IRS Tries to Assess a Constructive Dividend on the Sole Shareholder of a Construction Company in a Unique Way. (Parker's Federal Tax Bulletin: July 5, 2013)

The IRS recently used a unique approach to assess a constructive dividend on the sole shareholder of a construction company. In Welle v. Comm'r, 140 T.C. No. 19 (6/27/13), the IRS argued that the corporation's decision not to make a profit on services provided to the shareholder, who fully reimbursed the corporation for the cost of the services (including overhead), resulted in a dividend to the shareholder in the amount of the corporation's foregone profit. The Tax Court rejected this argument, saying that the IRS did not prove there was a distribution of property and the court could not see how the corporation's provision of services to the shareholder at cost resulted in the diversion of corporate assets or the distribution of its earnings and profits.

Facts

Terry Welle was the president and sole shareholder of TWC, a construction company specializing in multifamily housing projects. For most jobs that closed during 2006, TWC had profit margins of 6 to 7 percent.

Terry and his wife owned lakefront property in Detroit Lakes, Minnesota, on which they planned to build a second home (lakefront home). In 2004, they began construction of the lakefront home. To keep track of material and other construction costs, Terry caused TWC to open a cost plus job account on its books. The Welles, however, personally contacted all of the subcontractors and building supply vendors that built or supplied materials for the lakefront home and acted as their own general contractors during its construction.

During the construction, TWC paid the subcontractors and vendors directly, and its framing crew framed the lakefront home. The Welles repaid TWC for all amounts paid to the subcontractors and also reimbursed TWC for its labor and overhead costs. TWC, however, did not charge the Welles, and the couple 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 (i.e., forgone profit).

The IRS audited Terry and determined that he received a constructive dividend from TWC in 2006 of approximately $48,000. According to the IRS, this was the amount equal to TWC's foregone profit.

Taxpayer's Argument

Terry argued 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. Terry also contended that the IRS's determination of the measure of any constructive dividend that Terry may have received was erroneous because the services TWC provided to Terry were not comparable to the services it provided to its unrelated clients.

IRS's Argument

Before the Tax Court, the IRS cited Magnon v. Comm'r, 73 T.C. 980 (1980), in arguing that a shareholder receives a constructive dividend equal to the cost of the services provided to the shareholder by a wholly owned corporation plus the corporation's customary profit margin. In Magnon, the Tax Court held that the amount of the costs and overhead for electrical services provided by a corporation to its sole shareholders without expectation of repayment was a constructive dividend.

Tax Court's Analysis

The Tax Court rejected the IRS's argument and held that Terry did not receive a constructive dividend. With respect to the IRS's reliance on the Magnon case, the Tax Court noted that, in that decision, it did not hold that the constructive dividend the shareholder received included an amount corresponding to the corporation's forgone profit. Similarly, the court cited other decisions where it held that amounts expended by corporations in constructing homes for their shareholders constituted constructive dividends, but noted that it had never held that the constructive dividends in those cases included an amount corresponding to the corporations' forgone profit.

The Tax Court said it could not see how TWC's providing of services to Terry at cost resulted in the diversion of corporate assets or the distribution of its earnings and profits. Moreover, the court did not think that TWC's providing of services to Terry at cost was, in purpose or effect, a distribution of corporate earnings and profits a requirement necessary to find a dividend distribution.

The court also noted that the IRS could 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 Code Sec. 316(a), nor could the IRS cite any cases supporting such a position. The IRS's argument that its position followed from the general rule that constructive dividends are ordinarily measured by the fair market value of the benefit conferred, skipped an important analytical step, the court said. And that step was an initial finding that there had been a distribution of property to the shareholder that reduced the corporation's current or accumulated earnings. Absent that, there was no constructive dividend.

For a discussion of agricultural program payments, see Parker Tax ¶161,530.

Staff Editor Parker Tax Publishing

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