Constructive Dividends and Related Party Losses

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The Notice of Proposed Adjustments is issued to an entity which is legally deemed to have grossly violated the rules specified in the NPA. The Internal Revenue Service (IRS) issues the NPA. A response is required within the permitted time in order to expedite further sanctions. The company is not forced to comply with the recommendations but may make the modifications so as to ease future reporting of its financial matters and in the process create a good rapport with the IRS.

Companies can only deduct necessary expenses required towards the running of the business, hence compensation to managers and other employees regarding provision of professional services to the business only done to extent that is deemed reasonable. In so doing, the dividends to shareholders is not liable for deduction. This is according to the internal revenue code, section 162. An unreasonable payment to a major shareholder by the company will be subject to treatment as constructive dividend, hence not tax deductible and as such prone to double taxation.

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Stock redemption is acquisition of a company’s stock in exchange for property, according to the IRC code. According to 26 US codes 302, when a shareholder has a holding of either 50% of the shares or bellow that after redemption, the activity may not entirely be considered redemption. Otherwise, the payment may not be treated as a redemption but as a distribution. In such a case, under section 301, when a firm makes such a property distribution but ends up being treated not as stock redemption, it is subject to tax at the time of filing tax returns.

In this case, the company has the obligation to respond to the IRS either in acceptance or non-acceptance of the proposals and whether they have been implemented or not. The client received substantial issues in the NPA and as such special interest is needed in order to fix them. The issues raised are a rental loss, unreasonable compensation, and stock redemptions. These normally come in separate forms.

Unreasonable compensation
This is a gross issue since the Companies Act seeks to protect external stakeholders from a potential loss of their interests in the company. The client holds the majority of interests within his businesses without any doubt: 95% ownership in the warehousing and building supply sales and business and a further 50% in the construction company. However, this does not imply that he is alone in the venture. The Companies Act provides for payment of owners on a per share basis unless professional services are offered by them to the company. As such, the claim to take $10 million as salary is unreasonable.

The company has breached IRS guidelines that forbid the use of constructive dividends in paying personnel. To this issue, the client has no option but to comply with the proposed change. The firm may not file their next tax returns yet until this issue is dealt with and approval got from the IRS. Any delay to file tax returns attracts a penalty of 5% increase in the tax due. The company may, therefore, clear in time.

Stock redemption
Stock redemption is permitted by accounting standards and the treatment of such clearly specified. As such this was wrongly reported by treating it as a distribution. Drawing reference to basic accounting practice, stock redemption is considered an investment that is charged when income is stated. Considering it a distribution is in stark contradiction to accounting standards and procedures that are lawful and legally recognized. As such, disputing the NPA is legally justified. For this to be achieved, the client should respond to the IRS within the 30-day window.

Plan for future redemption of stock
To avert a future altercation, the company should take caution in its stock redemption activities and do it in a manner that disproportion is created in the shareholdings of the son and client. This could involve the sale of some stock before redemption so that ownership falls below 50% after redemption. This will make section 302 of the IRC applicable hence evading section 301 provisions that are applicable to property distribution.

Rental loss
The reported loss results from a building that was leased to the construction company that the client and the son owns jointly. It should be noted that a rental loss is a material item in tax reporting. Besides, all loses and credits allowed by law are tax saving and results in the collection of fewer amounts by the IRS than would otherwise not have been the case. This explains the keenness by IRS since such losses reduce their collection ultimately, as mentioned before. In this case, though, the loss is on a building that the client leased to the firm. The business is taken to be a separate financial entity in tax accounting from the individual. Being a company makes it even more binding. Such a loss, therefore, should only be reported in the financial books of the company only if it is controlled by the company in question. In this case, it is evident that the building is a personal property and not that of the company. So the rental loss should have been reported together with the income tax returns of the client and not included in the company’s financial returns filings.

It is the duty of the client (taxpayer) to correct this judgmental error and file his returns anew after making the corrections on this oversight. This will enable him to receive compensation of similar amount and avoid future taxation levied as a constructive dividend.

  • Cornell University Law School, 2015, “26 U.S. Code Section 318- Constructive Ownership of Stock”; Available at: https://www.law.cornell.edu/uscode/text/26/318
  • Internal Revenue Services, 2004, “Passive Activity Loss ATG- Chapter 2, Rental Losses”; Available at https://www.irs.gov/businesses
  • Patrick A. Mullin, 2013, “The IRS and Constructive Dividends to Shareholders”; Available at: http://www.taxdefense.com/practice/dividendsShareholders.php

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