By: A.J. Cook


Internal Revenue Service agents love to find benefits slipping out to shareholders from closely owned corporations. They call the benefits constructive dividends. Shareholders call them trouble. Hotel queen Leona Helmsley calls them a disaster.

Remember her highness. Her mistreated employees fed information to the IRS about benefits she received. Her corporation had spent its funds to renovate the estate owned by Mrs. Helmsley and her husband. She received a jail sentence for disguising these payments as legitimate business expenses.

The problem is not limited to businesses; it applies to professional corporations as well. Some lawyers, doctors, engineers, accountants choose the corporate structure to partially insulate their wealth from malpractice liability and for other reasons. They make the change with little regard for the potential constructive dividend menace.

Doctors Daniel Leavitt, Anthony Cuzzocrea and Wolfgang Wirth incorporated their Roanoke, Va., medical practice as Valley Pathology Associates, Inc. Though their laboratory was in a hospital, their work required a lot of travel. Valley Pathology provided cars for the doctors, who paid the corporation $20 a month rental for personal use.

The IRS examined the corporation's return. It increased each doctor's income saying the $20 was much less than a market rental charge. It said the low rental benefitted the doctors as shareholders.

The pathologists appealed. They argued the following:

• If they received a benefit, it was compensation for services and thus deductible by the employer corporation.
  
• The benefit couldn't be a dividend because the corporation didn't declare one.
  

The judge said no evidence supported the theory that the benefits were compensation. He also said that because the low rent benefitted the shareholders, the IRS could consider the personal car use a taxable dividend.

Unfortunately the doctors botched the whole operation. But the case offers you a road map for preventing constructive dividends. Initially their corporation could have treated the value of the personal use as compensation. True, the doctors still would have taxable income, but the corporation would get a deduction -- one equal to the other.

Evidence of compensation would need to be supported with written contracts. These would state that the doctors could use the cars personally as part payment for their services. The corporation would add the rental value to their salaries reported to the IRS.

The Moral: Turn constructive dividends into corporate deductions with a little plastic surgery.

A.J. Cook is a lawyer and CPA. His tax column appears weekly in numerous newspapers. Why isn't it published in your hometown newspaper? Ask its Business Editor to subscribe.

Copyright © 1987-2001 A.J. Cook All Rights Reserved
This information is not intended for use without professional advise.
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Released 5-3-93