In order to be deductible, a business expense must be both necessary and ordinary. A necessary expense is an expense that’s appropriate and helpful for your business. An ordinary expense is an expense that’s accepted and common in your field of business.

The IRS may sometimes challenge your deduction claim for particular types of business expenses. When doing so, an examiner might claim that payments made by a corporation to a shareholder for personal items that are below or above fair market value constitute as “constructive dividends.” Reclassifying your business expenses as dividends has adverse tax consequences.

 

Some Dividends Don’t have Deductions

Normally, a successful corporation would pay out dividends to its shareholders based on earnings for the calendar year. The exact amount of dividends a shareholder receives is dependent on their proportionate share of the company. These particular dividends are declared by the company on a specified date and then paid out or reinvested in additional shares to the shareholder.

In other instances, a corporation could make other payments to additional shareholders, which the IRS might classify as a “constructive dividend.” This happens when owners of a closely held business use corporate funds to pay for personal expenses. But it can also happen at multibillion-dollar conglomerates, and it could involve more than just paying for personal expenses through the business.

The problem of the matter is: Owning all or part of a company does not give you the unrestricted right to record or pay for expenses in the manner in which you see fit. Please note, there are restrictions and tax rules that must be followed.

 

Tax Consequences

From an income tax perspective, dividends paid out by corporations are typically taxable to shareholders at a personal level. Qualified dividends received by a C corporation shareholder are taxable at similar favorable tax rates as long-term capital gains. Presently, the maximum tax rate for qualified dividends is 15% (or 20% if you are in the top income tax bracket).

Unfortunately, dividends can not be deducted by the corporation. So, dividends are then paid using after-tax dollars, which means they are effectively taxed twice.

Compensation and other types of payment (such as management or consulting fees) are taxable to shareholders at an ordinary income tax rate. But, these legitimate expenses are usually deductible by the company (unless they are not at an arm’s length). In turn, depending on its particular circumstance, a corporation could try to disguise dividends as compensation or another type of payment.

If the IRS treats a payment as a constructive dividend, the business’ deduction that the corporation tried to claim for a payment (ex: a compensation deduction) is disallowed, thus increasing its tax liability. The IRS may impose interest or penalties for tax underpayments. Additionally, if the company’s owners purposely evaded their tax responsibilities, they may face criminal charges.

For shareholders, a constructive dividend is taxable as ordinary income. But, unlike compensation, a dividend payment is not subject to payroll taxes. In turn, the overall tax results for shareholders will vary.

The IRS is most likely to step in if it perceives that a company is paying personal expenses for its shareholders. This was the main issue presented to the U.S. Tax Court in one case. (Luczaj & Associates v. Commissioner, T.C. Memo 2017-42)

For example, some taxpayers, a married couple residing in California, owned a C corporation. The husband held 51% of the stock, and the wife owned 49%. The wife was the company’s only employee during the particular tax years in question, and the husband worked full-time as an adult transition coordinator at a high school, teaching and supervising special needs students.

The C corporation was engaged in the business of creating home mortgages, acting as an independent contractor for California Mortgage Group (CMG). The company’s main function was to solicit clients for CMG. After the company referred clients to CMG, these individuals were offered loans to help them purchase homes.

The wife’s sole responsibility was client searching for CMG. She had a desk in CMG’s main office, where she worked two days a week, sometimes more. She stated in a trial that she worked from home the rest of the week and typically met clients in a public place or at home.

In the two tax years in question, the corporation claimed deductions for a variety of expenses, including entertainment and travel, advertising, dues and subscriptions, insurance, telephone, gifts, medical expenses, utilities and maintenance, and depreciation. A few of these expenses included repairs to the couple’s personal residence, personal entertainment, and swimming pool expenditures.

The IRS contested almost all of the reported business expenses due to lack of business purpose or lack of substantiation. It proclaimed that the payments constituted a constructive dividend to the shareholders. Lastly, the IRS imposed accuracy-related penalties for the particular tax years in question.

The Tax Court came to an agreement with the IRS. The court deemed that many of the expenses that were claimed as promotional or marketing expenses were actually payments on personal expenses that benefited the shareholders. For example, the wife claimed 100% business use of the two vehicles but didn’t follow the procedures put in place by the IRS for documenting business use. The court also agreed that payments may be treated as constructive dividends without the corporation making a formal declaration of dividends.

 

More Than Personal Expenses

Constructive dividends can come in many ways. The most common instance is when a shareholder mistakenly tries to claim personal expenses — such as a vehicle, housing, or medical costs as a business expense. These are the other types of related-party transactions the IRS may classify as constructive dividends:

  • A large payment for corporate use of a shareholder’s personal property, such as rental payments for the company’s warehouse or office space,
  • A lease or purchase by a shareholder of company property at a price that’s significantly lower than fair market value,
  • A lease or purchase by the company of a shareholder’s property at a price that is greater than fair market value,
  • Excessive compensation paid to family members or shareholders,
  • Use of company-owned vehicles or other company property by family members or shareholders without paying the fair market value, and
  • A corporate loan (in some cases at a below-market interest rate) made to a shareholder to fund their personal items, where there’s no reasonable expectation of repayment.

Businesses should always keep contemporaneous and detailed records to support deductions and other tax positions, especially when it comes to transactions with any related parties.

 

The IRS typically won’t, for example, treat a payment as a constructive dividend if the company can display that it lacked sufficient earnings to pay for dividends or that a payment was, in fact, used to pay for necessary or ordinary business expenses, rather than personal expenses.

In some cases, expenses may fall into a “gray area” where you are unsure of the appropriate tax treatment. If you have any questions about your situation, ask us for help.

Hoberman & Lesser’s NYC accountants serve a broad cross section of businesses, ranging from publicly held companies, to private sector businesses, to individual entrepreneurs throughout New York, New Jersey, and Connecticut, and across the United States. To schedule a complimentary and confidential consultation with a member of our team, please contact us.