Discussion:Reclassification to Constructive Dividends
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Frank stewart (talk|edits) said: | 24 May 2006 |
| What can be done to reverse the IRS reclassification to dividends. My client (a corporation) invested $40,000 in another corporation (that he is a 50% shareholder). The IRS reclassified the $40k as a constructive dividend to my client personally. | |
| 24 May 2006 | |
| To whom the shares where issued? If the corporation has legal title to the shares, that is not a dividend, not an investment in sub (see the consolidation rules about control.) However, if the shares (of the second corporation)are in the name of the shareholder, the IRS is correct. | |
Frank stewart (talk|edits) said: | 25 May 2006 |
| Foxttron: Thanks for your input. The corporation has legal title to the shares, but the corporation that was invested in is also owned (50%) by the client/shareholder of the investing corporation. I will read the consolidation rules on control, what code section is that please?
Also, if there is a clear business purpose to the investment, would that help? | |
| 25 May 2006 | |
| The 1500 series (about 15 code sections)deals about consolidation rules and filing for a controlled group. Again, not knowing the specifics, I do not know if this applies to you. I believe that a clear business purpose would help, but, again, it sounds strange that the IRS would deny this investment a priori. I think they may have different motivations for reclassifying this investment. I would look carefully in the conclusion before answering them. I hope it helps. | |
| 27 May 2006 | |
| What did the Notice of Proposed Adjustment state as the reason for the reclassification? | |
Frank stewart (talk|edits) said: | 30 May 2006 |
| A document from the IRS said "In TCM, J Michael Shedd and Marita Shedd v. Commissioner. It was determined that unless there was a clear business purpose for the investment in a taxpayer's related corporation from another one of the taxpayer's corporations, the amount will be considered a constructive dividend to the shareholder. It would appear reasonable in this case that the advance was for the primary benefit of Mr. Campbell, a common shareholder in both businesses."
Thanks for your input. | |
| 1 June 2006 | |
| Here is the link to [|Shedd v. Comm] Start in the middle of page 14 for the constructive dividend discussion.
The first 13 1/2 pages do not apply here since there is apparently no question that an equity investment was made in your case. In Shedds, the taxpayers argued that they had made loans, and not contributed capital, to the corporation. However, it is still a good read for practitioners so they can better advise their clients who do want to make loans that will be respected by the IRS. You do not state what percentage of the corporation that made the investment the individual owns. I will assume that it is over 50% and that the individual erxercises control over that corporation. The premise of the IRS' adjustment in Shedds was that the corporation had no business purpose for making the investment. Therefore, it effectively made the investment on behalf of the individual taxpayer. The effect was the same as the first corporation (investOR) declaring a dividend to the individual taxpayer and the individual then making the investment in the second corporation (investEE). The individual would then have taxable dividend income. (Since the IRS is recasting the investment as a construcitve dividend, I have to assume that the investOR corporation has sufficient E&P (current or accumulated) to truly characterize the distribution as dividends. (This is the "Objective Distribution Test" discussed in Shedds.)) However, as Foxttron correctly asks, does your individual taxpayer client have control over the second corporation (the one that received the $40K). In Shedds, the investee corporation was 100%-owned by the Shedds so the Tax Court did not have to discuss control issues. However, in your case the individual owns 50% of the investee corporation. I do not believe, though, that the Code is going to have a brightline test for the percentage of control necessary to get out of constructive dividend treatment. So, the threshold question would be does your individual client have control of the investEE corporation? That is, is he the decision maker. I think de facto control is established regardless of 50% or 50+% and you will have to overcome the IRS' view on that. If he does not have control or exercise sufficient authority to establish indirect control over the money in the investEE cororation, then your facts diverge from Shedds and you can point that out to the IRS agent. If the agent does not back down and you are confident of your facts, then take it up the chain to the case manager, etc. If the individual taxpayer does exercise control, you will need to establish that the investOR corporation had a genuiine business purpose for making the investment in the investEE corporation. (This is the "Subjective Test of Primary Purpose" discussed in Shedds.) The purpose must be genuine and verifiable. The Shedds' discussion shuld get you started and may get you all the way "there" (i.e., one way or another" as you get all of the facts and circumstances from your client. I hope this helps in some way. | |
Frank stewart (talk|edits) said: | 2 June 2006 |
| Wow, thanks so much. I believe this information will be more than sufficient for me to make my argument. Thanks Again ! | |
