That’s the rule for determining whether there has been a constructive dividend from a C Corp to its shareholder, as stated by Judge Marvel in Terry J. Welle and Chrisse J. Welle, 140 T. C. 19, filed 6/27/13.
TJ and Chrisse built their dream house on the Detroit Lakes in Minnesota. They personally GC’d the job, but used TJ’s C Corp, TWC, a for-profit homebuilder, to funnel payments to subs and keep track of materials and labor on the job. TJ oversaw the job, picked the subs, and ran the show. He and Chrisse paid TWC for the actual cost of the TWC services they used, including overhead, but did not pay the customary 6% to 7% mark-up TJ applied to TWC’s off-the-street customers.
IRS claimed the 6% was a dividend to TJ, the sole stockholder of TWC, as it was a forgone profit.
No, says Judge Marvel. While provision of services by a C Corp to its shareholder may be a constructive dividend under Section 317(a), “‘(T)he 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.’” 140 T. C. 19, at p. 5 (Citations omitted).
In other words, was whatever the shareholder got the equivalent of corporate earnings (not a return of capital or a loan repayment)? Is the deal a way to funnel corporate profits to the shareholder tax-free?
“The Code does not define the term ‘earnings and profits’. See sec. 316(a); Henry C. Beck Co. v. Commissioner, 52 T.C. 1, 6 (1969), aff’d per curiam, 433F.2d 309 (5th Cir. 1970). As we have previously observed, the calculation of earnings and profits is not easy or obvious. See, e.g., Anderson v. Commissioner,67 T.C. 522, 527 (1976), aff’d, 583 F.2d 953 (7th Cir. 1978); Juha v. Commissioner, T.C. Memo. 2012-68, 103 T.C.M. (CCH) 1338, 1341 (2012). For example, although section 1.312-6(a), Income Tax Regs., provides that a corporation must compute earnings and profits using the same method of accounting employed in computing taxable income, earnings and profits are not equivalent to taxable income.” 140 T. C. Memo. 19, at p. 7.
In other words, the question is what has the C Corp earned, whether taxable or not, being given to the shareholder, as opposed to what is the shareholder’s capital investment being returned.
There are cases that say when C Corp’s build houses for their shareholders without being repaid in full, there is a constructive dividend. But nowhere has Tax Court held that forgone profit has any place in the calculation.
Judge Marvel: “Respondent [IRS] 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 the services (including overhead) constitutes a distribution of property that reduces the corporation’s earnings and profits under section 316(a), nor does respondent cite any cases supporting such a position. Respondent argues that his position follows from the general rule that constructive dividends are ordinarily measured by the fair market value of the benefit conferred. It appears to us, however, that respondent’s argument skips an important analytical step required by section 316(a)–we must first find that there has been a distribution of property to the shareholder that reduces the corporation’s current or accumulated earnings and profits. 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’….” 140 T. C. 19, at p. 9. (Citations omitted).
The C Corp’s net worth must be impaired in some way. TJ paid in full for TWC’s services plus overhead. So, says Judge Marvel, “(W)e 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.” 140 T. C. 19, at p. 10.
TJ’s use of corporate assets was at best incidental; TWC got paid in full therefor, so TJ did not grow greater and TWC did not grow less.