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Focus on constructive dividends

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in Small Business Tax,Small Business Tax Deduction Strategies

When a small business corporation is successful, it may pay out dividends to its shareholders, including the owner running the company. Although dividends paid by C corporations are taxable to the extent of the company’s earnings and profits (a tax term of art), they generally are eligible for preferential federal income tax treatment, just like long-term capital gains. Currently, the top federal rate on qualified dividends received by an individual taxpayer is 15%, or 20% if you’re in the top rate bracket.

Conversely, compensation is taxable to recipients at ordinary income rates, but these amounts are deductible by the company. Dividends are not deductible. For this reason, C corps usually prefer for payouts to shareholder-employees to be treated as compensation rather than dividends.

New decision: A husband and wife, residing in California, were the sole shareholders of a C corp (51% for the husband, 49% for the wife) involved in helping to originate home mortgages. The company acted as an independent contractor for California Mortgage Group (CMG), soliciting clients. After selected clients were referred to CMG, they were offered mortgages.

During the tax years in question, the wife was the only employee of the corporation, while the husband worked full time at a high school, supervising and teaching special needs students. The wife’s sole responsibility for the corporation was client recruitment for CMG. She kept a desk in CMG’s main office and worked there at least two days a week. She also testified at trial that she worked from home the rest of each week and usually met clients at home or a public place.

For 2012 and 2013, the corporation deducted numerous expenses, including travel and entertainment expenses, insurance, telephone expenses, advertising and gifts, medical expenses, utilities and maintenance, dues and subscriptions and depreciation. Some of these expenses were used for repairs to the couple’s personal residences, to buy swimming pools and for personal entertainment.

The IRS challenged most of the reported expenses due to lack of substantiation or a valid business purpose. It said the payments constituted disguised dividends.

Tax result: The Tax Court sided with the IRS. Many of the corporation’s expenses that were labeled as marketing and promotional payments were actually used for personal purposes and directly benefitted the shareholders. Thus, the payments were nondeductible disguised dividends that benefitted the shareholders rather than deductible expenditures that benefitted the corporation. (Luczaj & Associates, TC Memo 2017-42, 3/8/17)

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