Under some circumstances, the provision of services by a corporation to its shareholders is “property” within the meaning of Code Section 317(a), which can result in the IRS finding that there was a constructive dividend to the shareholder.

The Tax Court has stated that the crucial concept in a finding that there is a constructive dividend is that the corporation has conferred a benefit on the shareholder in order to distribute available earnings and profits without expectation of repayment. The IRS typically finds a constructive dividend in the case of an owner of a closely held corporation, as it did in the case of Terry Welle.

Welle is the president and sole shareholder of TWC, a construction company specializing in multifamily housing projects. In 2004 he and his wife began construction of a home on lakefront property they owned in Minnesota. Welle and his wife personally contacted all of the subcontractors and building supply vendors that built or supplied materials for the lakefront home and acted as their own general contractors during its construction.

Welle caused TWC to open a “cost plus” job account on its books. During the construction TWC paid the subcontractors and vendors directly, and its framing crew framed the lakefront home. Welle repaid TWC for all amounts paid to the subcontractors and also reimbursed TWC for its labor and overhead costs. TWC, however, did not charge Welle, and he did not pay TWC an amount equal to the customary profit margin that TWC used to calculate the contract price that it charged its unrelated clients.

The IRS determined that Welle received a dividend of $48,275 from TWC, equal to the foregone profit, and determined a deficiency of $10,620 in Welle’s 2006 federal income tax.

The Tax Court disagreed. It cited previous opinions indicating that a finding that a shareholder received a constructive dividend from a corporation is only appropriate where corporate assets are diverted to or for the benefit of a shareholder, in order to distribute available earnings and profits without expectation of repayment.

“We cannot see how TWC’s provision of services to Mr. Welle at cost resulted in the diversion of corporate assets or the distribution of its earnings and profits,” the court stated.

TWC maintained its corporate infrastructure and workforce for business purposes, the court noted. “Mr. Welle’s use of TWC during the construction of petitioners’ [the Welles] lakefront home was at most incidental to those purposes,” the court said.

“The most that can be said about Mr. Welle’s use of TWC is that he used the corporation as a conduit in paying subcontractors and vendors and that he obtained some limited services from corporate employees,” the court added. “Mr. Welle fully reimbursed the corporation for all costs, including overhead, associated with those services, and TWC did not divert actual value otherwise available to it by failing to apply its customary profit margin in determining the amount Mr. Welle had to reimburse the corporation.”

Therefore the court held that Welle did not receive a constructive dividend equal to TWC’s forgone profit.

The lesson here is that Welle did everything “by the book.” He repaid his corporation for all amounts paid to the subcontractors and also reimbursed the corporation for its labor and overhead costs. And he kept accurate records to show that he had done so. The tendency to commingle funds, keep shoddy or nonexistent records, or do anything that blurs the distinction between a corporation and its owners makes cases such as this much more difficult to litigate.

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