for profits.
C corporations track profits each year over time, as profits increase or decrease over time. This cumulative profits measure allows the corporation to know when amounts are taxed to the shareholder as profits.
Distributions of profits are subject to ordinary income tax for the shareholder. Distributions in excess of profits are either a tax-free return of shareholder contributions or taxable to the shareholder as a deemed sale of property. This tax system presents numerous tax planning opportunities.
About Constructive Dividends
Constructive dividends are one way taxpayers may under report income. As evidenced by the facts in this case, the taxpayer does not have to actually receive the funds for constructive dividends.
The “constructive” term refers to the fact that the corporation does not have to officially declare a dividend for their to be a dividend. In fact, the individual shareholder doesn’t have to receive the dividend at all. The payment or transfer just has to benefit the shareholder.
As in this case, that the monies went from the C corporation to trusts and the trusts paid the taxpayer’s personal expenses is a prime example. The taxpayer never received the funds directly. He just didn’t have to pay for his personal expenses himself.
These concepts are embodied in the following elements that must be met for there to be constructive dividends
- The expenditures do not give rise to a deduction on behalf of the corporation, and
- The expenditures create economic gain, benefit, or income to the owner-taxpayer.
But how do you prove the first element when the corporation is not part of the tax litigation process?
Proving the Expenses for the C Corporation
This dispute focused on whether some of the expenses were legitimate and allowable expenses for the business. To the extent the expenses are legitimate expenses, there would be no constructive dividends.
The taxpayer’s tax attorney argued that many of the expenses were legitimate and allowable for the business. In support of this, the taxpayer offered into evidence “hundreds of pages of photocopied receipts, expense ledgers, spreadsheets, and various other unsorted documentation.”
The IRS argued that the expenses for the C corporation were not allowable. These fact that the IRS disallowed these deductions for the C corporation was the basis of the constructive dividends. The IRS offered no evidence other than this.
Who Has the Burden: the Taxpayer or the IRS?
How should the court weigh the taxpayer’s argument supported by evidence with the IRS’s unsupported argument?
The general rule is that the IRS has the burden to show additional income and the taxpayer has the burden to establish deductions.
The IRS’s argument is that the taxpayer has additional income. It would seem the IRS has the burden of proof in this case. If this is the case, this means the IRS would need to come forward with some evidence to support its argument. A mere argument not supported by proof wouldn’t be sufficient.
The Tax Court and its Review Financial Records
The court did not address the burden. Instead, it concluded that the taxpayer had to reconcile its evidence to the IRS’s adjustments and it failed to do so:
These materials are not linked in any meaningful way to [the IRS’s] adjustments. At trial petitioner attempted selectively to link a very few of these items to deductible expenses of [his C corporation]. We did not find his testimony as to these few items credible or adequate to show that any particular item represented an ordinary and necessary business expense of [the C corporation].
The court did not explain why the taxpayer should have to reconcile to the IRS’s adjustments. It would seem more logical to reconcile to the tax returns the taxpayer and C corporation filed. In fact, it would seem more logical for the IRS to have to disprove the expenses deducted on the C corporations tax return, as again, this is a question of income not a deduction.
Saying that the records were disorganized and that the court would not put in the effort to understand the records was an easy way for the court to reach what it thought was the right result. The court likely reached this result as many of the expenses were personal in nature and not allowable. The taxpayer admitted that some of the expenses were in fact personal in nature. And the evidence included reference to another unrelated taxpayer who had the same tax adviser and whose fact pattern was similar. These two factors no doubt informed the decision in the court case.
But even then, it is hard to believe that some of the evidence presented could not be used by the tax court to allow some of the expenses and thereby disallow some of the constructive dividends.
That the tax court specializes in tax cases and is able to take a deeper dive into financial records is one of the primary reasons why taxpayers litigate cases in the tax court. If the tax court isn’t willing to consider records and, then for the tax court to construe the records against the taxpayer who offered them, calls into question whether the tax court is an appropriate forum for substantiation cases.