Payments to Related Company for Product Development Were Constructive Dividends to Common Owner.

(Parker Tax Publishing MARCH 2016)

The Tax Court determined that payments one company paid to a related company to develop a "hand washing monitoring system" were not deductible and were instead constructive dividends to the company's common owner. Deductions were allowed for the portion of the payments relating to expenses for information technology services. Key Carpets, Inc. v. Comm'r, T.C. Memo. 2016-30.

Background

Raymond Johnson and his wife incorporated Key Carpets, Inc. in 1994 primarily to sell carpets to realtors. Key Carpets was a successful business with over $2 million in gross receipts each year. In 1995, Johnson incorporated another company, Clean Hands, and was its sole shareholder. Johnson originally incorporated Clean Hands because he intended to reserve the name for a hand washing monitoring system that Key Carpets had begun to develop. The initial hand washing monitoring system was intended to work by dispensing soap when a person activated the system using a radio frequency identification (RFID) badge. Johnson intended to sell the RFID hand washing monitoring system (RFID system) to food service businesses so that employers could verify an employee's compliance with sanitation requirements.

In 2006 Clean Hands hired a computer technician to assist with the development of the RFID system. Johnson decided to hire the technician as a Clean Hands employee rather than as a Key Carpets employee because an employee was needed to work on the RFID system full time. After hiring the technician Johnson decided that the RFID system was no longer feasible, and the technician began working for Clean Hands to develop a new hand washing monitoring system that was voice activated (voice-activated system).

In addition to assisting with the development of the voice-activated system, the technician provided information technology (IT) services to Key Carpets. Key Carpets had a preexisting office location that included office space for Clean Hands in the back of that building, enabling the technician to easily work for both companies. The technician maintained a time log of his work during 2007, including his time spent developing the voice-activated system and providing IT services to Key Carpets, but did not maintain a log for 2008.

Key Carpets paid Clean Hands, ostensibly for developing the voice-activated system and providing Key Carpets with IT services. For 2007 and 2008 Key Carpets claimed deductions for "computer service and consulting" with respect to the amounts paid to Clean Hands. During an audit of Key Carpets, the IRS determined that only $3,928 of the claimed "computer service and consulting" expenses were allowable as a deduction, representing the portion of the expenses allocable to the technician's salary for IT services. The IRS did not allow Key Carpets to deduct for 2007 the portion of the technician's salary expense that the auditor determined was allocable to developing the hand washing monitoring system. For 2008, The IRS disallowed the entire deduction because the computer technician did not maintain a time log.

In 2012, the IRS issued a notice of deficiency for 2007 and 2008 to Key Carpets that disallowed the claimed deductions for "computer service and consulting," and a separate notice of deficiency to the Johnsons that determined that the payments from Key Carpets to Clean Hands were constructive distributions from Key Carpets to the couple.

Analysis

The Tax Court noted that although Key Carpets had an ownership interest in the initial RFID badge-activated hand washing system, the company had no ownership interest in the new voice-activated system that the technician developed as a Clean Hands employee, and that it received no benefits from the payments to Clean Hands for the development of the system. Therefore, the court said, the expenses were not ordinary and necessary, and Key Carpets could not deduct the amounts paid to Clean Hands for the development of the voice-activated system.

The court held that Key Carpets was, however, entitled to deduct the portion of the payments to Clean Hands for wage expenses allocable to the technician's providing IT services to Key Carpets. The court found that on the basis of the technician's credible testimony that he spent at least 15 percent of his time providing IT services to Key Carpets. Although for 2008 the technician did not maintain a time log of his work, the court determined the record supported finding that the technician provided similar IT services to Key Carpets in 2008 as he did in 2007. The court thus determined that Key Carpets was entitled to deduct 15 percent of the computer technician's salary expense.

With regard to the issue of constructive dividends, the court stated that whether a payment is a constructive dividend depends on whether it was primarily for the benefit of the shareholder. The court noted that it had previously held, in Gilbert v. Comm'r, 74 T.C. 60 (1980), that a transfer between related corporations can result in a constructive dividend to their common shareholder when the shareholder receives a personal benefit. Additionally, the court stated, where a shareholder is required to make capital contributions and causes a related company to pay the contributions, the payments are for the personal benefit of the common shareholder (Stinnett's Pontiac Serv., Inc. v. Comm'r, T.C. Memo. 1982-314).

The court observed that Johnson needed funds to support Clean Hands. Instead of making capital contributions directly to Clean Hands, the court found he caused Key Carpets to transfer funds to the business. The payments, the court said, therefore provided a personal benefit to Johnson and Clean Hands and were constructive dividends.

For a discussion of constructive dividends, see Parker Tax ¶44,120. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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