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Constructive dividends and intercorporate transfers: Mews turns back the hands of time.

In a classical tax system, corporate earnings are subject to double taxation--once when earned and again when distributed as dividends. Since dividends are the only form of income subject to double taxation, shareholders have used various ways to avoid reporting dividend income.

Under certain circumstances, a taxpayer can avoid reporting dividends by arguing that the distribution does not meet the definition of a dividend as contained in Section 316. Under this section, a distribution out of either current or accumulated earnings and profits constitutes a dividend.

There are two problems with this approach. First, either current or accumulated earnings and profits will sustain a dividend. Current earnings need not completely offset prior accumulated deficits. Distributions out of current earnings and profits represent taxable dividends, despite a deficit in accumulated earnings and profits.

The second problem is the lack of a specific definition of earnings and profits. The closest the Code comes is found in Section 312, which discusses the effect of certain transactions on the computation of earnings and profits. A review of Section 312 reveals that earnings and profits are not synonymous with the accounting concept of retained earnings. For example, the computation of earnings and profits requires the corporation to use straight line depreciation|1~ and the FIFO method of inventory|2~ while corporations are allowed to use accelerated depreciation and the LIFO inventory method where appropriate to compute retained earnings. Therefore, taxpayers find it extremely difficult to determine if any earnings and profits exist.

Most taxpayers take a more circuitous route to avoid dividends. Some of the approaches have included the payment of excessive salary, bargain purchases of corporate assets and putative loans to shareholders. In all of these cases, the Internal Revenue Service (Service) will attempt to reclassify part or all of the distribution as a constructive dividend. The Service has had considerable success in these cases.|3~

One approach used by taxpayers that has not been as widely discussed is intercorporate transfers between related corporations. The Service has been less successful in these cases, partially because the taxpayer does not have complete access to the funds since they remain in corporate form.

The rules that have been developed in this area have recently been overturned by the Seventh Circuit Court of Appeals in Mews.|4~ This article will discuss the prior rules and the decision in Mews. It also will attempt to point out planning opportunities and pitfalls.

Historical Development

The seminal case on constructive dividends in intercorporate transfers is Rushing.|5~ This case involved cash advances from one controlled corporation to another. The taxpayer argued that the advances were intercorporate debt, whereas the Service argued that the payments were constructive dividends.

The Tax Court decided it was not necessary to reach a conclusion on the character of the transfer. It is not necessary for corporate funds to be distributed to a shareholder to be considered a dividend; however, it is necessary that the funds be expended for his personal benefit or in discharge of his personal obligation. Rushing did not receive a direct benefit from the transfer; therefore, he did not receive a constructive dividend.

In Sammons,|6~ the Fifth Circuit Court of Appeals elaborated on and expanded the rule from Rushing into the current rule. After acknowledging that intercorporate transfers can result in constructive dividends the Court states:

In every case the transfer must be measured by an objective test: did the transfer cause funds to leave control of the transferor corporation and did it allow the stockholder to exercise control over such funds or property either directly or indirectly through some instrumentality other than the transferor corporation. If this first assay is satisfied by a transfer of funds from one corporation to another rather than by a transfer to the controlling shareholder, a second subjective test of purpose must also be satisfied before dividend characterization results.|7~

Thus the Court established a two-part test for constructive dividends--an objective transfer test and a subjective purpose test.

The subjective purpose test requires that the transfer be made primarily for the benefit of the taxpayer. In most cases, a business purpose for the transfer will negate the conclusion that the transfer was for the taxpayer's benefit, thereby avoiding constructive dividends. However, not all business purposes will suffice. If, as in Sammons, the stated business purpose is so tenuous and subordinate to the primary purpose of benefiting the shareholder, the business purpose will be ignored and the primary purpose test will be met.

The objective transfer test is usually easy to meet. The fact that the controlling shareholder was able to control transfers from one corporation to another will cause this test to be met. However, in Sammons, the Court found that this test was not met, and therefore the transfers did not result in constructive dividends.

Sammons highlights the difference between brother/sister corporations and parent/subsidiary corporations. In the brother/sister case, the second test involving the purpose of this transfer will normally be the controlling factor.

In a parent/subsidiary case, it is the first test involving the transfer that will be controlling. In parents/subsidiary cases, there normally has to be a second transfer of the asset outside the corporate group before the shareholder will be charged with constructive dividends. A second transfer is necessary because a transfer of cash within a parent/subsidiary group does not change or increase the control that the parent corporation's shareholders exercise over the funds. Therefore, the transfer test is not met until the funds leave the group and the shareholder exercises control over them.

In Kuper,|8~ the Fifth Circuit Court of Appeals expanded the two-part test of Sammons, while reversing a Tax Court decision for the taxpayer. The case involved a putative reorganization designed to result in a stock swap at the shareholder level. The transfer in question was a cash transfer from one corporation to another to equalize values which facilitated the stock swap. The Fifth Circuit concluded that the transaction was not a reorganization and was in fact a constructive dividend.

The Court once again applied the two-part test for constructive dividends. In discussing the purpose test, the Court stated that this part involves not only a subjective purpose element but also a objective benefit element. The Court divided this purpose test into two separate parts. According to the Fifth Circuit, the intention of this transfer had to primarily benefit the shareholder (a subjective determination) and result in an actual direct benefit (an objective determination).

The actual benefit in Kuper was the result of an equalized stock swap without a transfer of cash between the parties. Neither shareholder actually received the cash from the corporations. Instead, the transfer allowed the shareholders to exchange assets without the cash that would have been included if the cash transfer had not been made. Therefore, the shareholder received a direct benefit.

This version of the test focuses on both the reason for the transfer and its effect. Both parts must exist before a constructive dividend can result. From the taxpayer's perspective, this formulation allows him to defend against constructive dividend finding based on either subpart. The taxpayer can argue the transfer was not designed to provide him with a primary benefit by identifying a viable and substantive business reason for the transfer. Alternately, he can argue he did not receive a direct economic benefit from the transfer. In this case, the taxpayer should be prepared to show he did not receive any assets and he was not able to retain existing assets which he otherwise would have expended. Although the Court referred to this second argument as an objective determination, there could be substantial subjective elements involved in the final decision.

The Eleventh Circuit Court of Appeals quoted and used the two-part test from Sammons as modified by Kuper in Stinnett's Pontiac Service.|9~ The Court found the transfer in question was primarily for the taxpayer's benefit and that he received a direct benefit--an additional $6,000 in cash when the corporation liquidated in a separate transaction. Therefore, the transfer met both elements of the purpose test along with the objective transfer test.

The Fourth Circuit Court of Appeals addressed the constructive dividend issue in Mills.|10~ Although the Court did not specifically spell out the two-part test, it does cite both Sammons and Stinnett's Pontiac Service as precedent for its conclusion. The court concluded that the taxpayer did not receive a constructive dividend because they did not "discern |a~ direct and primary benefit that the transfer conferred upon John Mills."

The Fifth, Eleventh and Fourth Circuits appear to have adopted a uniform two-part test for constructive dividends. Although their opinions are not always phrased exactly the same, these Circuits appear to require a transfer to be made primarily for the taxpayer's benefit and to result in an actual benefit. This unanimous opinion was rejected by the Seventh Circuit in Mews.

Mews

Mews can be viewed as another case of bad facts making bad law. Taxpayer Levi Mews was convicted of filing false tax returns for 1982 and 1983. He was fined $50,000 and sentenced to 30 months in prison. His appeal centered around the charge to the jury concerning the constructive dividend issue as well as a comment made by the prosecution in closing arguments. The Court concluded the district court did not err and the decision was affirmed.

The constructive dividend issue centered around numerous transfers among corporations controlled by Mews. Some resulted in Mews receiving a direct benefit--for example, funds were used to buy a Cadillac for Mews' personal use. The benefit was indirect in other transfers.

The Court referred to the lower court's charge to the jury, which stated that for there to be a constructive dividend the transfers had to be primarily for the taxpayer's benefit and that, in fact, the taxpayer had received a benefit. The charge was based on Sammons and the other cases previously discussed.

Instead of rejecting this test, the Seventh Circuit nullified it by stating that the term "personal benefit" means absence of business purpose. In other words, unless the transfer served a business purpose of the corporate transferor, it was for the shareholder's benefit and resulted in a constructive dividend. In effect, this irradicates Sammons and all cases based on it.

According to the Seventh Circuit, the sole factor to be considered is the business purpose for the transfer. If this version of the test is accepted, it will reject the current test in use by the other circuits and turn the judicial clock back 50 years.

Conclusion

It is reasonable to conclude that Mews was guilty of tax evasion and deserved the sentence imposed by the district court. However, the Seventh Circuit could have upheld the conviction without rejecting the Sammons test.

The decision in Mews is interesting from an historical perspective. The Tax Reform Act of 1986 repealed the remnants of the General Utilities doctrine. Currently, it is virtually impossible to bail out corporate earnings without double taxation. Therefore, intercorporate transfers that do not result in a direct increase in shareholder wealth are not as much a concern as they used to be. As such, the Mews decision is not necessary to protect the government's revenue. Hopefully, Mews will not become the rule of law.

Taxpayers cannot dismiss Mews as easily. To avoid potential problems, taxpayers should be prepared to show a business purpose for any intercorporate transfer. This purpose should be substantial and not an afterthought. To the extent that these transfers are common in the industry, taxpayer can rely on Offutt|11~ as well as Sammons.

In addition to proving a business purpose, it would be helpful for the taxpayer to be able to demonstrate that he received no direct personal benefit from the transfer. One relatively easy way to prove that no benefit was received is to show that any funds received by the transferee corporation are loans. This argument can be used even if the transferred funds are used to pay a debt guaranteed by the controlling shareholder. According to the Tax Court, if the debtor was solvent at the time of the loan and the guarantor does not expect to pay the loan, the payment is considered as creating a loan.|12~ This should help avoid constructive dividend treatment in these cases.

Even in cases in which taxpayers can prove a viable business purpose, they should be aware of Rev. Rul. 69-630.|13~ It is the Service's position that any transaction between commonly controlled corporations resulting in a Section 482 adjustment will be treated as a constructive dividend to the controlling shareholder, followed by a non-deductible contribution by the shareholder to the other corporation. Rev. Rul. 69-630 changes the focus of the inquiry from business purpose to the arm's length nature of the transaction. It also raises the stakes in a Section 482 controversy from simply the proper amount of corporation income to be reported to the inclusion in shareholder taxable income of a non-deductible dividend.

Mews seems to have expanded the definition of constructive dividend to all intercorporate transfers that do not have a business purpose. Under Mews, taxpayers will have constructive dividends even if they do not receive any direct benefit from the transfer. This decision contradicts the decision in Sammons. Therefore, the controversy surrounding constructive dividends that existed prior to Sammons may be reopened.

Until the controversy is resolved, taxpayers must be very careful when structuring intercorporate transfers. To be sure that the Service will not reclassify the transfer as a constructive dividend, the taxpayer should concentrate on the business purpose of the transfer.

References

1 Section 312(k).

2 Section 312(n)(4).

3 For a more complete discussion of these approaches, see Federal Income Taxation of Corporations and Shareholders, by Bittker and Eustice, Fifth Edition, par.7.05.

4 U.S. v. Mews, 923 F.2nd 67, 67 AFTR2nd 529, (CA-7, 1991).

5 52 TC 888 (1969)

6 Sammons v. Comm., 472 F.2d 449, 31 AFTR2d 73-497 (CA-5), aff'g in part, rev'g and remanding in part, 71,145 PH Memo TC.x

7 Ibid at 73-498.

8 Kuper v. Comm., 533 F.2d 152, 38 AFTR2d 5162, 76-1 USTC 9467, rev'g 61 TC 624 (1974).

9 Stinnett's Pontiac Service v. Comm., 730 F.2d 634,53 AFTR2d 1197, 84-1 USTC par.9406.

10 Mills v. IRS, 840 F.2d 229, 61 AFTR2d 610, 88-1 USTC par.9180.

11 Comm v. Offutt, 336 F.2d 483, 14 AFTR2d 5649 (CA-4, 1964).

12 Simmons TC Memo 1983-349

13 1969-2 CB 112

Edward J. Schnee, PhD, CPA, is professor of accounting and director of the masters of tax accounting program, Culverhouse School of Accountancy, University of Alabama. He has authored over 50 articles on taxation and is a coauthor of a widely-used textbook on taxation.

Hughlene A. Burton, CPA, is a doctoral student at the Culverhouse School of Accountancy, University of Alabama in Tuscaloosa. She previously was a tax manager with Ernst & Young.
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Author:Schnee, Edward J.; Burton, Hughlene A.
Publication:The National Public Accountant
Date:Aug 1, 1993
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