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Lane Keeter, CPA

Partner: Tax Consulting, Estate Planning, and Heber Springs Managing Partner

Just Because You Spent It Doesn't Make It Deductible

Naturally, when you file a tax return for a business, you want to find and take all the tax deductions you can. Businesses that take the corporate form of operations are no different.

But not everything paid out of business coffers results in a tax deduction. While this article addresses corporations specifically in a few areas, there are also some general principles presented here that are applicable to most any type of business, whether incorporated or not.

First, foundationally, to be deductible a business expense must be both ordinary AND necessary. What does that mean? An ordinary expense is one that is common and accepted in a particular industry or field of business. By contrast, a necessary expense is one that is helpful and appropriate for your business.

Both elements must be present. The IRS will sometimes challenge deductions claimed for certain types of expenses as not meeting one or both of these tests.

Often when this happens, the IRS auditor may claim that such payments made by a corporation are personal in nature for the benefit of a shareholder. Payments either to or for personal items, or that are above or below fair market value, by law are what the IRS calls a "constructive dividend." Reclassifying business expenses as dividends has negative tax consequences.

Many corporations pay out dividends to their shareholders, usually based on earnings for the year. The amount of dividends a shareholder receives depends on his or her proportionate ownership share in the company, and typically is in the form of a cash payout.

However, a corporation may make other payments to (or for the benefit of) one or more shareholders, which as just mentioned, the IRS might classify as "constructive dividends." This often happens when owners of a closely held business use corporate funds to pay what really are personal expenses. But it can also occur at much larger corporations, and it may involve more than just running personal expenses through the business.

Some examples of personal expenses which have been ruled to be constructive dividends include travel, meal and entertainment expenses that the company could not prove were business related, repair and maintenance expenses for personal use property, and even housing and medical expenses paid by a corporation.

More specifically, and in some ways more common, are the following which often are called into question:

  • An excessive (i.e., greater than fair value) payment for corporate use of a shareholder's personal property, such as rental payments for the company's office or warehouse space,
  • A purchase or lease by a shareholder of company property at a price that's significantly below fair market value,
  • A purchase by the company of a shareholder's property at a price that far exceeds fair market value,
  • Excessive compensation paid to shareholders or their family members,
  • • Use of company-owned vehicles and other company property by shareholders (or their family members) without paying fair market value, and
  • A corporate loan (often at a below-market interest rate) made to a shareholder to fund personal items, where there is no reasonable expectation of repayment.

The bottom line is that owning all (or part) of a company does NOT give you the unrestricted right to pay and record expenses in any manner you see fit. There are tax rules and restrictions that must be followed.

So what are the tax consequences of such a reclassification? Let's just say it can be a double-edged sword!

Typically, a dividend paid out by a corporation, especially a C corporation, is taxable income to the recipient shareholder(s). That makes sense because they have received an economic benefit.

The bigger problem is that, unlike a business expense, a corporate dividend is NOT deductible by the corporation. Result ñ the shareholder pays income tax on something for which no tax savings are had by the corporation.

The only winner here is the government!

Further, when the corporation has deducted such payouts to begin with, but the IRS gets involved and re-characterizes them as constructive dividends, it is likely there will be penalties and interest imposed for the resulting tax underpayments. Worse, if the owners purposely evaded their tax responsibilities, they could face criminal charges.

While it can be easy to run afoul of the IRS on this issue, all is not lost. A business should always keep detailed, contemporaneous records to support its deductions and other tax positions, especially when it comes to transactions with related parties.

The IRS generally won't treat something as a constructive dividend if the company can demonstrate that it lacked sufficient earnings to pay dividends or that a payment was, in fact, used to pay ordinary and necessary business expenses, not personal expenses.

Avoid the temptation to skimp on this because it seems like "too much trouble". That could cost you big!

And, like everything else in the tax world, some expenses may fall into a "gray area" where you are unsure of the appropriate tax treatment. If you find yourself there or are unsure in any way, ask for help!

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