Constructive Transfers
It is axiomatic that the tax treatment of 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.
Benefit to the Shareholder
Thus, arrangements that purport to provide for the payment of compensation, rent, interest, royalties, etc., by a corporation to a shareholder – and which generally would be deductible by the corporation – may be examined by the IRS and possibly re-characterized to comport with their true nature.
Similarly with respect to a corporation’s satisfaction of an expense or other obligation that, on its face, is owing from a shareholder to a third party but for which the corporation claims a tax deduction by characterizing the amount as an expense incurred by or on behalf of the business.
In either case, the IRS’s examination of such payment may result in the treatment of all or a portion of the payment as a dividend[i] to the shareholder – rather than as payment of a bona fide corporate business expense – which will result in the disallowance of the deduction claimed by the corporation.
A “constructive” dividend typically arises when, and to the extent that, a corporation confers an economic benefit on a shareholder without the expectation of repayment.[ii]
Benefit to the Corporation
Of course, the flow of value between a shareholder and their corporation is not a one-way-street.
Although it seems not to occur as frequently as a constructive distribution by the corporation, there are instances in which a shareholder has tried to claim a tax deduction with respect to a benefit bestowed by the shareholder upon their corporation.
For example, a shareholder in a closely held corporation may satisfy an obligation owing, or an expense incurred, by their corporation even where the shareholder has no personal liability or other exposure for such payment.
In that case, generally speaking, the shareholder should be treated as having made a capital contribution to the corporation,[iii] and the corporation should be treated as having satisfied its own liability or paid its own expense, with the resulting tax consequences.
Although the foregoing makes perfect sense in the case of a C corporation, what if the corporation on behalf of which the shareholder pays the expense is an S corporation the income, deduction, gain, loss, and credit of which flows through[iv] to its shareholders for tax purposes? Should the corporation’s tax status make a difference?
The issue addressed in a recent Tax Court decision[v] was whether two shareholders (the “Shareholders”) who had paid certain bona fide business expenses incurred by their S corporation were entitled to claim a tax deduction therefor on their individual tax returns.
The Shareholders’ Payments
The Shareholders operated a business individually[vi] and through several related entities, including an S corporation (“Corp”) that was owned equally by the two Shareholders.
During the tax year in question, Corp owed property taxes to County and utility expenses to Power Co (the “Expenses”). The Shareholders directly paid these costs on behalf of Corp in proportion to their respective ownership interests in Corp (equally).
Tax Returns and Deficiency
Each Shareholder claimed business expense deductions[vii] on their respective U.S. Individual Income Tax Return[viii] for the amounts paid by such Shareholder.
Corp filed its U.S. Income Tax Return for an S Corporation[ix] for the same tax year[x] but did not claim a deduction on the return for the Expenses paid by the Shareholders. Thus, the Expenses were not applied against Corp’s income for the purpose of determining the ordinary business income that flowed through to the Shareholders.[xi]
Following an audit of the Shareholders’ respective federal income tax returns, the IRS determined significant aggregate deficiencies in the Shareholders’ income tax.
The IRS then issued the Shareholders notices of deficiency[xii] with respect to the determined deficiencies which, among other things, disallowed the deductions for the Expenses on the Shareholders’ respective individual income tax returns.
In response to the notices, each Shareholder filed a timely Petition with the U.S. Tax Court seeking a redetermination of the deficiencies asserted by the IRS.[xiii] Their cases were subsequently consolidated.[xiv]
At the Tax Court
The question before the Court was whether the Shareholders were entitled to “passthrough deductions” on their individual income tax returns for the Expenses they paid on behalf of Corp.
The Court began by explaining that, in determining their income tax liability for a taxable year, a taxpayer may deduct the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.
The Court also stated, however, that deductions for personal expenses are prohibited.[xv]
Shareholders’ Position
According to the Shareholders, the Court continued, their payments of Corp’s Expenses should have been considered capital contributions by the Shareholders to Corp, that Corp would have been entitled to deduct the Expenses as ordinary and necessary expenses paid in carrying out Corp’s business,[xvi] and this deduction would have reduced the income flowing from Corp, an S corporation, to the Shareholders.
IRS: “Personal” Expenses
The Court observed that the IRS did not dispute the foregoing characterization but still challenged the deduction of the Expenses on the personal income tax returns of the Shareholders.
According to the IRS, the Court explained, a taxpayer cannot claim a deduction for their payment of expenses owing or incurred by another taxpayer. This long-established principle, the IRS argued, extended to corporations because a corporation’s business is distinct from its shareholders.
Thus, the IRS contended, the Shareholders’ payment of the Expenses on behalf of Corp amounted to the payment of “personal expenses” for which the Shareholders could not claim a deduction notwithstanding that the expenses furthered Corp’s business.
An Exception
That said, both the Court and the IRS recognized there was an exception to the above rule pursuant to which a shareholder would be allowed a deduction for a payment made to “protect or promote” the business of the corporation when the corporation itself was financially unable to pay the expenditure.[xvii]
In order to come within this exception, one must first ascertain the purpose or motive which caused a taxpayer to pay the obligations of another person. For example, was the payment made to keep Corp in business and to thereby realize an investment return[xviii] through corporate profits? Or was the Shareholders’ purpose to protect or promote their individual business,[xix] realizing a return through continued profits in that business?
Once that motive has been identified, one must then judge whether the obligation paid was an ordinary and necessary expense of the taxpayer’s trade or business; that is, was it an appropriate expenditure for the furtherance or promotion of that trade or business? If it was, then the expense was deductible by the taxpayer paying it.
However, as the Court pointed out, the Shareholders did not contend that the present situation fell within this limited exception.[xx]
The Court’s Opinion
The Court stated that a shareholder is not entitled to a deduction from their personal income for their payment of the expenses of their corporation; such amounts constitute either a loan or a contribution to the capital of the corporation[xxi] and are deductible, if at all, by the corporation.
According to the Court, the Shareholders were, in effect, asking the Court to recognize an exception to the above rule in the case of S corporations. The Court added, however, that the Shareholders had failed to establish how such a result was supportable under the law. Unlike the income of a C corporation, the Court continued, the income of an S corporation escapes corporate-level taxation and “passes through” to the shareholders on a pro rata basis.[xxii]
Although an S corporation’s income eventually flows through to the shareholders, the Court observed that a corporation “remains a separate taxable entity [from its shareholders] regardless of whether it is a subchapter S corporation or a subchapter C corporation.” This means that the business expenses of an S corporation cannot be disregarded at the corporate level for purposes of determining their deductibility.[xxiii]
Consequently, the “income reaped” by an S corporation, the Court stated, “must be matched at the corporate level against the S corporation’s expenses that were incurred to produce that income before the net income or loss amount can flow through to the shareholders.”[xxiv] This matching is accomplished by reporting such items on an S corporation’s corporate return.
Finally, the Court pointed out that the Shareholders had not cited any instance in which a court had upheld a business expense deduction of an S corporation on a shareholder’s personal return under facts comparable to the ones presented.
The Court added that, in fact, it had previously rejected an argument similar to the one made by the Shareholders and refused to treat an S corporation differently from a C corporation where the shareholders of an S corporation had disregarded deductions at the corporate level for business expenses the shareholders had paid on behalf of the S corporation.
Accordingly, the Court upheld the disallowance of the Expenses as deductible expenses on the personal returns of the Shareholders.
Observations
Doesn’t see fair, does it? Maybe not.
It is implicit in the Code that a taxpayer generally may not deduct the expenses of another taxpayer, even though those expenses would otherwise be ordinary and necessary trade or business expenses.
Thus, for example, a shareholder (including a parent corporation) may not deduct compensation paid by it to the employees of its wholly owned corporation (subsidiary), even though the indirect benefit of their services inures to the shareholder as a shareholder (perhaps the sole shareholder) of the employer-corporation (or subsidiary).
Instead, because the payments by a shareholder (or parent corporation) are typically made to protect its investment in the corporation (or subsidiary), they represent an additional cost (basis) for its shares, and should be treated as an additional contribution to the corporation’s (or subsidiary’s) capital, accompanied by a constructive payment by the corporation (or subsidiary) of the cash bonuses to its employees, for which the subsidiary was entitled to an ordinary business deduction.[xxv]
As described above, there is a limited exception to this rule: A deduction may be allowable by a shareholder (or parent corporation) if it paid the related corporation’s business expense for its own direct and proximate benefit, or if the expense was incurred by the shareholder (or parent corporation) with the underlying motivating purpose of protecting and promoting its own business (as opposed to that of the related corporation).
It is sometimes difficult for the owners of closely held corporations to remember that their corporations are, in fact, separate taxpayers. Business exigencies or, more frequently, shareholder convenience may cause the owners to ignore corporate formalities or the importance of properly recording the reasons for or the circumstances surrounding a payment, thereby leading to unexpected tax results like the ones described in this post.
In order to avoid the IRS’s recharacterization of payments made by shareholders or a related business for their corporations, it is important that the parties consider the tax consequences thereof before the payments are made. This will require that they properly identify the reason for and nature of the payment, and that they contemporaneously document the flow of funds that actually occurs or is deemed to occur.
As always, shareholders and their corporations should endeavor as much as possible to approach their transactions with one another as if they were unrelated parties.
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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] 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. “Property” includes money and other property; under some circumstances, the courts have held that it also includes the provision of services by a corporation to its shareholders.
[ii] A dividend may be found even though neither the corporation nor the shareholder intended a dividend.
It should be noted, however, that not every corporate expenditure that incidentally confers economic benefit on a shareholder is a constructive dividend.
[iii] Perhaps with an adjustment to the shareholder’s percentage ownership interest in the corporation.
[iv] Pursuant to IRC Sec. 1366.
[v] Vorreyer v. Comm’r, T.C. Memo. 2022-97 (2022).
[vi] Keep this in mind.
[vii] Under IRC Sec. 162, which allows a business taxpayer to claim a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
[viii] IRS Form 1040 for the tax year in which the expenses were paid by the Shareholders.
[ix] On IRS Form 1120S.
[x] An S corporation is required to use the calendar year as its taxable year unless it established a business purpose for using a fiscal year. IRC Sec. 1378. That said, an S corporation may elect to use a taxable year with a deferral period of not more than 3 months, provided the corporation agrees to make an annual payment that, in effect, neutralizes the deferral benefit. IRC Sec. 7519.
[xi] See Part III of Sch. K-1 to IRS Form 1120-S.
[xii] The “90-day letter.” IRC Sec. 6212.
[xiii] A taxpayer to whom a notice of deficiency has been issued has 90 days after the notice was mailed to file a petition with the Tax Court for a redetermination of the deficiency asserted. IRC Sec. 6213.
[xiv] Tax Court Rule 141 authorizes the Court to consolidate cases pending before the Court that involve a common question of law or fact and their consolidation would avoid unnecessary costs, delay, or duplication.
[xv] IRC Sec. 262(a).
[xvi] IRC Sec. 162.
[xvii] Lohrke v. Commissioner, 48 T.C. 679 (1967).
[xviii] On their capital contribution.
[xix] You’ll recall the Shareholders operated the business individually and through related entities, including Corp.
[xx] Wonder why.
[xxi] According to the IRS, “[a] contribution to capital need not be made pro rata with contributions from other shareholders. . . [and] a payment to a corporation can be a capital contribution even if some shareholders contribute less than others or nothing at all.” Moreover, a contribution to capital may occur even if it “is not recorded as a contribution to capital on the corporation’s balance sheet.”
[xxii] IRC Sec. 1363(a) and Sec. 1366(a)(1).
[xxiii] Including for purposes of IRC Sec. 162.
[xxiv] IRC Sec. 1366(a).
[xxv] See, for example, Rev. Rul. 84-68.