When I practiced public accounting, many clients wanted to take money from their business without paying taxes. It was a common theme and I was amazed by the creativity of my clients with transferring wealth from their business to their personal life. This receipt of economic benefit without a mutual agreement to reimburse or compensate the company for the value is commonly referred to as a ‘Constructive Dividend’. The Internal Revenue Service (IRS) defines constructive dividends this way:
When a corporation confers an economic benefit upon a shareholder, in his capacity as such, without an expectation of reimbursement, that economic benefit becomes a constructive dividend, taxable as such. See INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE MEMORANDUM FOR DISTRICT COUNSEL, Number 200011003 dated October 27, 1999; specifically Page 4, 3rd paragraph.
Naturally, many of you reading this will say, ‘Well, I can figure a way to do it without getting taxed on this value’. And you’ll attempt something that many of us accountants have already seen and of course, the IRS has recorded. Just like the law of physics which you can’t beat, good luck trying to avoid taxation on this wealth transfer. The point of this article is define this term, educate the reader as to its understanding and explain the IRS two principles used to prove the existence of constructive dividends.
Within the Tax Code, dividends (economic benefit received from an investment, most commonly stock) are taxable as income. Therefore the common individual has to pay income taxes on dividends received. Please do not confuse dividends with distributions, there is a difference. Please read: Distributions and Dividends – Use in the Proper Context for further clarification. To avoid this income tax, shareholders will often try having their closely held business not pay dividends. The problem is that wealth is not transferred to the individual and remains in the company. To get around this, shareholders try to create ways to transfer value to the shareholder at the individual level.
Simply put, if the value or economic benefit is held and accrues to the shareholder and not the company, it is no different than issuing a dividend to the shareholder. One of the most common and initial tool to do this was a simple loan. The company agrees to loan money to the shareholder. Think about this, it makes sense, cash is transferred to the shareholder and the company has an asset (loan receivable) from a shareholder. Seems innocent enough, but the key lies in the terms of the loan. If there is no intention of paying back the loan with interest, this is no different from a dividend, the transaction’s name is the only difference. It is economically the same as a dividend. The IRS caught onto this early as noted in Welch v. Helvering, 290 U.S. 111 (1933).
As business owners matured and became more sophisticated, there were other types of loans utilized to qualify as exceptions to Welch v. Helvering. It didn’t take long before the IRS issued a long list of inclusions and restrictions. To get around the Code’s expanded definition, some companies used a third-party entity to hide the essence of a loan.
In Loftin & Woodward, Inc. v. United States, 577 F.2d 1206, 1214 (5th Cir. 1978) a closely held partnership owned by Loftin and Woodward used a closely held corporation also owned by Loftin and Woodward to absorb costs related to a land clearing project. Thus, profits were shifted over to the partnership where income is taxed differently than dividends from a company.
The IRS focused in on the fact that the ownership of the two entities were comparable and that the partnership merely served as a conduit to transfer profits to Loftin and Woodward.
The examples of profit shifting from a closely held corporation to the corporation’s shareholders goes from the original to bizarre. The following are more deceptive attempts:
- The company pays for personal expenses of the owners under the guise of ordinary and necessary expenses of the company. Common costs include cell phones, personal computers, other technology, auto costs, travel and more. See Commissioner of Internal Revenue v. Riss, 374 F.2d 161 (8th Cir. 1967).
- The company rents real estate owned by the shareholder(s) at a value greater than fair market value, Goldstein v. Commissioner of Internal Revenue, 298 F.2d 562 (9th Cir. 1962).
- The company is mandated by the lease to improve the property so at the lease’s termination, the shareholder(s) pick up value from the improved real estate.
- A company buys real estate or other property from the shareholder(s) at a value that exceeds the fair market value or in violation of the arm’s length transaction principle.
- A company acts as a guarantor of loans made to its shareholders for personal property from automobiles to boats.
There are two elements that the IRS must prove to confirm the existence of a constructive dividend.
One – actual economic benefit (not necessarily in the form of cash) was transferred to the shareholder, AND
Two – the transfer of wealth has no expectation of repayment or reimbursement from the recipient.
Finally, the courts look to the entire period of time involved and not just one accounting cycle. Therefore if a loan is made (economic benefit to the shareholder) in one accounting period and the loan was repaid in a successive accounting period, the transaction is considered a traditional loan and not a constructive dividend. With this in mind, the taxpayer should remember that it takes about three years for the IRS to demand and make a determination for a particular accounting period. Therefore, the taxpayer should begin to pay back the loan or have completely paid back the loan to avoid classification of this amount as a constructive dividend.
If you are an owner of a closely held business, there are other tools, legal methods, to transfer wealth from the company to you. The underlying reason for this is to avoid double taxation. Legal ways to avoid this include:
- Conversion to an S-Corporation;
- Increasing the shareholder’s compensation package;
- Utilizing accelerated depreciation;
- Use of key man insurance;
- Maximizing employee benefits.
There are others, but the above represent the ones that have the greatest impact on profitability and legal wealth transfer to shareholders.
Summary – Constructive Dividends
Congress codified a constructive dividend under Section 316(a) of the Internal Revenue Code. There are two underlying elements that must be met in order to construe a dividend to a shareholder. First, there must be economic benefit transferred to the shareholder. Secondly there must exist no expectation of repayment or reimbursement to the company for this economic benefit received. If constructive dividends are received, the taxpayer is obligated to pay income taxes on the value of this wealth transfer.
The taxpayer and corporate management must understand the definition of a constructive dividend, its primary forms and how to properly apply the rules used by the government to avoid unplanned transfers of economic benefit to owners of a closely held corporation. ACT ON KNOWLEDGE.