Closely Held C Corporations, Constructive Dividends, and More

August 12, 2019

Choice of Entity

The owners of a closely held business are generally free to select the form of business entity through which they will operate their business. In most cases, hopefully, the decision to operate as a sole proprietorship,[i] a partnership, an S corporation, or a C corporation will have been preceded by discussions between the owner(s) and their tax adviser during which they considered, among other things,[ii] protection from personal liability for the debts of the business, the economic arrangement among the owners,[iii] and the income tax and employment tax consequences of operating through one form of business entity versus another, including the withdrawal of value from the business.[iv]

Once the owners have sifted through these and other factors, and have decided upon a particular form of entity, it is imperative that they respect the entity as a separate person, and that they not treat it as an extension of themselves.[v] Only in this way can they be certain of the “limited liability” shield afforded by the entity; if they regularly disregard the entity, so may a creditor of the business.[vi]

In addition, by transacting with the entity at arm’s length – as one would do with any unrelated person – the owners may avoid certain unpleasant tax consequences, including “constructive dividends,” which are likely to become more common as a result of the 2017 tax legislation.[vii]

The Revival of Close “C’s”

Following the Act’s substantial reduction in the federal corporate income tax rate,[viii] the owners of many closely held businesses – who would otherwise have probably chosen a pass-through entity in which to “house” their business – have expressed an interest in the use of C corporations.

Some of these owners may choose to form such a corporation to begin a new business, or in connection with the incorporation of an existing sole proprietorship or partnership.

Others may decide to “check-the-box” to treat a sole proprietorship or partnership as an association taxable as a corporation.[ix]

Those owners who are shareholders of an S corporation may decide to revoke the corporation’s S election, or to cause the corporation to cease being a “small business corporation.”[x]

In any case, these owners will have to be reminded that the profits of a C corporation are subject to income tax at two levels: once when included in the income of the corporation, and again when distributed by the corporation to its shareholders.

With respect to this second level of tax, the owners of a closely held C corporation will have to be mindful of the separate legal status of the corporation, lest they transact with the corporation in such a way as to inadvertently cause a constructive distribution by the corporation that is treated as a taxable dividend to its owners.

Close Scrutiny

It is axiomatic that interactions between a closely held business – including a C corporation – and its owners will generally be subject to heightened scrutiny by the IRS, and that the labels attached to such interactions by the parties will have limited significance unless they are supported by objective evidence.

Thus, arrangements that purport to provide for the payment of compensation, rent, interest, etc., to a shareholder – and which are generally deductible by a corporation – may be examined by the IRS, and possibly re-characterized so as to comport with what would have occurred in an arm’s-length setting.

This may result in the IRS’s treating a portion of such a payment as a dividend distribution to the shareholder, and in the partial disallowance of the corporation’s deduction.

Constructive Dividends

According to the Code, a dividend is any distribution of property that a corporation makes to its shareholders out of its accumulated or current earnings and profits.[xi] “Property” includes money and other property;[xii] under some circumstances, the courts have held that it also includes the provision of services by a corporation to its shareholders.[xiii]

A “constructive” dividend typically arises where a corporation confers an economic benefit on a shareholder without the expectation of repayment, even though neither the corporation nor the shareholder intended a dividend. However, not every corporate expenditure that incidentally confers economic benefit on a shareholder is a constructive dividend.

Where a corporation constructively distributes property to a shareholder, the constructive dividend received by the shareholder is ordinarily measured by the fair market value of the benefit conferred.[xiv]

The issue addressed in a recent Tax Court decision[xv] was whether Taxpayer had received constructive dividends from Corporation.

Taxpayer’s Strategy

Taxpayer was a performer. During the years at issue, he had various engagements. Compensation for these performances was generally made by checks payable to Corporation, not to Taxpayer individually.

This arrangement was based on the concept that Taxpayer could shift their business income to a business entity (i.e., Corporation), which would then use the funds to pay Taxpayer’s personal expenses, and claim a deduction for these expenditures.

In furtherance of this “strategy,” Taxpayer organized Corporation. Taxpayer was Corporation’s sole stockholder, president, chief executive officer, chief financial officer, sole director, and treasurer.[xvi]

During the years at issue, in accordance with this plan, the fees paid for Taxpayer’s various engagements were generally made payable to an account at Bank under the Corporation’s name.[xvii] Taxpayer was the only individual with signature authority over this account. Taxpayer was also an authorized user of Corporation’s credit card account.

Also during these years, Taxpayer paid various expenses using the credit card and the funds deposited into the account at Bank. These expenses included airfare, payments to grocery stores, restaurants, and other miscellaneous expenses.[xviii]

Taxpayer filed personal income tax returns for the years at issue,[xix] on which were reported their wages from Corporation.

Corporation also filed tax returns for those years[xx], reporting gross profits, as well as expenses for wages, taxes, advertising, employee benefits, travel, and other items.

The IRS Challenge

The IRS selected Taxpayer’s and Corporation’s returns for examination. The IRS issued a notice of deficiency by which it adjusted Corporation’s taxable income by disallowing, for lack of substantiation, most of the claimed deductions and by adjusting upward its gross profits.

In a separate notice of deficiency, the IRS determined that Taxpayer had failed to report constructive dividends attributable to personal expenses that Corporation had paid on their behalf.

In fact, for all the years at issue, the IRS counted as constructive dividends those expenses that Corporation had reported, and that the IRS had disallowed, as deductions. The IRS also counted as constructive dividends the payments that Corporation had made on its credit card account.

Taxpayer petitioned the U.S. Tax Court for a redetermination of the asserted tax deficiency.

The Court’s Analysis

The Court began by noting that the IRS’s determination of constructive dividends was a determination of unreported income. It explained that the Court of Appeals for the Ninth Circuit, to which any appeal from its decision would lie,[xxi] required that the IRS establish “some evidentiary foundation” linking a taxpayer to an alleged income-producing activity. Once such a foundation has been established, the Court continued, the burden of proof would shift to the taxpayer to prove by a preponderance of the evidence that the IRS’s determinations were arbitrary or erroneous.

The Court found that the IRS had established a sufficient evidentiary foundation to satisfy any threshold burden. The evidence showed that Taxpayer owned 100-percent of Corporation and maintained authority over its checking and credit card accounts. Taxpayer was integrally linked to – apparently the only source of – the Corporation’s income-producing activity. The record showed that the IRS’s determination was based on an extensive review of both Taxpayer’s and Corporation’s activities, bank accounts, and other financial accounts. The IRS introduced evidence to show that Corporation made significant expenditures primarily for Taxpayer’s benefit.

The Court then turned to the substantive issue of whether a dividend had been paid.


In general, Sections 301 and 316 of the Code govern the characterization, for Federal income tax purposes, of corporate distributions of property to shareholders. If the distributing corporation has sufficient earnings and profits (“E&P”), the distribution is a dividend that the shareholder must include in gross income.[xxii] If the distribution exceeds the corporation’s E&P, the excess generally represents a nontaxable return of capital to the extent of the shareholder’s basis in the corporation’s stock, and any remaining amount is taxable to the shareholder as a gain from the sale or exchange of property.[xxiii]


According to the Court, it was Taxpayer’s burden to prove that Corporation lacked sufficient E&P to support dividend treatment at the shareholder level. The Court stated that, if neither party presented evidence as to the distributing corporation’s E&P, the taxpayer has not met their burden of proof. Because Taxpayer produced no evidence concerning Corporation’s E&P during the years at issue, Taxpayer failed to meet the burden of proving that there were insufficient E&P to support the IRS’s determinations of constructive dividends to Taxpayer. Therefore, the Court deemed Corporation to have had sufficient E&P in each year to support dividend treatment.


The Court then explained that characterization of a distribution as a dividend does not depend upon a formal dividend declaration.[xxiv] Dividends may be formally declared or constructive.

According to the Court, a constructive dividend is an economic benefit conferred upon a shareholder by a corporation without an expectation of repayment. Thus, if corporate funds are diverted by a controlling shareholder to personal use, they are generally characterized for tax purposes as constructive distributions to the shareholder.[xxv]

Such a diversion may occur, for example, where a controlling shareholder causes a corporation to pay the shareholder’s personal expenses; the payment results in an economic benefit to the shareholder but serves no legitimate corporate purpose.

A “distribution” does not escape taxation as a dividend simply because the shareholder did not personally receive the property. Rather, according to the Court, “it is the power to dispose of income and the exercise of that power that determines whether * * * [a dividend] has been received.” Whether corporate expenditures were disguised dividends presents a question of fact.

The Court then described the two-part test enunciated by the Ninth Circuit for determining constructive dividends: “Corporate expenditures constitute constructive dividends only if 1) the expenditures do not give rise to a deduction on behalf of the corporation, and 2) the expenditures create ‘economic gain, benefit, or income to the owner-taxpayer.’”

Taxpayer’s Situation

For all of the years at issue, the IRS determined the amount of constructive dividends on the basis of Corporation’s disallowed claimed deductions and also on the basis of additional charges made on the corporate credit card. Taxpayer claimed that many of these expenditures and charges represented legitimate business expenses of Corporation, but failed to offer into evidence any materials that were linked in any meaningful way to the IRS’s adjustments. Moreover, the Court did not find Taxpayer’s testimony credible or adequate to show that any particular item represented an ordinary and necessary business expense[xxvi] of Corporation.

In sum, Taxpayer’s documentation, in which personal living expenses were not clearly distinguished from legitimate business expenses, provided the Court with no reasonable means of estimating or determining which, if any, of the expenditures in question were incurred as ordinary and necessary business expenses of Corporation.

Because Taxpayer failed to show that the expenditures in question properly gave rise to deductions on behalf of Corporation, the remaining question was whether these expenditures created “economic gain, benefit, or income to the owner-taxpayer.”

The expenditures in question showed a pattern of payment of personal expenses. This pattern, the Court observed, was consistent with Taxpayer’s tax-avoidance strategy to have Corporation deduct Taxpayer’s personal living expenses as business expenses.

Indeed, Taxpayer did not identify any category of challenged corporate expenses that did not benefit him personally.

With that, the Court sustained the IRS’s determination that Taxpayer received and failed to report constructive dividends. Thus, Corporation’s taxable income was increased because of the disallowed deductions, and Taxpayer’s taxable income was increased by the dividend deemed to have been made.


The Court’s decision was hardly a nail-biter.[xxvii]

Notwithstanding that the outcome was a foregone conclusion, the case is instructive for both individual taxpayers[xxviii] and their advisers.

Although it illustrates but one application of the constructive dividend concept, it hints at the number of scenarios in which a careless shareholder of a closely held C corporation with E&P[xxix] may be charged with having received a taxable distribution.

It also raises some interesting questions that do not appear to have been before the Court, but of which a closely held business should be aware.

Constructive Dividend Scenarios – Third Parties

The Court’s decision found a distribution to Taxpayer though the transfers by Corporation were to someone other than Taxpayer – the transfers were made to third parties for Taxpayer’s benefit.[xxx]

Moreover, there was no expectation that Taxpayer would reimburse Corporation for its expenditures. In other words, there was no indication that the events, taken as a whole, constituted a loan from Corporation to Taxpayer.[xxxi]

Corporation could have tried to characterize most of its expenditures to or on behalf of Taxpayer as compensation paid to Taxpayer; after all, Corporation’s income was attributable entirely to Taxpayer’s performances. Provided the aggregate amount of compensation was reasonable, Corporation would have been entitled to a deduction therefor.

In fact, the IRS could have taken the same approach, though this would have supported a larger deduction for Corporation.

It should be noted that a constructive dividend could also have been found if the corporation, instead of satisfying the shareholder’s expenses or liabilities, had made a payment to or behalf of a member of the shareholder’s family. In that case, the shareholder would be treated as having made a gift to their family member following the deemed distribution.[xxxii]

Constructive Dividend Scenarios – The Shareholder

In addition to transactions between the corporation and third parties, a constructive dividend may also be found in direct dealings between the corporation and the shareholder.

For example, a purported loan by a corporation to a shareholder may be recharacterized, in whole or in part, depending upon the facts and circumstances, as a dividend distribution.[xxxiii]

Similarly, a bargain sale by a corporation to a shareholder – one in which the consideration paid by the shareholder in exchange for corporate property is less than the fair market value of the property – may be treated as a dividend to the extent of the bargain element.[xxxiv]

Indeed, any scenario in which the corporation and the shareholder are dealing with one another at other than arm’s length raises the possibility of a deemed distribution.

For example, a shareholder’s rent-free use of corporate-owned property may constitute a dividend distribution[xxxv] in an amount equal to the fair market rental rate.[xxxvi]

Conversely, a corporation’s payment of excessive rent for the use of a shareholder’s separately owned property, or excessive compensation for their services, may be treated as a dividend to the extent it exceeds a fair market rental rate or reasonable compensation.[xxxvii]

At this point, it should also be noted – despite the result reached in the Court’s decision, above – that there is no necessary correlation between a corporation’s right to a deduction for a payment and the tax treatment of the payment to a shareholder, say, as an employee. In other words, the fact that a deduction for compensation was reduced to the extent it was unreasonable, does not “entitle” a shareholder-employee to dividend treatment as to the disallowed amount.[xxxviii]

Other Potential Arguments

At some point during the discussion of the Court’s decision, above, did you wonder why the IRS seemed to have respected Corporation as a bona fide business entity? After all, it was Taxpayer’s strategy to use Corporation to receive the income that Taxpayer earned, to cause Corporation to pay Taxpayer’s personal expenses using such income, and then for Corporation to claim business deductions for such payments (as far-fetched as that seems), thereby resulting in Taxpayer’s only being taxed on the wages paid by Corporation.

In fact, according to a footnote in the Court’s opinion[xxxix], the IRS had previously asserted that Taxpayer had failed to report “certain gross receipts” as a sole proprietor, on Schedule C, Profit or Loss from Business, but dropped it as “duplicative of the constructive dividend determination.”

In order for the IRS to have raised this argument, it must have concluded that Corporation was a sham for tax purposes, that it lacked a business purpose. It’s also possible that the IRS decided, under “assignment of income” principles, that Corporation’s income should have been reallocated to Taxpayer as the “true earner” of such income.

Why, then, would the IRS have dropped this alternative argument?

The case most cited for the treatment of corporations as entities separate from their owners for tax purposes is Moline Properties.[xl] It stands for the proposition that a corporation created for a business purpose or carrying on a business activity will be respected as an entity separate from its owner for federal tax purposes. Although the Supreme Court did not indicate the degree of corporate activity that was necessary in order for the corporation to be respected, subsequent decisions have not set a very high threshold.

It is likely for this reason, plus the fact that recharacterization of the corporation’s payments as dividends, rather than as deductible expenditures, resulted in double taxation of Corporation’s profits, that the IRS decided not to pursue its alternative position.

Last Word

If the owners of a business decide to operate the business through a separate entity – whether it is a corporation or a partnership/LLC – they must treat with the entity as they would with an unrelated person. By respecting the entity’s separate existence, they may maximize the legal and economic benefits of their choice, and avoid unexpected, and costly, tax consequences.

[i] A single-member LLC; one that is disregarded for tax purposes. Reg. Sec. 301.7701-3.

[ii] For example, the pass-through of losses generated by the business, the ability to distribute to the owners the proceeds from a borrowing, the ability to raise capital, etc.

[iii] In other words, how they intend to share profits. For example, will certain owners be entitled to a preferred return on their capital?

[iv] Of course, they will have also discussed whether the taxpayer-owner(s) were even qualified to utilize a particular form. For example, the owners may not all qualify to hold shares of stock in an S corporation, or their economic arrangement may be such that it would fail the single class of stock requirement for S corporation status.

[v] Their alter ego.

[vi] “Piercing,” basically.

[vii] The Tax Cuts and Jobs Act (P.L. 115-97); the “Act.”

[viii] From a maximum graduated rate of 35-percent to a flat rate of 21-percent, effective for tax years beginning after December 31, 2017.

[ix] Reg. Sec. 301.7701-3.

[x] IRC Sec. 1361 and Sec. 1362.

[xi] IRC Sec. 312 and Sec. 316.

[xii] IRC Sec. 317.

[xiii] https://www.taxlawforchb.com/2014/07/receiving-services-from-your-business/

[xiv] Where the fair market value cannot be reliably ascertained, or where there is evidence that fair market value is an inappropriate measurement, the constructive dividend can be measured by the cost to the corporation of the benefit conferred.

[xv] Patrick Combs v. Commissioner, T.C. Memo 2019-96.

[xvi] Taxpayer’s spouse acted as secretary.

[xvii] The opinion does not state that Taxpayer was employed by Corporation, though Corporation did pay wages. In addition, the opinion is silent as to whether clients retained Corporation, which then provided the contracted-for services through its employee, Taxpayer.

[xviii] Rental was not separately identified as an expense.

[xix] IRS Form 1040.

[xx] IRS Form 1120.

[xxi] See IRC Sec. 7482(b)(1)(A).

[xxii] IRC Secs. 301(c)(1), 316.

[xxiii] IRC Sec. 301(c)(2) and (3).

[xxiv] For example, see N.Y.’s BCL Sec. 510.

[xxv] A variation on the “substance over form” doctrine.

[xxvi] IRC Sec. 162.

[xxvii] Go figure why Taxpayer pursued it as far as they did.

[xxviii] We are not addressing situations involving shareholders that are themselves corporations; among other considerations, these may trigger application of the dividends received deduction. IRC Sec. 243.

[xxix] And in some cases, an S corporation with E&P. This would occur where the S corporation was previously a C corporation, or where the S corporation acquired a C corporation in a tax-free reorganization.

[xxx] It should be noted that the “personal” expenditures need not have been for living expenses or personal debts. For example, if the corporation had made a charitable contribution to a qualifying organization for which a shareholder claimed a deduction, the shareholder would be treated as having received a dividend distribution, the amount of which it then transferred to the charity.

[xxxi] For example, the expenditures were not recorded as loans, nor did Taxpayer give Corporation a promissory note.

[xxxii] See, for example, Reg. Sec. 1.351-1(b)(1).

[xxxiii] Likewise, the forgiveness of an actual loan may be treated as a dividend.

[xxxiv] The value of the corporation is reduced by the amount of the bargain element.

[xxxv] That being said, the incidental or insignificant use of corporate property may not justify a finding of a constructive dividend.

[xxxvi] See IRC Sec. 7872 with respect to loans by a corporation to a shareholder that bear a below-market rate of interest.

[xxxvii] However, query whether the IRS would make this argument; after all, the rate applicable to qualified dividends[xxxvii] is lower than the ordinary income rate applicable to rent. IRC Sec. 1(h)(11).

[xxxviii] The employee would still be treated as having received compensation taxable as ordinary income (a maximum federal rate of 37-percent), rather than a dividend taxable at 20-percent.

[xxxix] Footnote 3.

[xl] 63 S.Ct. 1132 (1943).