Withdrawing Value

Any tax adviser who has represented closely held businesses and their owners long enough realizes there are certain recurring themes that transcend the otherwise unique characteristics of the industry of which the business is a part, the market or geographic region in which the business operates, the overall economic climate, and even the personal traits of its owners.

Last week we explored a variation on one of these themes – the withdrawal of value from a closely held business on a tax-efficient basis – when we reviewed several of the factors that the owners of a closely held business (organized as a C corporation[i]) should take into account in setting the amount of compensation the business should pay the owners in exchange for their services while preserving the corporation’s ability to deduct such payments in determining its taxable income.[ii]

Of course, the receipt of compensation for services is only one kind of transaction in which a shareholder may engage with the corporation by which value may be “removed” from the entity. Most of these transactions involve the shareholder acting other than in their capacity as a shareholder. For example, the shareholder may own another business with which the corporations transacts, or the shareholder may own property individually that they lease or license to the corporation, as the case may be.

In recognition of the corporation’s separate legal existence, these transactions should be analyzed for “pricing” purposes as occurring between the corporation and one who is not a shareholder.[iii] There are circumstances, however, in which a shareholder “forgets” this legal reality and acts other than at arm’s length with their corporation.

Which brings us to this week’s topic, which is just another facet of the above-described theme: the constructive dividend.

Constructive Dividends

Aside from the sale or redemption/liquidation of a shareholder’s equity interest in a corporation, the corporation’s distribution of a “dividend” to its shareholders in respect of their shares represents the only means, strictly speaking, by which a shareholder realizes a return on their investment in the corporation.

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.[iv] “Property” includes money and other property-in-kind.[v]

In the case of a “standard” dividend, the corporation’s board of directors decides it would be appropriate[vi] to distribute some of the corporation’s earnings to a class of its shareholders; basically, a return on the shareholders’ investment.[vii]

A “constructive” dividend[viii] typically arises where a corporation confers an economic benefit upon a shareholder as such[ix] without the expectation of “payment” – “consideration” may be the better word, whether in the form of services or property commensurate to the value of the benefit – even though neither the corporation nor the shareholder necessarily intended a dividend.[x]

More often than not, the deemed distribution will be attributable to the widely held belief among many business owners that they are free to transact with their business as they see fit; after all, they own the entity that owns the business.[xi] This faulty logic is manifested in the pervasive use by owners – albeit to varying degrees[xii] – of business resources for non-business purposes.[xiii]

How is it Measured?

Where a corporation constructively distributes property to a shareholder, the constructive dividend received by the shareholder is ordinarily measured by the fair market value of the benefit conferred.[xiv] Where the shareholder has provided some consideration to the corporation, whether in the form of property or services, the excess value of the benefit over this consideration is the measure of the dividend.

For example, the corporation’s payment of a shareholder’s personal expenses may be treated as a deemed distribution of a dividend equal to the amount of the payment.[xv] The rent-free personal use of a corporation’s plane may be treated as a constructive dividend equal to the rental value of the plane. An interest-free loan to a shareholder may be treated as a dividend equal to the foregone interest.[xvi] The bargain sale of a corporate asset to a shareholder may yield a dividend equal to the bargain element. The corporation’s payment of a premium over the value of property sold or services rendered by the shareholder may be treated as a dividend to the extent of such premium.

Based on the foregoing, one would be correct in suspecting that the identification of a constructive dividend is not necessarily a walk in the park, especially where the shareholder wears many hats vis-à-vis the corporation, or where reasonable minds may differ as to the value of the benefit conferred.

Unfortunately, this was not the case for Taxpayer in a recent decision of the U.S. Tax Court;[xvii]  indeed, it is difficult to imagine a set of facts more favorable to the IRS’s position that Taxpayers received constructive dividends from Corp.

Hogs Get Slaughtered

Taxpayers (spouses) were the only shareholders and the only corporate officers of Corp. As such, they controlled almost every aspect of Corp’s business, including its finances. They actively participated in Corp’s daily operation, frequently working 50 to 60 hours per week, and performed all levels of tasks required in the business.

However, during the years at issue Taxpayers did not receive a salary from Corp. Rather, Corp made payments in the form of management fees to Management Corp, a second corporation[xviii] owned entirely by Taxpayers, which in turn paid wages to Taxpayers and to their children[xix] for services purportedly rendered to Corp. No written contract or fee agreement was prepared in connection with Corp’s arrangement with Management Corp.

Corp made payments in the form of management fees to Management Corp, which in turn paid wages to Taxpayers and their children for services they purportedly rendered to Corp.

The management fees and rent payments from Corp were Management Corp.’s only income for the years at issue.

It’s Personal, Not Business[xx]

During the years at issue Corp maintained one or more credit card accounts for which Taxpayers were authorized users, as were their children at varying times. Taxpayers and their children used the credit cards to make purchases necessary to operate Corp’s business, but they also regularly used the cards to pay many thousands of dollars in personal expenses, all of which Corp invariably paid. In addition to routine personal purchases, such as restaurant meals, auto expenses, and personal medical expenses, Taxpayers either used the corporate credit card (or had Corp pay their personal credit card charges) for such expenses as college tuition, vacations, jewelry, and other luxury items. Their children made personal purchases with the credit cards even though they were not employees of Corp, and even during periods when they were not employees of Management Corp.

In addition, Corp provided Taxpayers and their children with several luxury vehicles that were titled in their names and used by them personally. Indeed, Corp paid the notes on the vehicles and claimed depreciation deductions for them on its tax returns. Neither Taxpayers nor their children maintained any mileage logs or other records of the extent, if any, to which they used the vehicles for Corp’s business purposes.

During the years at issue, Corp’s accountant (and later its in-house bookkeeper)

prepared Corp’s general ledgers and financial statements using information provided by Taxpayers. For example, Taxpayers would provide bank statements from Corp’s operating, payroll, and loan accounts.[xxi] Taxpayers also provided credit card statements but did not provide any guidance as to which expenditures were business expenses and which were personal. Although Taxpayers and their children used the credit cards for both business purchases and personal expenditures, they did not categorize their business expenses or notate the statements to indicate which purchases were personal. Similarly, the checks reflected on Corp’s bank statements were not coded as to whether they related to a business expense or a personal expense.


Despite the lack of guidance from Taxpayers, CPA (and later the bookkeeper) reasonably determined that many of the expenses on the credit card statements were personal and used a general ledger account entitled “A/R–Officer” – basically, non-taxable loans[xxii] to officers, as opposed to taxable dividends or wages – as a catchall for credit card charges that CPA determined were Taxpayers’ personal expenses.

The “A/R–Officer” general ledger account increased significantly during the years at issue primarily on account of charges to the credit cards.

Tax Returns

Corp’s tax returns were prepared by CPA using the general ledgers and financial statements prepared by CPA or the bookkeeper. The returns reported gross receipts and Corp claimed deductions for the expenses as posted in its general ledger.

The returns included “Note Rec. Officer” among Corp’s current assets on the Schedule L, Balance Sheets, attached to the returns, reporting the amounts believed to be personal expenditures.[xxiii] However, Taxpayers never made any interest payments with respect to, or principal repayments of, the amounts designated as the “Note Rec. Officer.”[xxiv]

At the same time, Corp did not pay Taxpayers any wages, nor did it make any “formal” dividend distributions.

On their returns, Taxpayers reported little to no tax owing for the years at issue. Their reported income for each year included the wages received from Management Corp. They did not report wages, salary, or dividends from Corp for any year.

The IRS examined Taxpayers’ tax returns for the years at issue; the examination also covered the tax returns of Corp and Management Corp for those years.

Throughout the examination, Taxpayers attempted to conceal their receipt of personal benefits from Corp. For example, Taxpayers claimed that their son’s wedding (paid for by Corp) was “a big celebration of” Corp and that the various trips they and their children made to the Bahamas, Europe, Hawaii, Las Vegas, and New Orleans (all paid for by Corp) were for business or so that they would not be distracted while performing administrative tasks.[xxv]

The Court

Following the examination, the IRS issued a notice of deficiency to Taxpayers, as well as notices of deficiency and determination of worker classification to Corp determining that Taxpayers were employees of Corp and should have received wage compensation during the years covered.

Taxpayers petitioned the Tax Court for redetermination of the asserted deficiencies.

Deemed Compensation

The Court observed that, during the years at issue, Taxpayers performed substantial services for Corp as its only officers yet they did not receive any compensation from Corp during those years.

However, the Court also noted that, during that time, Taxpayers received – either directly to themselves or indirectly to their children[xxvi] or other businesses – substantial economic benefits from Corp in the form of money, property, and other remuneration.

According to the IRS, the Court continued, these benefits constituted a mix of wages and dividends.

After sustaining the IRS’s determination that Taxpayers were employees of Corp, the Court agreed that a portion of the remuneration provided to Taxpayers (whether directly or indirectly) was in consideration for their work; as such, it constituted wages. Taxpayers, the Court stated, provided substantial services to Corp, and received compensation in the form of money, property, and other benefits. Such compensation constituted gross income to them.[xxvii]

Constructive Dividends

The Court then addressed the IRS’s determination that Taxpayers, as shareholders of Corp, received approximately $2 million in constructive dividends from Corp over the course of the years at issue.

The Court explained that, when a corporation distributes property to a shareholder as a dividend, whether formally (initiated by board resolution) or informally (de facto, by simply providing an economic benefit, as in this case), the shareholder must include the actual or deemed distribution in gross income to the extent of the corporation’s earnings and profits.[xxviii]

A constructive dividend arises, the Court explained, when a corporation confers an economic benefit upon a shareholder “without expectation of repayment and the corporation on the date of the deemed distribution had current or accumulated earnings and profits.” The Court stated that the shareholder need not receive the dividend directly and must include in their gross income any payments the corporation makes on the shareholder’s behalf.

According to the Court, in determining whether a shareholder received a constructive dividend, one must consider whether the payment benefited the shareholder personally rather than furthering the interest of the corporation.

Once one has concluded that a corporation has constructively distributed property to a shareholder, the amount of the constructive dividend received by the shareholder has to be measured. The Court indicated that such a dividend would ordinarily be equal to the fair market value of the benefit conferred upon the shareholder.

In the present case, the Court stated, the IRS based its determination, that constructive dividends were paid to Taxpayers, upon Corp’s distribution of property to Taxpayers and its payment of personal expenses, including the use of credit cards, payments on personal car loans and personal auto insurance, the distribution of vehicles, repairs on real property, the payment of real property taxes, loan repayments on personal residences, and other similar instances.

Meanwhile, Taxpayers did not present any arguments or evidence to dispute the IRS’s determination of dividends.

Based on the foregoing record, it was obvious to the Court that the amounts expended by Corp constituted economic benefits to Taxpayers as shareholders of Corp. “Gross income,” the Court stated, “is construed broadly to include all ‘accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.’”

Thus, the Court held that the value of the constructive dividends received by Taxpayers should have been included in their gross income as such and taxed accordingly.


The Court’s decision was hardly a surprise. Notwithstanding the outcome was a foregone conclusion, Taxpayers’ case is instructive as an illustration of what may happen to a careless shareholder.

It is axiomatic that interactions between a closely held business – including a C corporation – and its owners will generally be subject to heightened scrutiny by the IRS. When examining the tax returns of such a corporation, the IRS will, as a matter of course, inquire into the arm’s-length nature of any transaction between the corporation and any of its shareholders, and it will inquire as to the business purpose behind certain expenditures by the corporation. The labels attached to such interactions by the parties will have limited significance unless they are supported by objective evidence.

Thus, arrangements that purport to provide for the payment of compensation, rent, interest, etc., to a shareholder – and which are generally deductible by a corporation – may be examined by the IRS, and possibly re-characterized so as to comport with what would have occurred in an arm’s-length setting.

This may result in the IRS’s treating a portion of such a payment as a dividend distribution to the shareholder, and in the partial disallowance of the corporation’s deduction.

Bottom line: shareholders have to recognize the distinction between themselves and their closely held corporation, and they must treat with the corporation, to the extent reasonably possible, as they would with an unrelated person. By respecting the corporation’s separate existence, the shareholders may avoid unexpected, and costly, tax consequences.

Hogs do get slaughtered.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] This includes any non-corporate “eligible entity” that has elected under Reg. Sec. 301.7701-3 to be treated as an “association” for tax purposes; for example, an LLC or a partnership that has “checked the box” by filing IRS Form 8832.

[ii] https://www.taxslaw.com/2022/03/reasonable-compensation-meets-the-principal-shareholder-of-a-c-corp/ .

[iii] IRC 707(a) is the comparable rule for partnerships.

In any transaction between a shareholder and their corporation, one has to consider the impact of various “related party rules” that seek to curtail what Congress has determined may be abusive practices. See, e.g., IRC Sec. 1239, which applies to the gain recognized on a sale of depreciable property between a shareholder and a controlled corporation.

[iv] IRC Sec. 312 and Sec. 316.

[v] IRC Sec. 317.

That said, under some circumstances, the courts have held that a constructive dividend also includes the provision of services by a corporation to its shareholders.

It is important not to lose sight of the tax consequences to the corporation that makes an in-kind distribution of property to its shareholders: the corporation is treated as having sold such property for an amount equal to its fair market value. IRC Sec. 311(b).

[vi] Subject to the corporation’s having sufficient surplus as a matter of state law; also subject to any bank covenants restricting the distribution of earnings.

[vii] This kind of dividend is, more often than not, paid in money, though it may also be paid in other stock of the corporation, or in a promissory note of the corporation, or in-kind.

[viii] A deemed distribution to a shareholder.

[ix] The capacity in which the taxpayer receives the economic benefit will determine the character of the benefit and how it is taxed; for example, an amount paid to a shareholder for their services is compensation; an amount paid for the use of a shareholder’s capital (for a loan of money or the use of real property) is interest or rent.

[x] Indeed, such a dividend, by its nature, is not declared by the board of directors.

However, not every corporate expenditure that incidentally confers an economic benefit on a shareholder is a constructive dividend. For example, the corporation’s opening of a location near a restaurant owned by a shareholder should not, without more, be treated as a constructive dividend notwithstanding the economic benefit enjoyed by the restaurant.

As an aside, you’ll note that such incidental benefit will often prevent a finding of improper “private inurement” in the case of an insider with respect to a tax-exempt charity.

[xi] Not the best example of deductive reasoning.

[xii] Some are more blatant than others.

[xiii] Wait a second, shouldn’t someone object to this practice? Unfortunately, owners who are themselves “transgressors” are less likely to object to another owner’s “transgressions” so long as such transgressions are not “excessive.” When that implicit line is crossed, shareholders become less forgiving, especially if the economics of the business are not up to par. Mutually assured destruction?

[xiv] Where the fair market value cannot be reliably ascertained, or where there is evidence that fair market value is an inappropriate measurement, the constructive dividend can be measured by the cost to the corporation of the benefit conferred.

[xv] It is important to note that the corporation may intend for the benefit to serve another purpose; for example, compensation for services rendered by the shareholder. In that case, the tax treatment of the value transferred will be very different for both the corporation and the shareholder. In order to demonstrate this intention, it behooves the corporation to memorialize it in writing prior to or simultaneously with the transfer of the benefit.

[xvi] IRC Sec. 7872.

[xvii] Hacker v. Comm’r, T.C. Memo. 2022-16.

[xviii] Treated as an S corporation for federal income tax purposes.

[xix] The children were not employees of Corp during the years at issue.

[xx] Where would we be if Sonny had uttered these words to Michael instead of “It’s business, nothing personal.”

[xxi] Though they failed to provide any records relating to substantial undeposited cash payments received by Corp.

[xxii] The receipt of loan proceeds is not taxable because the borrower is obligated to repay the loan; there has not been an accretion of wealth. This premise underlies the ability to refinance debt secured by real property and to withdraw the equity from such property without immediate adverse tax consequences.

[xxiii] Schedule L to Form 1120 includes a line for “loans to shareholders”.

[xxiv] Although it was not stated expressly, it appears no promissory notes were given by Taxpayers to Corp to evidence their indebtedness to Corp.

[xxv] Speaks for itself, doesn’t it?

[xxvi] Although not addressed by the Court, Taxpayers should also have been treated as having made a gift to their children. See Reg. Sec. 25.2511-1(h)(1). For example, a transfer of property by a corporation to individual X is a gift to X from the stockholders of the corporation. If X was also a shareholder, the transfer is a gift to X from the other stockholders only to the extent it exceeds X’s own interest in such amount as a shareholder.

[xxvii] Reg. Sec. 1.61-2(a)(1). Taxpayers offered no argument or evidence to show that the wages the IRS determined were erroneous or unreasonable or should be excluded from gross income.

[xxviii] IRC Sec. 61(a)(7); IRC Sec. 301(a), (c)(1); IRC Sec. 316.