SOME BACKGROUND DETAILS

A dividend is a distribution by a corporation out of either current or accumulated earnings and profits. The distribution must be to a shareholder in his or her capacity as a shareholder. A dividend does not have to be formally declared or even legal under state law. Transactions between a corporation and a shareholder can result in a constructive dividend. For example, the payment of excessive salaries can be considered a constructive dividend. (1)

In 1937, the Eighth Circuit Court of Appeals in Helvering v. Gordon held that a transfer of funds between commonly controlled corporations was a constructive dividend to the controlling shareholders. The case involved a rebate for part of a manufacturer's purchase price of raw materials to a related corporation to hide the true profitability of the manufacturing company from its customers. Since Gordon, there have been numerous cases involving transfers between controlled corporations. However, it has not always been clear when a constructive dividend will result, or under what theory.

The U.S. Claims Court in Morowitz and the Fourth Circuit Court of Appeals in mills recently considered this issue. Morowitz was charged with a constructive dividend whereas Mills was not. Each case took a different approach to determine who benefited from the transfer. Morowitz was charged with a constructive dividend when the shareholder- plaintiffs failed to establish a valid business purpose for the intercorporate cash transfer. Additionally, shareholders failed to show evidence indicating they received no direct or tangible economic benefit from said payment. On the other hand, a constructive dividend was not charged to Mills because the parties involved intended the transfer between related corporations to create a valid business debt requiring repayment, and the transfer did not directly benefit the stockholder.

CONSTRUCTIVE DIVIDEND

There has never been any dispute that a transfer of property between commonly controlled corporations can result in constructive dividends to shareholders. There has been confusion in the application of the concept to specific circumstances.

In Knipe the Tax Court took the broad position that the exercise of power to transfer property to another corporation results in receipt of a constructive dividend. This case involved payment for purported services rendered by one corporation to the other. In fact, the recipient corporation furnished little or no services to the payor, and accordingly the transfer was found to have no valid business purpose. This transaction could have been attacked at the corporate level under Sec. 482, which provides the IRS with the right to reallocate income and deductions among commonly controlled corporations to prevent tax avoidance. Rather than raising this issue, the IRS in Knipe asserted that the common shareholders received constructive dividends as a result of exercising their power to effect a cash transfer between the corporations. The Tax Court agreed. However, the effect on, or taxation of, the two corporations was not dealt with in this case.

This broad approach was used in several other cases. For example, the District Court in Sammons charged the jury to find a constructive dividend if the taxpayer caused one corporation to distribute its income to another. This case involved sale of assets between related corporations for less than fair market value. Once again, the IRS could have used Sec. 482 to reallocate income between the corporations. Instead, the IRS argued that the transaction resulted in a constructive dividend to the controlling shareholder. The District Court agreed, and considered the transaction an indirect sale of assets to a shareholder in which dividend income must be reported. Exercise of the power to transfer assets between corporations resulted in a constructive dividend.

In Rushing, the Tax Court was faced with a loan between two commonly controlled corporations. This case differs from Knipe and Sammons because presence of a loan rather than a bargain transaction prevented the IRS from reallocating income between the corporations under Sec. 482. Although the Court found a valid business purpose for the debt, it stated it was not necessary "... to decide whether the advances were bona fide debt." The Court concluded the shareholder did not receive a constructive dividend because the test is whether the transaction was designed primarily to benefit the shareholder and not whether the taxpayer exercised the power to transfer assets as used in the prior cases. In this case the Court concluded direct shareholder benefit was not the transaction's purpose.

The Rushing requirement that the transaction be primarily for shareholder's direct benefit provides a much narrower rule for finding constructive dividends than the one contained in Knipe. The Court limits its conclusion even further by stating: "Since no direct benefit was received, we cannot properly hold Rushing received a constructive dividend."

Rushing differs from Knipe not only in holding but also in its facts. Knipe involved a transaction that could have been attacked at the corporate level under Sec. 482 while Rushing involved a general transfer between corporations and not a potential Sec. 482 situation. Therefore, Rushing is probably the better precedent. It also is the more limited holding as to constructive dividends.

THE TWO-PART TEST

The Fifth Circuit Court of Appeals adopted and expanded upon the rule from Rushing in Sammons. In Sammons, the Court examined transactions between both brother-sister and parent-subsidiary corporations, and provided a two-part test for determining constructive dividends. The first part is the distribution test. As stated by the Court: "Did the transfer cause funds or other property to leave control of the transferor corporation and did it allow stockholder to exercise control over such funds or property either directly or indirectly through some instrumentality other than the transferor corporation. This is an objective test. The second part is the purpose test. Was the transfer primarily for direct benefit of the shareholder rather than part of the normal business transactions of the corporations? This is a subjective intent test. This two-part test was used by the Tax Court in Gulf Oil Corporation in a case in which Sec. 482 could have been used. To the extent that the test in Gulf Oil is followed, the potential conflict between cases in which Sec. 482 could have been used (e.g., Knipe) and cases in which it could not (e.g., Rushing) is resolved.

This two-part test is superior to the prior analyses of constructive dividends. First, it distinguishes the actual transfer from the motive for the transfer. This eliminates the problem the District Court had, in Sammons, of having to define the transaction in terms of a distribution of earnings rather than a transfer of property. The District Court in Sammons followed the Knipe analysis. It concluded the taxpayer- shareholder exercised his power to distribute income from one corporation to another, and thus had the enjoyment and realization of that income. The income distribution occurred when the shareholder caused one corporation to sell assets to another commonly controlled corporation at a price substantially below fair market value of the assets.

BROTHER-SISTER VERSUS PARENT-SUBSIDIARY

Sammons helps explain the difference between brother-sister corporate transactions and parent-subsidiary transactions. In brother-sister transactions the distribution test is always met because the assets, after transfer, are controlled by the shareholders through a legally separate entity. In parent-subsidiary situations, the transfer of assets between corporations neither increases nor decreases shareholders' control over the assets. Therefore, all parent-subsidiary cases require a second transaction. The assets must leave the recipient corporation's control and come within control of the shareholder without adequate consideration before a constructive dividend is found.

THE ROLE OF BUSINESS PURPOSE

The Fifth Circuit Court of Appeals clarified the purpose test in Kuper. The purpose part consists of two separate tests. First, it requires the subjective determination that the transaction was designed primarily for the direct benefit of the shareholder. Second, it requires an objective determination that the shareholder received actual primary economic benefit from the transaction. The Court stated, "This objective facet of the Sammons, primary benefit test ... inevitably overlaps with the Sammons' objective distribution test. . . . " In Kuper, three shareholders with common control of two corporations contributed stock of one corporation to the other, thereby creating a parent-subsidiary group. The parent corporation made a capital contribution to its subsidiary immediately before it exchanged 100% of the subsidiary stock for 100% of one shareholder's interest in itself, the parent. After the transactions were completed, two of the shareholders owned one corporation and the third shareholder owned the other. The Court of Appeals agreed with the Tax Court's determination that this series of transactions was, in effect, a taxable stock exchange between shareholders, and that the transactions were designed primarily for the direct benefit of the shareholders. The transactions in Kuper would have allowed the shareholders to achieve a stock exchange without exchanging money and without incurring taxes. Although separation of disagreeing shareholders was a valid business purpose achieved by the Kuper transactions, the Court stated ". . . it is not the ultimate motivating factor which is in question but rather the intent behind the specific route by which the larger purpose was accomplished." Additionally, the Court of Appeals found a net distribution of funds from parent corporation had occurred, and the "funds came within the direct control of ... shareholders who used them for their own benefit as shareholders."

Subdividing the purpose test into two parts has allowed other Courts to appropriately analyze the role of business purpose. For example, the Tax Court has held that existence of a valid business purpose for the transaction will nullify a finding of primary benefit to shareholders. (2) In all cases in which there is a business purpose, benefit to the shareholder is derivative in nature. Therefore, a constructive dividend is not found.

The lack of a valid business purpose will not automatically result in the find of a constructive dividend. In Laure, a wholly owned corporation assumed the liabilities of another corporation owned by the same shareholder in a putative A" reorganization. The Tax Court found that the transaction was not a valid merger. It also found that there was no business purpose for assumption of the liabilities. The Court concluded, however, that the controlling shareholder of the two corporations should not be charged with receipt of a constructive dividend even absent a business purpose, because the shareholder did not receive a direct benefit from the transaction. The facts are somewhat distinctive in that transferor corporation was insolvent and the assumed debt was owed to the transferee. The basic theory, however, is generally applicable. For a controlling shareholder to be charged with a constructive dividend on an inter-company transfer, the shareholder must actually receive a direct benefit from the transfer. Absence of business purpose alone is an insufficient basis for finding a constructive dividend.

On appeal, the Sixth Circuit in this case found a valid business purpose for the transaction and reversed the Tax Court's decision. Even so, the Tax Court's opinion indicates the Court's position in those cases in which business purpose is absent, and is therefore helpful in planning.

The two recent cases, Morowitz and Mills, do not actually use previously developed rules to determine the tax consequences of the disputed transaction; however, both decisions imply an acceptance of the rules and are consistent with them. In both Morowitz and Mills the Courts looked for a valid business purpose and absence of a direct shareholder benefit in the intercorporate transfer. The Court in Morowitz stated that for a constructive dividend to be found in a transfer between brother-sister corporations, there must be a distribution of assets from one corporation to another. The distribution must result in shareholder's ability to exercise control over the assets other than through the transferor corporation. If this distribution has occurred, the Courts in both Morowitz and Mills stated the transaction must be analyzed to determine if it was undertaken primarily for direct benefit of the shareholder and if it resulted in a direct primary benefit to the shareholder. If these conditions are met, the shareholder should report a constructive dividend.

SPECIAL SITUATIONS

The rules for constructive dividends have been applied to several special situations that have amplified their conclusions. One situation involved transfers to pay loans guaranteed by the shareholder. In Wortham Machinery Co. a taxpayer caused one corporation he owned to issue stock in exchange for the assets and liabilities of another corporation he also owned. At the time of the transaction the transferor corporation was insolvent. The taxpayer reported the transaction as a "C" reorganization. Both the Tenth Circuit Court of Appeals and the District Court rejected this classification because the transaction lacked business purpose.

As part of the purported "C" reorganization transaction in Wortham, the transferee corporation paid debts of the transferor corporation guaranteed by the controlling shareholder. The question before the Court was whether these payments resulted in a constructive dividend to the controlling shareholder. Since the original transaction was not a reorganization, it is possible to view the debt payment as two transactions: first, a transfer from one corporation to another, and second, a payment by the recipient of a shareholder-guaranteed debt. When viewed this way, the transaction meets the distribution test for a constructive dividend. The lack of business purpose for the transfer and debt payment caused the transaction to meet the first half of the purpose test, i.e., a transaction entered into primarily for the shareholder's benefit. The only unanswered question was, "Did the shareholder receive an actual direct benefit?" The Court held that removal of the secondary liability under the guarantee was the requisite direct benefit and thus concluded that the shareholder received a constructive dividend.

It was easy for the Wortham Court to find a direct benefit to the shareholder because the corporation was insolvent. In Wilkof, the Tax Court found a constructive dividend even though the corporation was solvent and not in default. In Wilkof there was a transfer of funds, which taxpayers claimed was a loan from one corporation to its sister corporation. The sister corporation used the transferred funds to repay a bank loan, although, at the time, the lender made no indication "... that any principal payment was required or desired." Without the transferred funds, the sister corporation would have been unable to repay the loan at that time. The Court concluded the facts surrounding the transfer indicated it could not be considered bona fide indebtedness.

BENEFIT TO SHAREHOLDER

The Court next considered whether the transfer was designed to primarily benefit the shareholder. The Court found the taxpayers' investment in the transferee corporation was "strongly enhanced" by the transfer. Additionally, the transferee used the transferred funds to repay bank debt that was personally guaranteed by the taxpayers. The Court reasoned that removal of potential recourse to the shareholder's personal assets was sufficient direct benefit. The Court referred to its prior decision in Cox to support this conclusion. However, the Cox case involved an insolvent corporation. The decision in Wilkof contains no other references or discussion regarding the finding of direct shareholder benefit through the relief from potential recourse to shareholder assets. The decision in Wilkof is very broad and ignores the right of recourse the shareholders would have if they were required to pay debts of a solvent corporation.

In Schwartz the Tax Court appears to back off from Wilkof's broad decision. The case involved payment of shareholder guaranteed notes as part of a Chapter XI settlement. The Court's decision states: "Payments made by one corporation to satisfy a debt of another corporation personally guaranteed by a shareholder of the former can, under certain circumstances be sufficient benefit to the shareholder if the debtor corporation would otherwise default on its obligation" (emphasis added). The Court went on to find a business purpose for the transaction nullifying any constructive dividend.

This decision seems to require both a current or potential default on the debt as well as additional circumstances before a constructive dividend will result. The decision does not discuss what these other circumstances could be. If absence of a business purpose is such a circumstance then this decision is nothing more than a specific application of the general two-part rule. Based on prior Tax Court and Court of Appeal cases, except Wilkof where the corporate debtor was solvent, this would be the most appropriate interpretation as well as the most consistent.

A variation on the loan theme is presented in Stinnet's Pontiac Service, Inc. In this case, various transfers were made from one corporation to its sister corporation. The common shareholder, who owned 74% and 43% of the transferor and transferee corporations, respectively, agreed with the two other transferee corporation shareholders to contribute additional capital to the transferee to meet its pre- operating and operating needs. The transferee corporation never became profitable. The Tax Court found that no valid business debt existed.

In Stinnett's the transfer between corporations eliminated the shareholder's liability to contribute additional capital. The Tax Court found the existence of a constructive dividend. The Court applied the two-part test in arriving at this conclusion. This case, when added to prior loan cases, leads to the conclusion that the shareholder will be deemed to receive a direct benefit if the inter-corporate transfer eliminates a liability satisfiable from shareholder funds. The constructive dividend treatment will result even if shareholder's liability is contingent, provided the taxpayer does not have a real ability to recover the assets or a corporate business purpose for the transfer.

NATURE OF CONSTRUCTIVE DIVIDEND

The second special situation involves Sec. 482, which provides the IRS with authority to reallocate income, deductions, etc. among commonly controlled entities to prevent tax avoidance. In Rev. Rul. 69630 the IRS states that when an allocation is made under Sec. 482, the transaction is treated as a distribution to the common shareholder followed by a contribution by that shareholder to capital. In other words, the transferor corporation will be treated as having paid a constructive dividend and the transferee corporation as having received a non- deductible contribution from the common shareholder. Although this ruling involved a bargain sale, it was generally accepted that the recharacterization would apply to any Sec. 482 allocation. Care is advised however, as this conclusion may not hold up when put to the test.

PLR 8703004 involves the sale of a business for less than fair market value between commonly controlled entities as part of a corporate liquidation. The IRS ruled that Sec. 482 applies to this transaction, which was governed by old Sec. 337 that provided non-recognition of gain on sale of property during a corporate liquidation. Within the discussion, the Government stated a constructive dividend will generally result from a Sec. 482 allocation. The IRS also stated that this result can be avoided by showing a business purpose for the transaction.

A literal reading of this ruling would permit the taxpayer to avoid automatic dividend treatment in Sec. 482 cases; however, a closer reading of the opinion raises a question. If the taxpayer can prove a business purpose for the transaction and can show the corporation was the primary beneficiary, wouldn't the taxpayer avoid Sec. 482 entirely since Sec. 482 requires tax avoidance? If the answer is no, then questions as to what tax avoidance is, and how to prove it, arise. Until further clarification of the IRS's position is obtained, it is generally safe to assume that Sec. 482 reallocations between brother-sister corporations will result in constructive dividends.

UNANSWERED QUESTIONS

Two questions merit further consideration. First, what is the definition of control in the phrase "commonly controlled corporations"? Second, what is the type of income to be reported by the shareholder with ownership in two or more corporations?

CONTROL

For the IRS to find a constructive dividend from an inter-corporate transfer, there generally must be common control of both corporations. In Helvering v. Gordon, the Court stated, "The entire arrangement was made possible by the facts that the shareholder and spouse owned all the stock, and thereby dominated and controlled both the transferor and transferee corporations." Often the requisite control obviously exists. For example, in many cases either the taxpayer or the taxpayer and family own all the stock of both corporations, Beyond that however, the opinions rendered in constructive dividend cases have not addressed the definition of control or attribution rules that might be applicable in measuring control. When considering attribution of stock ownership among family members, it is safe to assume that if Sec. 267 would prohibit loss on sales between the individuals, then these individuals will be aggregated and treated as one for purposes of determining control.

In those cases in which the taxpayer does not own all the stock of both corporations, it is likely the IRS will use the definition from Reg. Sec. 1.482-1(a)(3):

The term "controlled" includes any kind of control, direct or indirect whether legally enforceable, and however exercisable or exercised. It is the reality of the control which is decisive, not its form or the mode of its exercise.

In other words, if the shareholder has the ability to affect the actions of the corporation, he or she controls it.

The use of the Sec. 482 definition is reasonable, given the number of cases that involve Sec. 482 transactions. However, the definition does lack a degree of specificity that would allow taxpayers to know the bounds of the term. To date this has not caused a great deal of trouble. Still, it would be helpful if the IRS would specify a definition for the term control.

CHARACTERIZATION OF INCOME

It has generally been assumed that if a common shareholder is required to report income resulting from an inter-corporate transfer, such income is classified as dividend income. This classification limits the amount of potential ordinary dividend income to the transferor corporation's earnings and profits and prevents the transferor corporation from taking a deduction under Sec. 162 for a trade or business expense. It is possible that the dividend characterization assumption is incorrect.

In Davis the Sixth Circuit Court of Appeals held that the shareholder was required to report as income the full amount of money diverted for personal use from his wholly owned corporation. The amount was not limited by the corporation's earnings and profits. In Benes, the Tax Court held that the taxpayer received income when a corporation expended funds to build a personal residence for him. The amount of income again was not limited by the corporation's earnings and profits. Both cases relied on Sec. 61, or its predecessor, as the basis for the total inclusion in income. Sec. 61 defines gross income as " . . . all income from whatever source derived...."

Although Davis and Benes involve transfers, direct and indirect, to a shareholder rather than to a related corporation, the IRS could potentially argue for unlimited ordinary income in cases involving intercorporate transfers based on Sec. 61 and Davis. If the IRS is successful, taxpayers would be precluded from limiting ordinary income to the corporation's earnings and profits. This conclusion would raise two interesting questions. First, since the transfer that conferred a benefit on the shareholder is not a dividend, is it earned income, portfolio income or passive income? The income is probably not portfolio income because it is not characterized as dividend income. Earned and passive income are the remaining alternatives. Most likely the IRS would rule the income is earned income to prevent offset by passive losses. That conclusion raises the second question. Can the corporation deduct the amount included in income by the shareholder? Usually the payor corporation is entitled to a deduction when the shareholder recipient reports earned income. This could result in a reduction in total tax liability by avoiding the double tax of dividends as well as shifting income into the lower individual tax bracket. It is not likely the IRS would propose this outcome, but it is possible for the shareholder- taxpayer to raise the issues.

The viability of this argument has declined recently. In Truesdell the Tax Court ruled that amounts diverted to a shareholder were dividends limited by earnings and profits. The Tax Court declared it will no longer follow its own decision in Benes. Specifically, the Court rejected the Sixth Circuit reasoning in Davis which was the basis of the Benes decision. Instead, the Tax Court decided to follow DiZenzo, a Second Circuit Case, and Simon, an Eighth Circuit Case. Both of these cases concluded that Sec. 301, which describes the tax treatment of a distribution of property "... made by a corporation to a shareholder with respect to its stock. . . " and Sec. 316, which defines dividends, limits and overrides Sec. 61. Sec. 61 formed the basis of the Davis decision.

There appears to be a split among the Circuits. The reasoning in Truesdell and the prior cases classifying the transaction as a dividend is the more persuasive. Future litigation is necessary to resolve this question and determine its relevance to the brother-sister corporation transfer transaction.

CONCLUSION

Transactions between brother-sister corporations can result in constructive dividends to the controlling shareholder. The two-part (distribution/purpose) test is the best theoretical determinant of the existence of a dividend. The first part or distribution test requires an actual transfer of funds by the corporation such that the corporation's shareholders can exercise control over funds they did not have before. The second part or purpose test actually contains two separate tests. The first sub-test requires a subjective determination that the intent of the transfer is primarily to benefit shareholders. A valid business purpose for the transfer nullifies this test. The second sub-test requires objective determination that the shareholders received a direct benefit from the transfer. A taxpayer can avoid a finding of constructive dividends by proving that the transfer did not meet either the distribution test or either subpart of the purpose test.

Even if the courts adopt this two- part test there are unanswered questions concerning when two corporations are commonly controlled and the type of income that the shareholder will report. Future litigation will be necessary to determine classification of the income.

FOOTNOTES

1. For a complete discussion of the various types of constructive dividends, see Bittker and Eustice Federal Income Taxation of Corporations and Shareholders, Fifth edition, Warren Gorham & Lamont, Para. 7.05.

2. See for example Rapid Electric Co. 61 TC 232 (1973) and Edward Wilkof TC Memo 1978-496.

Edward J. Schnee, PhD, CPA, is Professor of Accountancy and Director of Professional Programs in the Culverhouse School of Accountancy at The University of Alabama He is the author of articles on taxation that have been published in a number of periodicals.

Barbara J. Cortese, CPA, is a Senior Manager-Tax with KPMG Peat Marwick in Omaha, Nebraska