Those who own C corporations have to be careful about what amounts are paid out to or benefit the corporate shareholders. This is particularly true for closely held and family corporations.
On audit, the IRS will often assert that these distributions are constructive dividends. This is usually a bad answer for taxpayers as it increases the tax for the corporation and the individual owners. Having good books and records of earnings and profits can help avoid this often harsh consequence.
The recent Fabian v. Commissioner, T.C. Memo. 2022-94, case provides an opportunity to consider constructive dividends and how they are treated.
Facts & Procedural History
This tax court case involves a fraudulent lease scheme. It ended up in criminal convictions, etc. This article does not get into those parts of the transaction. Instead, it just focuses on the sale-leaseback rules and the taxpayer’s argument about the arrangement and the court’s holding.
With this sale-leaseback transaction, the selling entity was a C corporation that was wholly owned by the taxpayer. The selling entity purportedly bought computer equipment and then sold the equipment to a third party. The third party paid the selling entity for the equipment.
The third party functioned as a brokerage that leased the equipment back to the entity that sold it. The third party collected three months of rent for its efforts and then remitted the remaining rent payments to its investors.
The fraudulent acts we are skipping over relate to the inflated value of the equipment purchased that the selling entity reported to the parties. It also relates to whether the purchases were actually made. The entity allegedly created false records reflecting the inflated values to the third party or others. Again, this article does not address those aspects of the case.
On audit by the IRS, the IRS determined that the selling entity made transfers to its sole owner and payments that were for the personal benefit of its sole owner. The IRS adjusted the sole owner’s individual income tax account to report these amounts as constructive dividends.
About Constructive Dividends
The C corporation reports its items of income, expense, etc. on its own tax return and it pays its own income taxes. The owner or shareholder of the corporation pays income tax on amounts distributed to it.
There are a number of ways distributions can be made to the individual owner. This can include tax wages, certain non-taxable employee benefits and retirement contributions, loans, and even dividends.
Constructive dividends are those that are paid by the corporation to the individual owner for his or her own personal benefit. They can also include amounts paid to third parties by the corporation on behalf of the individual owner. So all you have to have is an economic benefit to the shareholder without expectation of repayment and one that advances a personal interest as opposed to the business interest of the corporation.
Dividends, including constructive dividends, are usually a bad answer as they result in double tax. Specifically, the corporation usually cannot deduct the dividends, so it pays income tax on these amounts, and then the shareholder usually has to pay income tax personally on the amount of the dividend.
Compare this to wages paid by the corporation to the individual owner–which can also be a bad answer. The corporation is able to deduct these amounts. The individual owner is the only party that has to pay income tax on these amounts. So there is one level of income tax. There may also be another level of payroll tax that is owed by the corporation (and the IRS may be able to assess a trust fund penalty against the individual owner for the trust fund portion of these taxes).
Compare this to tax-free benefits. The corporation may be able to deduct these amounts and the individual owner may not have to report the amounts for income tax purposes. And there is likely no payroll tax due on the benefit paid.
An even better position is that the distribution was actually a return of capital.
Dividend vs. Return of Capital
This brings us back to this case. This case focuses on whether a constructive dividend is actually a dividend or a return of capital.
The court case provides the following summary of the taxpayer’s position as to the constructive dividends:
Petitioner believes that, during the years at issue, SPI, Inc., had no earnings and profits, so that any of the Table 4 payments determined to be distributions with respect to SPI, Inc.’s stock would not be dividends. See §§ 301(c)(1), 316(a); see also Podlucky v. Commissioner, T.C. Memo. 2022-45, at *9 (holding that constructive distributions of misappropriated corporate funds did not constitute dividends to controlling shareholder because of inadequate corporate earnings and profits). Moreover, he believes that he had sufficient adjusted basis in his SPI, Inc. shares that the amount of actual or constructive distributions to him during those years did not exceed that basis and, accordingly, produced no gain. See § 301(c)(2).
Thus, the taxpayer was arguing that the corporation was incurring losses as its expenses exceeded its income during these years. If that is the case, there would be no Earnings and Profits for the corporation. Our tax rules do say that amounts paid to the individual owner of a corporation in excess of the corporate E&P are a non-taxable return of capital to the individual owner.
The transactions were significant and the accounting was complex in this case. It appears that this made it difficult for the individual owner to show that the entity had no E&P. The court recited facts that suggest that this could have been the case, however. The income would have consisted of gains on the sale of the property, which there might be minimal gains if the property was sold at or near the value it was purchased for, and the ongoing rent payments and related losses exceeded the amount of the gain.
The taxpayer argued that the sale-leaseback transactions were not valid sales. Therefore there was no gain on the sale of the equipment. Absent any gain or income, there could be no E&P. This in turn means that distributions were a non-taxable return of capital to the individual owner.
The court did not go for this argument. It concluded that the records before the court did not clearly show the absence of corporate E&P (basically, it was not the court’s job to piece all of that together–which is consistent with other constructive dividend cases). The court also concluded that the taxpayer’s argument amount not having any gain fails as the taxpayer cannot disavow the structure of the sale-leaseback transactions it structured.
This case shows how important it is to evaluate distributions or benefits conferred on owners of C corporations. The IRS and courts are usually required to respect the validity of the C corporation. The result is often an IRS adjustment for constructive dividends and double tax. As argued by the taxpayer in this case, showing that there was no corporate E&P is often the best way to avoid the harsh tax consequences of constructive dividends. This requires accurate books and records.