Constructive Dividends Redemptions and Related Party Losses

The Notice of Proposed Adjustments is issued to a person, natural or a corporation who is deemed by the internal revenue service to be in gross violation of the rules specified in the NPA. The person to whom the notice has been addressed should respond within the permissible time frame to avoid further sanctions. The NPA refers to a set of issues of which financial and tax handling by the reporting company does not satisfy the requirements of the IRS, and to which specific attention and possible reporting modifications have been requested. The company in question is not forced to agree with the suggestions, but may still comply so as to ease its future reporting while also creating a good rapport with the revenue authority.

Once the notice has been received, the reporting company has the obligation to respond to the IRS, which should be done in less than 30 days upon its reception. This response ought to be accompanied by reasons why the changes have not been effected if the company opts against implementing the proposed changes. In case the proposed adjustments fail to be developed adequately, the IRS review process of the changes may take a longer time period than is normal. The revenue authority should do maintain records of the proposed adjustments sent to a specific taxpayer. The record should contain the effort taken so as to acquire the response in good time.

The IRS presents to the taxpayer in question this notice of proposed adjustments by sending them form 5701. The form has three parts, and is designed to provide a written record of the adjustments proposed. However, the use of form 5701 is not a legal requirement, and the IRS may use any other method that records the information presented to taxpayers. As a result, the preparation and use of the form should be tailored to suit the uniqueness of the proposed issue to be adjusted; the taxpayer, as well as the expected agreed or disagreed status of the adjustment proposal. The form may however serve as cover sheet for Form 886A, whose major importance is to explain the items on form 5701. The relationship between the two forms facilitates incorporation explanation of the key issues into the report of the revenue agent.

As per 26 US Code 317, IRC, the redemption of stock is the process of acquiring stock of company in exchange of property. As per 26 US Code 302, the redemption of stock will not be considered as the redemption if immediately after the redemption the shareholder owns 50% or more than 50% of the total voting power of the company. Thus the payment made in order to acquire the stock will not be considered as stock redemption. As per 26 US Code 301, IRC when the company makes the distribution of the property and the distribution is not considered as redemption of stock then it will be considered as the distribution under section 301. Thus the distribution of the property received by the shareholder is taxable at the time of filling return.

  1. As per section 162 of internal revenue code the companies can deduct only the ordinary and necessary expenses that were required in regard to running of the business thus the compensation to the employees and managers in regard to providing services to the business will be deductible to the extent they are eligible in regard to extent they are considered reasonable and the payments to shareholders in the form of dividends are not deductible. The reasonable pay of an employee is based upon several different factors such as input of the employee, special skills possessed, years of experience, education possessed by the employee.
  2. As per the rules of internal revenue service the payment of dividend to a shareholder which is not clearly described as dividend is deemed to be dividend by IRS thus it is charges tax on them accordingly. When the company makes an unreasonable compensation to the manager who is the major shareholder of the company it will be constructive dividend. The company makes higher payments in order claim the payment as the tax deductible expense but the unreasonable payments are not tax deductible. The constructive dividends are prone to double taxation first the taxation at the level of the company as they are not tax deductible and second the taxation on receipt by the shareholders.

Client’s Situation

The client under consideration received a NPA seeking to address three separate and independent issues; unreasonable compensation, stock redemptions, and a rental loss. This would ideally come on separate forms, but with the aid of form 886A, several issues may fit on the same form 5701 while form 886A carries the distinguishing explanations. All the three raised by the IRS are substantial, and thus need special interest in attempting to fix them. To handle these issues exhaustively, they will be handled separately, as below.

To start with, the issue of unreasonable compensation is gross, as the spirit of the Companies Act sought to protect external stakeholders from potential loss of their interests in the firm. At 95 percent ownership in the building supply sales and warehousing business, and the 50 percent share of ownership in the construction company, the client undoubtedly holds the largest of interests within his businesses. But he is no alone. The Companies Act requires that owners, simply called stockholders, be paid on a per share basis, unless they offer professional services to the business. As such, the client cannot reasonably claim to take home a $10 million salary. The base salary is already too steep, and would ultimately drain the company’s cash flows. The company, however, is in breach of IRS guidelines that disallows use of constructive dividends in remunerating personnel.

To this issue, the taxpayer has only one option, which is complying with the proposed change. While there may be arguments that will undoubtedly fail to hold water, the breach of regulations is there for all to see. The company may not file their next tax returns unless this issue is rectified and duly approved by the IRS. The delay to file tax returns for whatever reason is punishable by a 5 percent increase in the tax due, and therefore the company would want to avoid incurring such responsibility by clearing in time.

The second issue, stock redemptions, was wrongly reported. While the accounting standards permit stock redemptions, the treatment of such a transaction is clearly specified, and it is in no way a distribution. Based on the accounting practice, redeeming stock is considered an investing activity that will be charged upon the statement of income. Therefore, considering it as a distribution contradicts the very accounting standards recognized by the law, therefore forming laudable grounds to dispute the NPA. To achieve this, the taxpayer should respond to the IRS within the permitted 30 days upon receiving the NPA to get a better chance of fixing the issue with little fuss. When responding to the IRS, caution needs be exercised to avoid hiring a professional for irregularities involving small sums such that expert fees exceed the amount involved.

The stock redemption should in such a manner that it may create disproportion in the shareholdings of the client and son which may involve sale of some stock before the redemption of stock takes place such that the ownership is less than 50% after redemption which will make the applicability of section 302 and thus evade the provisions of section 301 applicable on distribution property.

A rental loss is a material item in tax reporting. All loses and credits allowed by law are tax saving, and result into the IRS collecting a smaller figure in taxes than would have been the case. It is therefore ordinary for the authority to be very keen with items that reduce the taxes that they would have otherwise collected. The client being considered reported a loss on a building leased to the firm. In tax accounting, a business is considered to have a separate financial entity from the individual, especially in the case of the company, and should only be reported in the company’s financial statements if it is controlled by the business. However, the rental loss in this case should have been reported together with the client’s income tax and not included in the financial returns filed by the corporation. It therefore calls for the taxpayer to correct this error of judgment and file their returns afresh after correcting these mishaps in order to receive similar amounts in compensation in the future and avoid the taxation as a constructive dividend.