|It's a Bird, It's a Plane …
No … it's a dividend.
June 1, 2009
Originally published in the May 2009 issue of Tax Insider.
All tax advisors know that when a corporation makes a cash distribution to all of its shareholders that such a distribution is taxed as a dividend. If the distributing corporation is an S corporation, the dividend is generally not taxable to the shareholders to the extent of the corporation's Accumulated Adjustments Account ("Triple A"). If the distributing corporation is a C corporation, the dividend is generally taxable to the shareholders to the extent of the corporation's current and accumulated earnings and profits (E&P).
The same analysis applies to a distribution of non-cash property. Under IRC Section 301(b), the fair market value of the property distributed is a dividend to the shareholder (subject to the Triple A rules applicable to S corporations and the E&P rules applicable to C corporations). Distributions of non-cash property are tricky in that the fair market value of the distributed asset may not be easily ascertainable. Yet, since the corporation must report to the IRS the fair market value of the dividend on IRS Form 1099-DIV, it has an affirmative duty to procure a valuation of the distributed assets. Otherwise, the distributing corporation is potentially subject to penalty for failure to file correct information returns with the IRS.
In simple terms, a "constructive dividend" involves:
Constructive dividend analysis can be tricky. In the first example involving payment of personal travel expenses, a constructive dividend would apply if the payment were for the shareholder's spouse or children. In that case, the shareholder is treated as receiving a dividend and making a gift in the amount of the dividend to the spouse or child. Another tricky area involves so-called mixed payments. Assume that an accounting firm prepares the tax returns for both the corporation and shareholders. Under the constructive dividend rules, the portion of the accounting firm's fee that related to the preparation of shareholder tax returns is treated as a dividend to those shareholders.
There are a category of expenses that involve part personal and part business that a corporation may or may not be required to treat as constructive dividends. The scope of those payments is beyond the scope of this article, but may include certain proxy costs, costs incident to the sale or redemption of corporate stock, costs incurred in connection with the preservation of the reputation of a corporate executive/shareholder and entertainment costs that have a mixed corporate and personal purpose.
The tax treatment of a constructive dividend is easy to describe. The corporation cannot deduct the amount of the constructive dividend as an ordinary and necessary business expense. Thus, if a shareholder receives a constructive dividend of $5,000 (either due to not paying for the use of a corporate asset or the corporation's payment of personal expenses), the corporation cannot deduct such amount and the corporation is required to report the $5,000 dividend to the IRS as a dividend.
Tips for the Tax Advisor
The challenge for the tax advisor is that constructive dividends do not usually jump out when he or she undertakes a review of the corporation's financial records. Personal use of corporate assets or corporate payment of relatively small amounts of personal expenses cannot be gleaned from a high-level review of the financial statements. Yet failure to properly account for constructive dividends can have devastating consequences. From the standpoint of the shareholder, failure to report constructive dividends on personal income tax returns can lead to substantial civil and even, in egregious cases, criminal penalties. From the standpoint of the corporation, deducting as corporate expenses the amount of constructive dividends coupled with the failure to file proper information reports with the IRS on constructive dividends can cause the corporation to be subject to civil and even, in extreme cases, criminal penalties.
Best practices now require the tax preparer to inquire of any corporation whether they have made a constructive dividend to a shareholder. In particular, a tax preparer of corporate tax returns should directly ask the corporation if any shareholder used corporate assets for personal use or whether the corporation paid the personal expenses of a shareholder. The answer to that question should be memorialized in the preparer's work papers. If the preparer fails to make such inquiries, it is possible that, if the amount of the constructive dividend is large or obvious enough, the IRS may attempt to impose penalties on the preparer under IRC Section 6694 or even attempt to sanction the preparer under Treasury Circular 230.
Constructive dividends have been around as long as the Internal Revenue Code, yet escape much attention. However, in this era of increased IRS enforcement and penalty assessment, it behooves corporate taxpayers and their tax preparers to engage in the proper due diligence to ensure that neither the corporation, corporate shareholders nor the tax preparer land in the penalty box for failure to properly account for constructive dividends.
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Larry Jacobson, an attorney and CPA, is a senior partner in the Chicago office of the law firm of Schiff Hardin LLP. He holds a BA from Washington University, an MBA from the University of Chicago, an MSOD from the University of Pennsylvania and a JD from the Georgetown University Law Center.