MLR

Tax Court: IRS wrong about constructive dividend

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In a recent case, the Tax Court has held that the sole owner of a corporation did not receive a constructive dividend when the corporation provided construction-related services to him without charging its standard profit margin.

Terry Welle was the president and sole shareholder of Terry Welle Construction, Inc. (TWC). Welle and his wife owned property on which they planned to build a second home. When construction began, to keep track of material and other construction costs, Welle caused TWC to open a “cost plus” job account on its books.

However, the Welles 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, and its framing crew framed the home.

The couple repaid TWC for all amounts paid to the subcontractors and also reimbursed TWC for its labor and overhead costs. However, TWC did not charge an amount equal to the customary profit margin that it charged unrelated clients.

The IRS calculated TWC’s forgone profit as $48,275 and charged that amount to Welle as a constructive dividend.

The Tax Court disagreed with the IRS. The court found that Welle did not receive a constructive dividend equal to TWC’s forgone profit because the transactions did not result in the distribution of current or accumulated earnings and profits (Terry J. and Chrissie J. Welle, v. Commissioner, 140 TC No. 19, June 27, 2013).

The IRS cited the general rule that constructive dividends are ordinarily measured by the fair market value of the benefit conferred. However, the court stated that the IRS’s argument skipped the important step in constructive dividend analysis of actually finding a distribution that reduces that corporation’s current or accumulated earnings and profits.

TWC’s failure to charge its customary profit margin was not a diversion of actual value. And the forgone profit was not a vehicle for distributing TWC’s current or accumulated profits.