Small business owners typically regard their company as a personal possession and do not really appreciate the concept of company structure. Therefore, many companies record keeping is insufficient. The resulting problem is that withdrawal of cash or other property from the company that is not properly documented is classified by the IRS as a “constructive dividend.”
PROBLEM; In a closely owned company, when an owner withdraws cash or other property, the owner typically wants to structure the deduction so that the company receives a tax deduction. In this way, the withdrawal is taxed only once; i.e. to the owner with a personal tax return; and the concept of double taxation is avoided. In some cases, owners state that the withdrawal from the business is a loan; thus avoiding taxation of their personal income tax return.
If the IRS reviews registration of a corporation and determines that withdrawal of funds is really a proceeds in the form of disguises, the transaction is classified as a constructive dividend. In such cases, the deduction is not only taxed for the individual owner, but the company 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 lawsuits involving the reclassification of the withdrawal of closely affiliated companies as constructive dividends clearly indicates that many shareholders in the United States are trying to hide the withdrawal of funds so as to minimize the tax bite.
The IRS, of course, argues that corporate distributions, whether direct or indirect, provide benefits to shareholders and should be reclassified as constructive dividends. The following is a list of some key areas that should be considered by owners of closely-owned businesses as areas typically subject to reclassification by the IRS. The discussion of each area also provides some tax advice advice so that the likelihood of reclassification by the IRS is minimized.
EXCELLENT compensation; One way to generate a tax deduction is to pay extra salaries and / or bonuses to shareholder employees. However, when such compensation by the IRS is considered excessive, the company loses a tax deduction and therefore reports a higher profit, which is fully subject to corporation tax. If a salary is deemed to be excessive, the IRS may dismiss the entire amount of damages until the taxpayer can prove how much the salary is justified.
For example, if a corporation pays its president $ 300,000.00 in a year, the IRS may reject the entire amount until the president can prove what the average salary in the industry is for the sales level of the business. If the president can justify $ 100,000.00 salary, $ 200,000.00 of the total compensation amount would be classified as a constructive dividend.
The IRS typically uses six factors to determine whether a shareholder employee’s pay 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 gross pay and the company’s profitability
4. A comparison of the compensation rates in the industry for companies with similar sales,
5. The role and importance of employees in the overall profitability of the company and
6. The company’s general pay or compensation policy towards all employees.
It is important that not all of the company’s profits are distributed as salary to the shareholder / employees. The typical practice of distributing all business profits in the form of wages gives an appearance that attempts to avoid double taxation. As a result, checking the IRS will almost always result in a reclassification of compensation, as there is a relationship between the reasonableness of the salary and the job performed.
In addition to the concept of fairness, the company’s board of directors should set the compensation levels and state the reasons for paying the compensation. The setting of compensation must also be in line with the employee’s duties and responsibilities and be consistent with what is paid to similar employees in comparable large companies in the industry. A higher than normal level of compensation must be in direct proportion to the various shareholdings among all shareholders.
LOANS TO SHAREHOLDERS; In many situations, shareholders try to withdraw corporate funds and avoid all forms of taxation by classifying the withdrawal as a loan. Of course, a shareholder who receives a loan payment from a company does not need to report the proceeds as income, so the proceeds avoid taxation completely. The problem, of course, is that failure to pay interest on the loan and properly structuring the withdrawal as a loan can cause the IRS to classify the loan as a constructive dividend and thus make the withdrawal fully taxable to the shareholder.
Loan reclassification occurs in many closely owned companies when the company cannot afford the loan. Many companies are thinly capitalized and use the loan concept as opposed to approving a debt structure. In many situations, rather than the shareholder withdrawing funds, the shareholder will lend funds to the company and try to treat the investment as a loan; This gives the company a very small capital base. When the company then generates cash, the shareholder withdraws the money to pay off his loan to the company.
If such a situation exists, viz. where the company has a very small capital base and the shareholder has lent money to the company, the IRS classifies the redistribution of funds to the shareholder as a constructive dividend. The key to getting around the reclassification is whether the shareholder and company have a valid loan as opposed to strictly a payment of corporate assets. To strengthen the argument, there are four tax planning tips to consider:
1. The company must have sufficient capital to buy all the major assets to run a business. Any loan from the shareholder to the company should not be for the acquisition of basic assets to function.
2. If a loan exists between a shareholder and a company, there must be an unconditional written obligation to repay the loan at a reasonable time in the future. The entire transaction must be structured in the form of an actual note, the same as with a third party loan.
3. The loans must be secured so that there is no doubt that the loan is really a debt instrument.
4. Any loans must be in writing and be structured as if they were loans between independent, external agencies; such as the local bank and the company. Accordingly, there should be no terms or conditions for repayment of the loan that would not be allowed between a third party and the company.
PERSONAL USE OF CORPORATE PROPERTY; If a shareholder uses corporate property for personal purposes, the IRS has the right to classify the real market value of the commercial property as a constructive dividend, making the use of such property fully taxable on the shareholder’s tax return. Such a reclassification often causes the business to lose a tax deduction for any expenses, such as depreciation or insurance related to that property. While the government does not have an official declared policy in this area, readers should be aware that the courts are constantly developing principles that support the IRS.
A person can help themselves as well as the company in the personal use of corporate property by creating a bona fide program to reimburse the company for any personal use of the company’s assets. No distinction should be made in the business register between property used personally by shareholders. Such a distinction is a clear indication that the company does not have the right to own such property. All legal documents involving corporate property used by individual shareholders must be in the name of the company. If a property is owned by an individual and yet listed as an asset in the corporate books, the IRS has every right to classify the transaction as a constructive dividend.
EXPENDITURE EXPENDITURE; One of the areas where the IRS is more often involved in agreements with expenses that are deducted by a closely owned company. Many expenses are personal for the shareholder / employee. When the IRS reviews such expenses and rejects expenses for business purposes, the shareholder is considered to have received a constructive dividend that is fully taxable. This area has a double barrel effect, as the company loses the deduction it tried to take, while at the same time the shareholder has to pay tax on the product, which they initially tried to classify as a reimbursable business expense.
Many situations deal with expenses that the shareholder receives as a result of renting property to the company. The company’s rent payment is deducted; while the income received by the shareholder is offset by depreciation on personal interest. If the rental price is too high, the IRS does not reject the cost of being deducted and the company loses the tax benefits. At the same time, the IRS classifies the rental income tax as constructive income; causing the shareholder to lose any depreciation deduction that would normally apply to rental housing.
In some companies, the shareholder has the company’s purchase of insurance policies over the shareholder, making the shareholder or family member the beneficiary. The Tax Act provides that if the shareholder is the policy owner and the company pays the premiums, the premiums paid by the company will be classified as dividend to the shareholder. Accordingly, any policy that a company has during its shareholders’ lifetime should be wholly owned by the company where the company is the beneficiary or classified as a split-dollar policy.
If the company wishes to lend funds to a shareholder so that the shareholder can buy and pay the premiums on a life insurance policy, the loan category (as previously mentioned) applies in such situations. The main points are that the shareholder must neither be involved as the owner nor the recipient of insurance where the company makes premium payments.
It should be noted that the only exception to the insurance statements made in the previous section is insurance that qualifies under a special section of the Internal Revenue Code, section 79. As illustrated in a previous chapter, the IRS allows a corporation to to purchase insurance and pay premiums for coverage that may not exceed $ 50,000.00 for employees, including stockholders where employees or stockholders can identify the beneficiaries. The insurance will be classified as group life insurance.
As I discuss here, the tax law is confusing to many shareholders in closely owned business in the United States. However, regardless of the complexity of the tax law, shareholders should be aware that every time the IRS looks at a closely owned company that distributes cash and / or stock to shareholders, the question arises as to whether the distribution should be classified as a constructive dividend. Close compliance with tax planning tips contained in this chapter is important if shareholders in closely owned corporations do not want the IRS to reclassify funds or property that they received from their corporation as dividends.