In a report released last week, the U.S. Treasury Department explained that the so-called “tax gap” – i.e., the difference between the amount of federal income taxes owed by taxpayers for a taxable year and the amount actually paid for such year – “disproportionately benefits high earners who accrue more of their income from non-labor sources where misrepresenting is common.”[i]
According to the report, the largest contributors to this shortfall are the underreporting of income and the overclaiming of deductions on tax returns. These practices, the report continues, are prevalent among higher-income taxpayers with “opaque income sources,” among which the report includes sole proprietorships, partnerships and S corporations, rental real estate, and small C corporations;[ii] in other words, the owners of closely held businesses.
The President is relying upon the data in the Treasury’s report to pressure Congress into closing the tax gap, in part, by increasing the IRS’s enforcement capabilities, requiring more information reporting with respect to “opaque income streams,” and regulating tax return preparers.[iii]
Rock and Hard Place
The Administration’s interest in providing the IRS with enhanced resources for enforcement operations coincides with the President’s proposals to increase the top individual tax rate for ordinary income, eliminate the preferential individual rate for long-term capital gains and qualified dividends, limit the use of like kind exchanges, increase the corporate income tax rate, eliminate the basis step-up at death and impose a mark-to-market gains tax at that time, and enact other tax-generating measures.[iv]
Many higher-income taxpayers, including the owners of many closely held businesses, will consult their advisers and, after thoughtful consideration, will formulate a reasonable plan for responding to the enactment of the proposed tax increases.
Such a plan may include the acceleration of certain income or gains, to take advantage of current rates, and the deferral of certain expenses or losses, to offset future income or gains that may otherwise be subject to increased tax rates. It may also involve the taxpayer’s relocating their business or personal domicile from a higher-tax to a lower-tax state. Another component may involve the timing of income recognition – for example, using installment sales – to remain below any annual income threshold at which higher rates would apply.[v]
However, some higher-income taxpayers – primarily business owners who operate through an entity, such as a partnership or closely held corporation, from which they derive “opaque income streams” – will respond to the tax hikes in a way that demonstrates why the IRS refers to these businesses as “opaque income sources.” The government’s promise to take a more aggressive stance on tax enforcement will do little to dissuade these taxpayers from utilizing what has thus far been a “winning” formula, at least in their eyes.[vi]
Did I Hear Correctly?
One business owner recently gave me a glimpse of what they planned to do in the face of the expected tax increases. Our conversation started out so well; I did not foresee its conclusion.[vii]
The sole shareholder of an S corporation explained that the corporation was in a personal service business which did not represent an appreciating asset that would eventually be sold at a gain. The shareholder told me that the corporation paid him a reasonable salary for his services,[viii] and that he took distributions in respect of his stock every year.[ix]
He explained further that he was concerned about his income tax liability from the pass-through of the corporation’s business income under the S corporation rules;[x] the Administration’s proposal to increase the top rate on individuals to 39.6 percent heightened his concern, as did its proposal to extend the base on which employment taxes were imposed.
He was interested, he told me, in revoking the corporation’s “S” election. By converting to a C corporation, he continued, the income of the business would be taxed at the lower corporate rate.[xi] (Someone had clearly done their homework.)
I reminded him of the second level of tax that is imposed on corporate income, when it is distributed to shareholders.[xii] I then asked whether he intended to stop taking dividend distributions from the corporation. He would suspend distributions, he said, until he built a reasonable reserve in the corporation;[xiii] the amount distributed would thereafter be adjusted.
How then, I asked, would he withdraw value from the corporation to maintain his accustomed cash flow? Through increased compensation? (You ask a stupid question,[xiv] . . .)
The corporation will pay, and claim a deduction for, many of his personal expenses, says he straight-faced, including the cost of maintaining his apartment in the city, his automobiles, etc. (At that point, more stupid questions came to mind, but I restrained myself.)
“Other Expenses” and “Add Backs”
I wish the foregoing dialogue were fictional, but it was not. I am certain many tax advisers reading this post have had similar exchanges with clients (or potential clients) over the years.
I am also confident that other tax advisers – perhaps in preparation for an audit – have had the experience of asking a client to identify the expenses included on their corporate or partnership tax returns as “other deductions,” only to be told those items were, “you know, miscellaneous expenses.”[xv]
Mind you, these experiences are not unique to tax folks. I daresay that most transactional attorneys who regularly deal with the purchase and sale of closely held businesses have had their own experiences with this issue. For example, they have likely grown accustomed to the list of “add backs” that buyers request for purposes of getting a better handle on the profitability of the target business.[xvi] These are often one-time bona fide business expenses incurred by the seller that will not be incurred again by the buyer. All too often, however, they consist of personal expenses of the owners that are regularly “run through” the business.
It is axiomatic that interactions between a closely held business and its owners will generally be subject to heightened scrutiny by the IRS, and that the labels attached to such interactions by the parties will have limited significance unless they are supported by objective evidence.
Arrangements that provide for payments to or on behalf of a shareholder – for which the corporation claims a deduction – may be examined by the IRS and possibly re-characterized to comport with what would have occurred in an arm’s-length setting.
Thus, a portion of such a payment may be treated by the IRS as a dividend distribution to the shareholder, for which the corporation is not allowed a deduction.[xvii]
A corporation’s payment of a shareholder’s personal expenses – as suggested by the client referenced above – is an example of non-arm’s-length dealing that exposes the shareholder to the unpleasant tax consequences of “constructive dividends.”
As you know, the profits of a C corporation are subject to income tax at two levels: once when included in the income of the corporation, and again when distributed by the corporation to its shareholders. With respect to this second level of tax, the owners of a closely held C corporation will have to be mindful of the separate legal status of the corporation, lest they transact with the corporation in such a way as to cause a constructive distribution by the corporation that is treated as a taxable dividend to the owners.
According to the Code, a “dividend” is any distribution of property that a corporation makes to its shareholders out of its accumulated or current earnings and profits.[xviii] “Property” includes money and other property.[xix]
A “constructive” dividend typically arises where a corporation confers an economic benefit[xx] on a shareholder without the expectation of repayment,[xxi] even though neither the corporation nor the shareholder intended a dividend.[xxii]
Thus, if corporate funds are diverted by a controlling shareholder to personal use, they are generally characterized for tax purposes as constructive distributions to the shareholder.
Such a diversion may occur, for example, where the shareholder causes the corporation to pay the shareholder’s personal expenses; the payment results in an economic benefit to the shareholder but serves no legitimate corporate purpose.
The expenditures in question often demonstrate a pattern of payment of personal expenses. This pattern was consistent with Taxpayer’s tax-avoidance strategy to have Corporation deduct Taxpayer’s personal living expenses as business expenses.
It should be noted that a constructive dividend could also have been found if the corporation, instead of satisfying the shareholder’s expenses or liabilities, had made a payment to or behalf of a member of the shareholder’s family. In that case, the shareholder would be treated as having made a gift to their family member following the deemed distribution.
In addition to transactions between the corporation and third parties, a constructive dividend may also be found in direct dealings between the corporation and the shareholder.
For example, a purported loan by a corporation to a shareholder may be recharacterized, in whole or in part, depending upon the facts and circumstances, as a dividend distribution.
Indeed, any scenario in which the corporation and the shareholder are dealing with one another at other than arm’s length terms raises the possibility of a deemed distribution.
Thus, a shareholder’s rent-free use of corporate-owned property may constitute a dividend distribution in an amount equal to the fair market rental rate.[xxiii]
Conversely, a corporation’s payment of excessive rent for the use of a shareholder’s separately owned property, or of excessive compensation for their services, may be treated as a dividend to the extent of the excess.
The Risk is Real
To some business owners, and even some advisers, the risks described in the foregoing discussion may seem quite remote. I assure you they are not.
Indeed, a recent Chief Counsel Advice (“CCA”)[xxiv] addressed an issue raised by a taxpayer who was the majority shareholder in a C corporation. It was determined under examination that the corporation had paid the taxpayer’s personal expenses from corporate accounts; consequently, the payments were reclassified by the IRS as a dividend distribution – a constructive dividend – by the corporation to the taxpayer that should have been included in the taxpayer’s gross income. Moreover, the IRS asserted that the 3.8 percent surtax on net investment income[xxv] should be imposed with respect to the constructive dividend.
The taxpayer was also an employee of the corporation and was involved in the day-to-day operations of the corporation’s business.
The taxpayer contended that because they materially participated in the corporation’s business as an employee, the dividend income that they received from the corporation was not subject to the surtax on net investment income (“NII”), because the dividend income was derived in the ordinary course of a business that was not a passive activity of the taxpayer.[xxvi]
The Office of Chief Counsel disagreed with the taxpayer and concluded that dividend income received by an individual shareholder from a C corporation – whether formally declared by the corporation’s board or constructively found by the IRS – in which the shareholder was also an employee was subject to the tax on NII.
The CCA explained that a 3.8 percent tax is imposed on net investment income of a higher-income individual for the taxable year. “Net investment income,” it stated, means: (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business which is not a passive activity with respect to the individual, (ii) other gross income derived from a trade or business which is a passive activity with respect to the individual, and (iii) net gain attributable to the disposition of property other than property held in a trade or business which is not a passive activity with respect to the individual.
The term “gross income from dividends,” the CCA continued, includes amounts treated as dividends pursuant to subchapter C of the Code that are included in gross income (including constructive dividends).[xxvii]
Dividend income received by an individual taxpayer from a C corporation is net investment income unless such income is derived in the ordinary course of a trade or business. To qualify for the “ordinary course of a trade or business” exception, the dividend income must be derived in a trade or business conducted (1) directly by the taxpayer (or through a disregarded entity owned by the taxpayer), or (2) through a passthrough entity (partnership or S corporation). Since a C corporation is not a passthrough entity and is also not a disregarded entity, dividend income received by a C corporation shareholder generally cannot satisfy the “ordinary course of trade or business” exception.[xxviii]
C corporation stock generally produces dividend income to its shareholders and the stock is generally treated as property held for investment unless the dividends are derived in the ordinary course of a trade or business. Under these rules, any dividend income paid by a C corporation would not be derived by a shareholder in the ordinary course of a trade or business unless the shareholder is a dealer or a trader in stock or securities. Being a shareholder in a C corporation in and of itself is not a trade or business that would cause the dividend income received by the shareholder from the C corporation to be properly treated as derived in the ordinary course of a trade or business.
Moreover, the foregoing analysis does not change, the CCA stated, simply because a shareholder may be treated as materially participating in a trade or business activity conducted through a closely held C corporation.
Accordingly, any dividend income received by a shareholder from a C corporation will be subject to the tax on NII, irrespective of whether the shareholder was treated as materially participating in the trade or business activity of the C corporation.
Query why, in the scenario described by the CCA, the IRS chose to treat the corporation’s payments of the shareholder’s personal expenses as a dividend rather than as compensation? After all, the shareholder was also employed by the corporation and provided what were described as meaningful services.
For one thing, compensation treatment would have generated a deduction for the corporation, thereby swapping one deduction for another, although it would also have generated additional income to the shareholder and the imposition of additional employment taxes.
However, by finding a constructive dividend instead, the IRS denied the corporation a deduction for the amount paid, while also increasing the shareholder’s income tax and investment income surtax liabilities.
Therein lies the lesson for any shareholder-taxpayer who may consider having their corporation pay, and claim a deduction for paying, the taxpayer’s personal expenses. At that point, the taxpayer will have lost the ability to characterize the nature of the payment, and the IRS will be free to treat as it deems proper – i.e., in a manner that maximizes the benefit to the government.
By continuing to treat the corporation as an “opaque income source” in the face of both the threatened tax hikes and the revived enforcement capabilities of the IRS, the taxpayer-shareholder is asking for trouble.
Don’t you love the euphemism, “misrepresenting”? I guess the IRS is careful about throwing “F bombs.”
[ii] The IRS estimates a 55% misreporting rate for such income sources. Likewise, there is a significant employment tax gap associated with such business incomes.
By contrast, the compliance rate for ordinary wage and salary income is 99%. IRS, 2019. “Federal Tax Compliance Research: Tax Gap Estimates for Tax Years 2011-2013.
[iii] Some of whom are much too accommodating of their clients’ wishes.
It also follows on the heels of widely disseminated reports regarding what can only be described as the obscene growth in the fortunes of the wealthiest Americans over the last year or so.
[v] For example, Mr. Biden has proposed the imposition of a higher capital gain tax rate for taxpayers with annual income of more than $1 million.
[vi] It is amazing how many of these folks equate the government’s not having called them out for their practices with the wisdom of what pursuing such practices. The reasoning is specious, but people too often see what they want to see.
[vii] The experience reminded me of a joke. No offense is intended.
A teacher asked whether any member of her kindergarten Sunday school class could tell her what they celebrated at Easter. One student told her it was the day on which people wore costumes and went door to door asking for candies. Another suggested it was the day on which people exchanged presents. Frustrated with their responses, the teacher finally called upon one child who had been eagerly trying to ger her attention. This child said to the teacher, “On the third day after Jesus was placed in a tomb, He was resurrected, and the stone that blocked the entrance to the tomb was rolled away” – at this point, the teacher was beaming that one of her kids knew the meaning of Easter, but her joy was short-lived – “then Jesus stepped out of the tomb, saw His shadow, and went back inside because it meant we were going to have an extra month of winter.”
[viii] See Rev. Rul. 74-44. Basically, if an S corporation makes distributions to an employee-shareholder while paying them an unreasonably low wage for their services, the IRS may recharacterize part of the distribution as wages; in that case, the distribution qua compensation is subject to employment taxes (whereas a distribution, as such, was not).
[ix] IRC Sec. 1368. The distributions were state law “dividends” by which the shareholder removed corporate profits he had already included in his gross income under the S corporation rules. IRC Sec. 1366 and Sec. 1367.
[x] IRC Sec. 1366.
[xi] Under existing rules: 37% individual rate vs 21% corporate rate. As proposed by Mr. Biden: 39.6% vs 28%. (Many centrist Democrats have stated they will not support a corporate tax rate over 25%.)
[xii] IRC Sec. 301.
[xiii] He seemed to be aware of the accumulated earnings tax. IRC Sec. 531 et seq.
[xiv] In the sense that you already know the answer, it’s not what you want to hear, but you ask the question anyway.
[xv] When this line on the tax return is completed, the taxpayer is directed to attach a statement that details the items included. Do you know how many times I have seen statements with nothing more than the phrase “other expenses” repeated?
[xvi] These extraneous expenses are added to EBITDA. Thus, where the price for a business is determined on a multiple of EBITDA, the buyer must be alert to the seller’s attempts to “stuff” the add backs.
[xvii] Thus, the corporation’s taxable income is increased because of the recharacterization of the payment as a nondeductible dividend.
[xviii] IRC Sec. 316 and Sec. 312.
[xix] IRC Sec. 317. Under some circumstances, the courts have held that a dividend may take the form of services provided by a corporation to its shareholders.
[xx] Where a corporation constructively distributes property to a shareholder, the amount of the constructive dividend received by the shareholder is ordinarily measured by the fair market value of the benefit conferred.
[xxi] In other words, there was no indication that the events, taken as a whole, constituted a loan from the corporation to the shareholder.
[xxii] However, not every corporate expenditure that incidentally confers economic benefit on a shareholder is a constructive dividend.
[xxiii] As an aside, it’s interesting to note that the IRS has never seriously treated a child’s use of a parent’s property as a gift.
[xxiv] CCA 202118009.
[xxv] IRC Sec. 1411.
[xxvi] IRC Sec. 1411(c)(2).
[xxvii] Treas. Reg. Sec. 1.1411-1(d)(3).
[xxviii] Treas. Reg. Sec. 1.1411-4(b).