Corporations & Shareholders
The Tax Court held that the sole shareholder of a corporation did not receive a constructive dividend when the corporation provided construction services to the shareholder at cost.
Background
TWC is a construction company that specializes in multifamily housing projects. Terry Welle is TWC’s president and sole shareholder.
Welle owned lakefront property in Detroit Lakes, Minn., on which he decided to build a second home (the lakefront home). In 2004, Welle began construction of the lakefront home. To keep track of material and other construction costs, he caused TWC to open a “cost plus” job account on its books. Welle, however, contacted all of the subcontractors and building supply vendors that built or supplied materials for the lakefront home and acted as his own general contractor during its construction.
During 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 Welle did not pay to TWC, an amount equal to the customary profit margin that TWC used to calculate the contract price that it charged its unrelated clients (forgone profit).
The IRS determined that Welle received a constructive dividend of $48,275 from TWC in 2006, equal to the forgone profit on the construction services it provided to him. Welle challenged the IRS’s determination in Tax Court.
Constructive Dividends
Under Sec. 61(a)(7), a taxpayer includes dividends in gross income. Sec. 316(a) defines a dividend as any distribution of property that a corporation makes to its shareholders out of its earnings and profits accumulated after Feb. 28, 1913, or out of its earnings and profits for the tax year. Under Sec. 317(a), property includes money, securities, and any other property except stock in the distributing corporation. Under some circumstances, the provision of services by a corporation to its shareholders constitutes property within the meaning of Sec. 317(a).
A constructive dividend occurs when a corporation confers an economic benefit on a shareholder without the expectation of repayment. Generally, the amount of a constructive dividend is measured by the fair market value (FMV) of the benefit conferred.
The Tax Court’s Decision
The Tax Court held that Welle did not receive a constructive dividend when TWC provided him services at cost and he timely paid TWC for the services. The court found that TWC’s provision of services at cost to Welle did not result in a diversion of TWC assets or a distribution of its earnings and profits.
The IRS argued that under the Tax Court’s decision in Magnon, 73 T.C. 980 (1980), a shareholder receives a constructive dividend equal to the cost of the services provided to the shareholder by a corporation plus the corporation’s customary profit margin. Welle contended that he did not receive a constructive dividend because a shareholder does not receive a constructive dividend when a corporation provides services to the shareholder at cost.
The Tax Court admitted that in a number of cases, including Magnon, it had held that there was a constructive dividend where a corporation provided construction services to a shareholder and the shareholder did not pay for the services. However, the court stated it had not held in any of these cases that the constructive dividends should include forgone profits.
Citing a wide variety of its own and appellate precedent, the Tax Court found that, for a constructive dividend to occur, there must be a distribution or diversion of corporate property to or for the benefit of the shareholder, that reduced the corporation’s earnings and profits. The court explained that it had held in the past that a constructive dividend occurs where there is a bargain sale of property by a corporation to a shareholder, or where a shareholder uses corporate property and does not pay full value for the use of the property. However, the court pointed out that it had also found that an incidental or insignificant use of corporate property might not be considered a constructive dividend.
Looking at the facts in the present case, the Tax Court noted that TWC had an existing corporate workforce and infrastructure for its business purposes, and Welle’s use of TWC was incidental to those business purposes. Because Welle fully reimbursed the corporation for all costs, including overhead, TWC did not divert actual value otherwise available to it by failing to apply its customary profit margin in determining how much Welle had to pay for its services. Thus, the court concluded that the provision of services by TWC to Welle was not a vehicle for the distribution of earnings and profits to Welle and that Welle had not received a constructive dividend.
Reflections
As the Tax Court mentions early in its opinion, the usual measure of a constructive dividend is the FMV of the benefit conferred. Under this measure, the discussion in this case should have been about the FMV of the services TWC provided to Welle, not about whether forgone profits were a constructive dividend to Welle. The IRS argued that the value of the services provided to Welle should be the FMV of the services to an unrelated customer of TWC, i.e., the cost to the customer, which would be TWC’s costs for the services plus the company’s profit markup. Thus, the problem to the IRS was not that forgone profits were not included in the constructive dividend, but that the value of the constructive dividend for the services was improperly determined. However, the Tax Court chose to focus on whether there had been a distribution or diversion of corporate property that benefited Welle and reduced the corporation’s earnings and profits. The court decided that the mere use of the corporation as a conduit did not amount to a distribution that reduced earnings and profits.
It is somewhat surprising, given the results in the long line of cases that the IRS cited, that the Tax Court did not find a constructive dividend here. Perhaps this case signals a new, less-stringent standard in these situations, but given the IRS’s litigating position and the prior case history, taxpayers should probably not count on it.
Welle, 140 T.C. No. 19 (2013)
