Owners of small corporations typically view their corporation as a personal possession and do not really appreciate the concept of the corporate structure. Accordingly, record keeping in many corporations is inadequate. The resulting problem is that the withdrawal of cash or other properties from the corporation that is not properly documented is reclassified by the IRS as a “constructive dividend”.
THE PROBLEM; Typically, in a closely held corporation, whenever an owner withdraws cash or other property, the owner wants to structure the withdrawal such that the corporation receives a tax deduction. In this fashion, the withdrawal is only taxed once; i.e., to the owner on a personal income tax return; and the double taxation concept is avoided. In some instances, owners indicate that the withdrawal from the company is a loan; thus avoiding taxation on their personal income tax return as well.
If the IRS reviews the record keeping of a corporation and determines that the withdrawal of funds is really a dividend in disguise, the transaction will be reclassified as a constructive dividend. In such instances, the withdrawal is not only taxed to the individual owner, but the corporation also loses the right to obtain a tax deduction for the withdrawal. The end result is that the withdrawal is subject to double taxation.
A review of court cases involving reclassification of withdrawals of closely-held companies as constructive dividends clearly indicates that many stockholders in the United States attempt to conceal the withdrawal of funds, such that the tax bite is minimized.
The IRS naturally argues that corporate distributions, whether they be direct or indirect, provide benefits to stockholders and should be reclassified as constructive dividends. Following is a listing of some key areas that should be considered by owners of closely-held corporations as areas that are typically subject to reclassification by the IRS. The discussion of each area also provides some tax planning advice so that the probability of reclassification by the IRS is minimized.
EXCESSIVE COMPENSATION; One method of generating a tax deduction is to pay additional salaries and/or bonuses to stockholder employees. However, when such compensation is considered by the IRS to be excessive, the corporation loses a tax deduction and, therefore, reports a higher profit, which is fully subject to the corporate tax. If a salary is considered to be excessive, the IRS can disallow the entire amount of compensation until the taxpayer can prove how much salary is justified.
For example, if a corporation pays its president $300,000.00 in one year, the IRS can disallow the entire amount until the president can prove what the average salary in the industry is for the sales level of the company. If the president can only justify $100,000.00 salary, then $200,000.00 of the total amount of compensation would be reclassified as a constructive dividend.
The IRS typically applies six factors in determining whether or not a stockholder employee’s salary is excessive:
1. The employee’s qualifications for the job description,
2. The nature and extent of the employee’s work,
3. A comparison between the gross salary and the profitability of the company,
4. A comparison of the compensation rates in the industry for companies with similar sales,
5. The role and importance of the employee to the company’s overall profitability, and
6. The general salary or compensation policy of the company with respect to all employees.
It is important that not all of the profits of a company be distributed as salaries to the stockholder/employees. The typical practice of distributing all of the corporate profits in the form of salaries provides an appearance of trying to avoid the double taxation. As a result, scrutiny by the IRS will almost always result in a reclassification of the compensation, as a relationship exists between the reasonableness of the salary and the job performed.
In addition to the reasonableness concept, the Board of Directors of the company should set the compensation levels and specify the reasons for paying the compensation. The setting of the compensation should also be in line with the employee’s duties and responsibilities and be consistent with what is paid to similar employees in comparably sized companies in the industry. A compensation level that is higher than normal should be in direct proportion to the various stock ownership among all stockholders.
LOANS TO SHAREHOLDERS; In many situations, stockholders try to withdraw corporate funds and avoid all forms of taxation by classifying the withdrawal as loans. Obviously, a stockholder receiving a loan payment from a corporation does not have to report the proceeds as income, so the proceeds escape taxation completely. The problem, obviously, is that the failure to pay interest on the loan and to properly structure the withdrawal as a loan can cause the IRS to reclassify the loan as a constructive dividend, thus making the withdrawal fully taxable to the stockholder.
Reclassification of loans occurs in many closely held companies when the company cannot really afford to make the loan. Many companies are thinly capitalized and utilize the loan concept as opposed to approving a debt structure. In many situations, rather than the stockholder withdrawing funds, the stockholder will loan funds to the corporation and attempt to treat the investments as a loan; thus causing the company to have a very small capital base. Then, when the company generates cash, the stockholder withdraws the funds in payment of his loan to the company.
If such a situation exists, i.e., where the company has a very small capital base and the stockholder has loaned money to the company, the IRS will reclassify the distribution of funds to the stockholder as a constructive dividend. The key to getting around the reclassification is whether or not the stockholder and the corporation have a valid loan as opposed to strictly a payment of corporate funds. In order to strengthen the argument, there are four tax-planning tips that should be taken into consideration:
1. The company should have enough capital equity to purchase all of the key assets to operate a business. Any loans by the stockholder to the company should not be for the acquisition of basic assets in order to operate.
2. If a loan does exist between a stockholder and a company, there should be an unconditional written obligation to repay the loan at a reasonable date in the future. The entire transaction should be structured in the form of an actual note, the same as it would be with a loan from a third party.
3. The loans should be secured so that there is no question that the loan is truly a debt instrument.
4. Any loans should be in writing and should be structured the same as if they are loans between independent, outside agencies; such as the local bank and the company. Accordingly, there should be no terms or conditions to the repayment of the loan that would not be allowed between a third party and the company.
PERSONAL USE OF CORPORATE PROPERTY; If a stockholder uses corporate property for personal purposes, the IRS has the right to reclassify the fair market value of the corporate property as a constructive dividend, thus making the use of such property fully taxable on the stockholder’s tax return. Such reclassification often causes the corporation to lose a tax deduction for any expenses, such as depreciation or insurance, that are related to the property in question. While the government does not have an official stated policy in this area, readers should be aware that the courts are constantly developing principles that support the IRS.
An individual can help himself as well as the corporation in the area of personal use of company property by setting up a bona fide program for reimbursing the corporation for any personal use of company assets. There should be no distinction in the corporate records between property that is used personally by stockholders. Such a distinction is a clear indication that the company has no right owning such property. All legal documents involving company property that is used by individual stockholders should be in the name of the corporation. If any property is owned by an individual and yet listed as an asset on the company books, the IRS has every right to reclassify the transaction as a constructive dividend.
DISALLOWED EXPENSES; One of the areas that the IRS more frequently becomes involved in deals with expenses that are deducted by a closely-held corporation. Many expenses are personal to the stockholder/employee. When the IRS reviews such expenses and disallows the expenses for business purposes, the stockholder is deemed to have received a constructive dividend, which is fully taxable. This area has a double barrel effect in that the company loses the deduction that it tried to take, while at the same time the stockholder has to pay taxes on the item, which they originally tried to classify as a reimbursable business expense.
Many situations deal with expenses that the stockholder receives as a result of renting property to the corporation. The rental payment made by the company is deducted; while the income received by the stockholder is offset by depreciation deductions on a personal return. If the rental rate is too high, the IRS will disallow the expense from being deducted and the company will lose the tax benefits. At the same time, the IRS will reclassify the receipts of the rental income as constructive income; causing the stockholder to lose any depreciation deduction that would normally apply to rental property.
In some companies, the stockholder has the company purchase insurance policies on the life of the stockholder making the stockholder or family member the beneficiary. The tax law stipulates that if the stockholder is the owner of the policy and the corporation pays the premiums, the premiums paid by the corporation will be reclassified as dividends to the stockholder. Accordingly, any policies that a company has on the life of its stockholder should be fully owned by the corporation with the corporation being the beneficiary or be classified as split-dollar policies.
If the corporation wishes to loan funds to a stockholder so that the stockholder can purchase and pay the premiums on a life insurance policy, the loan category (as previously discussed) applies to such situations. The bottom line is that the stockholder should not be involved as either the owner or the beneficiary of any insurance policies where the company makes the premium payments.
It should be noted that the one exception to the insurance statements made in the previous paragraph is insurance which qualifies under a special section of the Internal Revenue Code, Section 79. As illustrated in an earlier chapter, the IRS allows a company to purchase insurance and pay premiums for coverage not to exceed $50,000.00 on the life of employees, including stockholders, wherein the employees or stockholders can identify the beneficiaries. The insurance would be classified as group term life insurance.
As I discuss here, the tax law is confusing to many stockholders of closely held businesses in the United States. Regardless of the complexity of the tax law, however, stockholders must be aware that whenever the IRS looks at a closely held corporation that distributes cash and/or property to stockholders, the question arises as to whether or not the distribution should be classified as a constructive dividend. Close adherence to the tax planning tips that are contained in this chapter is important if stockholders of closely held companies do not wish to have the IRS reclassify funds or property that they received from their corporation as dividends.