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Sole shareholder's legal expenses.

The Tax Court, in Lenward C. Hood, 115 TC No. 14, held that a corporation's payment of its sole shareholder's criminal legal expenses was a nondeductible constructive dividend to the shareholder.

The taxpayer (formerly a sole proprietor) incorporated a food, paper and plastic goods business in 1988; he was the sole shareholder and integral to the business's success. There was no written agreement between the taxpayer and the corporation as to the latter's assumption of assets and liabilities stemming from the pre-existing sole proprietorship.

In 1990, the taxpayer was indicted for tax evasion, as he had failed to file sole proprietorship returns for 1983 and 1984. He was eventually acquitted; the corporation paid his $103,188 in legal fees and deducted the cost on its 1991 return.

The IRS later determined that the corporation was not entitled to deduct the legal fees; further, the taxpayer received a constructive dividend of $86,279 on the corporation's payment of such fees.

The Tax Court first noted that, on virtually the same facts, it held in Jack's Maintenance Contractors, Inc., TC Memo 1981-349, rev'd, 703 F2d 154 (5th Cir. 1983), that such fees were deductible. However, the Fifth Circuit later reversed, holding that the payment of the legal fees constituted a nondeductible constructive dividend. The Fifth Circuit reasoned that the payment primarily benefited the shareholder, not the corporation, even though the shareholder was indispensable to the business's success.

The Hood court noted that a constructive dividend arises when "a corporation confers an economic benefit on a shareholder without the expectation of repayment ... even though neither the corporation or the shareholder intended a dividend." It concluded that, because the (l) taxpayer was not experiencing financial difficulties or otherwise unable to pay his legal fees and (2) the corporation could not show that, had it failed to pay the fees, the taxpayer would have been incarcerated, there was no direct and proximate link between the payment of the legal fees and the benefit to the corporation. Thus, the corporation's legal fee payment was a nondeductible constructive dividend.
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Title Annotation:tax evasion
Author:Laffie, Lesli S.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Oct 1, 2000
Previous Article:Alternative date.
Next Article:Food and beverage deduction.

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