Jack Townsend has an excellent post today (all of his posts are excellent) about C corporation constructive dividends.
In United States v. Ellefsen, ___ F.3d ___, 2011 U.S. App. LEXIS 18684 (8th Cir. 2011), the appeals court addressed the issue of whether the IRS properly reclassified payments made by a C corporation to a trust, of which the sole shareholder of the corporation was the only beneficiary, as non-deductible dividends to the shareholder.
The taxpayer claimed that the payments should have been reclassified as deductible wages rather than dividends, thereby allowing the corporation to avoid double-taxation.
Here’s what the Court said:
We conclude that the district court did not abuse its discretion in allowing Vandenberg to testify that the funds flowing through the Aegis system constituted constructive dividends.
“[W]here controlling shareholders divert corporate income to themselves, such diverted funds should be treated as constructive dividends.” Simon v. Comm’r, 248 F.2d 869, 873 (8th Cir. 1957); see Truesdell v. Comm’r, 89 T.C. 1280, 1300 (1987) (“In concluding our discussion of the constructive dividend issue, we would emphasize that in a case such as this, diverted amounts taxed to a shareholder as constructive dividends also remain fully taxable to the corporation to which attributable.”).
[The corporation] paid [the surgeon] a salary for his personal services, presumably the salary that he, as sole shareholder, demanded. Although the corporation likely could have paid him more for those services and properly deducted that amount as a business expense — with [the surgeon] then paying income tax on his additional compensation — the Ellefsens did not structure Brian’s income in that way. They instead decided to utilize the Aegis [trust] system and falsely deduct management fees from [the corporation’s] corporate tax returns.
The income was not taxed at all — despite the fact that [the surgeon] was spending the money — until after the government subpoenaed documents from [the accountant] and [the surgeon] decided to amend his personal tax returns.
In these circumstances, we conclude that the so-called management fees were properly considered constructive dividends.
It is not uncommon for a corporate taxpayer to pay the personal expenses of its shareholders with corporate funds. However, such use of corporate funds is taxable to the shareholder and must be included on the shareholder’s tax return in one of three income categories:
- Non-employee compensation
(Note: There are non-income categories that the payments might be reclassified to, such as the repayment of shareholder loans, the return of shareholder capital, and loans to shareholder. But see Footnote 1, below, for an explanation as to why the after-the-fact claim that the shareholder payments were one of these items probably won’t work)
Categorization as dividends is the worst possible outcome because dividends are not deductible by the corporation. This results in double taxation. First, at the corporate level and then again at the shareholder or individual level.¹
It is my experience, however, that most IRS auditors and IRS appeal agents, in order to expedite the closing of the audit, will agree to reclassify payments made by corporations for the benefit of a shareholder to one of the first two categories thereby allowing the corporation to avoid double-taxation. But the Ellefsen case – even though it deals with a more premeditated and egregious circumstance than the mere payment by the corporation of a shareholder’s personal bills – will make it less likely that the IRS will be as generous in the future.
This is precisely what happened to Ellefsen.
First, since he chose to categorize (i.e. form) the corporate payments as something other than compensation, he is bound by that choice and cannot, ex post facto, claim that those payments were really wages or some other tax deductible corporate expense.
Second, the IRS ignored the actual form Elefesen chose for this transaction (i.e. deductible payments to his trust) and recast them as dividends under the substance over form doctrine.