Taxing Lessons Case Summaries

Case — Constructive Dividends

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TL Case Summ

THE QUESTION

Did a taxpayer receive a constructive dividend in the amount of the forgone profit on a home his construction company built for him?

THE DISPUTE

Taxpayer Says: He did not receive a constructive dividend because a shareholder does not receive a constructive dividend when a corporation provides services to the shareholder at cost.

Internal Revenue Service Says: The taxpayer received a constructive dividend from his corporation when the corporation built his lakefront home without charging an amount equal to its customary profit margin.

THE LAW

From Internal Revenue Code Section 61(a)(7): Includes dividends in a taxpayer’s gross income.

From Internal Revenue Code Section 316(a): Defines a dividend as any distribution of property that a corporation makes to its shareholders out of its earnings and profits accumulated after February 28, 1913, or out of its earnings and profits for the taxable year.

From Internal Revenue Code Section 317(a): Defines property as money, securities, and any other property except stock in the distributing corporation. We have held that, under some circumstances, the provision of services by a corporation to its shareholders constitutes “property” within the meaning of section 317(a).

From Hood v. Commissioner, 115 T.C. 172, 179 (2000) (quoting Magnon v. Commissioner, 73 T.C. at 993-994): “A constructive dividend arises ‘[w]here a corporation confers an economic benefit on a shareholder without the expectation of repayment, * * * even though neither the corporation nor the shareholder intended a dividend.'”

From Truesdell v. Commissioner, 89 T.C. 1280, 1295 (1987) (quoting Noble v. Commissioner, 368 F.2d 439, 443 (9th Cir. 1966), aff’g T.C. Memo. 1965-84): “‘The crucial concept in a finding that there is a constructive dividend is that the corporation has conferred a benefit on the shareholder in order to distribute available earnings and profits without expectation of repayment.'”

THE CAUSE OF THE DISPUTE

When your corporation makes payments to you in your capacity as a corporate shareholder, you may have received a constructive dividend, even if the corporation did not formally declare the payment to be a dividend. For example, if you take a loan from your business, but make no effort to establish a bona-fide debtor/creditor relationship (by setting up a written note, making repayments or taking other steps), the IRS can reclassify the payment as a dividend to you.

Generally, constructive dividends are treated the same way as regular dividends under tax law. They are taxable income to you, and nondeductible for the corporation.

In this case, the taxpayer was the president and sole shareholder of a C corporation construction company. In 2004, he built a second home for himself. He established a job account on the corporate books to keep track of construction costs, and had part of the work done by corporate employees, as well as subcontractors the company regularly worked with. He reimbursed the corporation for all amounts paid to subcontractors, and for labor and overhead costs. He did not pay the company an amount equal to its standard profit margin.

The IRS says the taxpayer received a qualified dividend equal to the amount of the forgone profit because constructive dividends are ordinarily measured by the fair market value of the benefit conferred—in this case, a benefit that should have included the forgone profit.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the ?

THE COURT’S DECISION

Download (PDF, 64KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(
For the taxpayer. The most that can be said about the taxpayer’s use of the corporation is that he used it as a conduit in paying subcontractors and vendors and that he obtained some limited services from corporate employees. He fully reimbursed the corporation for all costs, including overhead, associated with those services, and the corporation did not divert actual value otherwise available to it by failing to apply its customary profit margin in determining the amount the taxpayer had to reimburse the corporation. We therefore conclude that this arrangement did not operate as a vehicle for the distribution of current or accumulated earnings and profits within the meaning of section 316(a).
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