Small Business Taxes & ManagementTM--Copyright 2013, A/N Group, Inc.
You don't have to formally declare a dividend from a C corporation to have a taxable dividend. You don't even have to write a check to yourself. The payment of salary in excess of what the IRS considers reasonable, the payment of personal expenses by the corporation, paying a relative who does no work for the business, etc. can all result in a "constructive" dividend. (In order for the payment to be a dividend, the corporation has to have accumulated earnings and profits. That's roughly equivalent to retained earnings.)
For a C corporation the tax treatment of a dividend is harsh. It's not deductible by the corporation, but it is income to the shareholder. Moreover, the top tax rate on dividends is now higher than in the recent past.
Before you click the back button on your browser, read the discussion below. It could apply to you even if you do business as an S corporation, LLC, partnership, etc.
Corporation's Performance of Services for Shareholder
But it's not unusual for shareholders to deal with their business. For example, Fred owns a car dealership. When he needs maintenance done on the family car he's not going to take it Mike's Auto Repair.
In a recent Tax Court case Terry J. Welle et ux. (140 T.C. No. 19) the taxpayer was the sole owner of a C corporation, Terry Welle Construction, Inc. (TWC). The taxpayer and his wife used the company to facilitate the construction of a vacation home. They personally contacted subcontractors and vendors. They acted as their own general contractor. To keep track of material and other construction costs, the taxpayer caused TWC to open a "cost plus" job account on its books.
During construction TWC paid the subcontractors and vendors directly, and its framing crew framed the home. The taxpayers repaid TWC for all amounts paid to the subcontractors and also reimbursed TWC for its labor and overhead costs. TWC, however, did not charge the taxpayers, and the taxpayers did not pay to TWC, an amount equal to the customary profit margin that TWC used to calculate the contract price that it charged its unrelated clients.
The IRS determined that the taxpayer received a qualified dividend of $48,275 from TWC, an amount equal to the foregone profit.
The taxpayers argued that a shareholder does not receive a constructive dividend when a corporation provides services to the shareholder at cost. The taxpayer also argued that the IRS's measure of any constructive dividend that may have been received was erroneous because the services TWC provided were not comparable to the services it would have provided to an unrelated party (e.g., TWC didn't have to deal with subcontractors and vendors). The Court did not address the taxpayers' second argument because the Court found the taxpayer received no dividend.
The Court noted that where a corporation distributes property to a shareholder, the constructive dividend is received by the shareholder is ordinarily measured by the fair market value of the benefit conferred. However, where fair market value cannot be reliably ascertained or ther is evidence that fair market value is an inappropriate mode of measurement, the constructive dividend can be measured by the cost to the corporation of the benefit conferred.
The Court went on to say that the IRS has not, in prior cases, asserted that the constructive dividend received by a shareholder included an amount corresponding to the corporation's foregone profit. The IRS just argued that its position followed from the general rule that constructive dividends are ordinarily measured by the fair market value of the benefit conferred. The Court sided with the taxpayer and said it could not see how TWC's provision of services to the taxpayer at cost that was reimbursed resulted in the diversion of corporate assets or the distribution of its earnings and profits.
Measuring the Benefit
The taxpayer won, in part, because he reimbursed the company for all its costs plus overhead. Even taxpayers who may routinely reimburse their business for direct out-of-pocket costs fail to include an additional amount for overhead. Often that's not insignificant. In our example about Fred having work done on his car by his dealership, the cost would include the parts, labor and associated taxes, and overhead (e.g., building rent, office staff, etc.).
In the case of an item of property distributed to a shareholder, the value of the dividend is equal to the excess of the fair market value over the sale price. Looking to our example with Fred and his car dealership, if he takes a car off the lot, without any payment to the company, to give to his brother-in-law as an anniversary present, the dividend would be equal to the fair market value of the car. If he writes a check to the dealership for $20,000 for a car with a fair market value of $32,000, the dividend would be $12,000
What about when the corporation provides a shareholder with the use of company property? If the shareholder does not fully and reasonably reimburse the corporation for the use, the shareholder has received a constructive dividend equal to the fair market value of the use of the property. The classic case here is the use of a company car or airplane. In both of those situations the IRS has come up with specific rules on how to value the use. In other situations valuing the use of property, e.g., construction equipment borrowed for a week, might be done by published rental rates.
S Corporations, LLCs, Partnerships, etc.
These entities don't have the same problem. A distribution from one of them generally does not result in taxable income. For example, Fred's S corporation pays his son's car insurance. On audit the IRS disallows the deduction. The disallowed deduction increases Fred's personal income, but there's no double tax as there would be with a C corporation.
So there's no concern right? Wrong. First, you'll probably have to pay the 20% accuracy-related penalty on the increased tax. Second, it puts you in a bad light with the IRS. And, if egregious enough, and/or some other factors are present, the IRS could assert fraud. Third, if the occurrences are significant enough, you could lose the protection afforded by your corporation or LLC.
Finally, there's an important tax reason that could prove costly. Distributions in excess of your basis in an S corporation, partnership, LLC, etc. produce capital gain income. And, if you have no basis any losses will be disallowed. Here's a simple example:
Example--Fred incorporates Madison Inc., an S corporation, with $1,000 of capital. The business has profits of $4,000 the first year, but Madison pays $12,000 for the lease on Fred's car which is 100% personal use. The $12,000 is counted as a distribution. Between the profits and the initial capital, Fred's basis is only $5,000. The $12,000 distribution results in a $7,000 capital gain.This problem is much more likely to occur in a thinly capitalized (i.e., not much equity capitalization) and/or one that has sustained losses. Unfortunately, that describes many small businesses.
Some businesses, such as home contractors, auto repair shops and dealerships, some retail stores, etc. are more likely to encounter the issue than others. Be aware that if you're audited for many businesses that's one of the areas that will be examined.
While it's best to avoid personal dealings with your business, for many taxpayers it's almost certain to happen. If you treat yourself as you would an outsider, you're generally on safe ground. If there are special valuation rules, you should use them. Your tax advisor should be able to help.
Copyright 2013 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 07/08/13