In income
tax land if …
- You own a corporation, and
- The corporation has property, and
- The corporation gives you the property, and
- You do not pay anything for it, …
… then the
IRS will consider you as receiving distribution from the corporation. The
classic distribution is a dividend, taxable to you and not deductible by the
corporation.
Perhaps the
corporation distributes property and you pay some – but not all – of what the
property is worth. A classic example is a corporation distributing a car to the
owner’s child for a nominal amount. There is a distribution taxable as a
dividend, and the dividend amount would be the value of the car over any amount
paid. It would not be the full value of the car in this case.
The tax code
views a C corporation (we are not discussing S corporations in this blog) as an
entity distinct from its shareholders. That is how Congress justifies taxing
the corporation on its income and then taxing the shareholders again when they
receive dividends sourced to that income. Since there are two entities, there
cannot be double taxation.
But there
is, of course, and it takes sleight of hand to maintain the illusion. Many if
not most tax advisors – including me – have steered most of our closely-held
business clients away from C corporations and to passthrough entities: perhaps S
corporations, partnerships or limited liability companies. Sometimes the weight
of the double taxation is unacceptable.
The Tax
Court decided the Welle case just last month. Sure enough, it involved a
C corporation and a dividend. More specifically, it involved what the IRS saw
as a new species of dividend.
Let’s walk
this through.
There is a
construction company (TWC) in North Dakota. It is wholly-owned by Terry Welle (Welle).
TWC primarily does multifamily construction, and its historical profit has been
around 6 or 7 percent.
Welle
decides he is going to build a lakefront property in Minnesota.
NOTE: Excuse me here,
but how about going south with that lakefront property? Is Minnesota that much
warmer than North Dakota?
Back to our
story. Welle has a company that builds things. He used TWC’s accounting system
to track his costs, and he also used its workers to frame the Minnesota house.
The company did a calculation of the costs, including overhead, and Welle
reimbursed the company to the penny.
The IRS
comes in and finds fault. The IRS wants to know where the company’s profit is. Welle
reimbursed the company at cost, including overhead, meaning that they made no profit
from him. The IRS says that there should be and must be a profit. They calculate
that profit to be around $48,000. Since he did not reimburse the company its erstwhile
profit, the IRS assessed him with a $48,000 dividend. It wants $10,620 in
income tax.
Oh, the IRS
also wants an accuracy-related penalty of over $2,100.
Wow! The IRS
is assessing a penalty on a tax theory it has never trotted out before? That
is brazen.
This case
goes to Court. The IRS argues that a corporate distribution must be measured at
fair market value. Fair market value is the amount that would fully reimburse a
company for its direct and indirect costs, as well as render a profit. One cannot disagree with that summary of microeconomics
101.
The Court tells the IRS to back up.
It wants the IRS to point to the distribution event before its gets to any
issue of measuring and valuing. The Court reasons that a distribution requires
assets to be “diverted to or for the benefit of a shareholder.” It must be a
vehicle to “distribute available earnings and profits without the expectation of
repayment.”
Show us the distribution, says the
Court.
The IRS offers and the Court reviews
a number of cases, but it cannot see how corporate assets were expended. Welle received
services, but then again he paid for them. At most, he used the company as a
conduit in maintaining records and paying subcontractors. The company was no
better or worse for transacting with him. The event was a nullity.
In frustration, the Court writes:
Respondent does not explain how a corporation’s decision not
to make a profit on services provided to a shareholder who fully reimburses the
corporation for the cost of services (including overhead) constitutes a
distribution of property that reduced the corporation’s earnings and profits
under Section 316(a), nor does the respondent cite any cases supporting such a
position.”
The Court
decided for Welle and against the IRS.
My thoughts?
This is one of the lamest tax theories I have come across, and I have near 30
years in the profession. What was the IRS up to? Are there that many North
Dakota contractors building lakefront homes that the IRS decided to go where no
serious tax practitioner had gone before?
Let us segue
for a moment.
Do you
remember Nina Olsen? She is the Taxpayer Advocate, and we have spoken of her
before. The Advocate is supposed to sit outside the IRS and function as a
watchdog. It is great idea, but I must admit the IRS for the last half-decade
or so has seemed less than interested in the Advocate. Nonetheless, she is
promoting an idea she calls the IRS “apology payment.” The idea is to pay a taxpayer something when
the behavior of the IRS causes excessive delay or expense or an undue burden
resulting in significant hardship to the taxpayer.
This idea is
being refloated in response to the 501(c)(4) scandal. Ms Olson argues that apology
payment would:
Serve as a symbolic gesture that the government recognizes
its mistake and the taxpayer’s burden. These payments might enhance the public perception
of the IRS and the tax system as just and fair.”
Great idea,
although a $1,000 flat sum may be insufficient in some cases.
I would like to see Welle receive his apology payment for the IRS wasting his time.
