Academic journal article Journal of Accountancy

Corporate Payment of Shareholder Expenses

Academic journal article Journal of Accountancy

Corporate Payment of Shareholder Expenses

Article excerpt

The IRS closely scrutinizes all related party transactions. In addition to verifying that the items involved are stated at fair market value, it checks to make sure the transaction is properly classified. Recently, the Tax Court considered the correct classification of a corporation/shareholder transaction.

Lenward Hood created Hood's Institutional Foods (HIF) in 1978 as a sole proprietorship. In 1988 he incorporated the business and became the sole shareholder and principal employee. In 1990 Hood was indicted for criminal tax evasion with respect to HIF's income before its incorporation. He was acquitted on all counts in 1991. The corporation paid--and deducted--$103,188 for Hood's legal fees. The IRS denied the deduction and reclassified the payment as a constructive dividend to Hood. He appealed.

Result. For the IRS. Hood argued that HIF was entitled to the deduction based on the Tax Court's decision in Jack's Maintenance Contractors, TC Memo 1981-349. In that case--on almost identical facts--the court held that the corporation could deduct the legal fees it paid for an indispensable shareholder-employee based on Lohrke, 48 TC 679. In Lohrke, the court held that one taxpayer can deduct the expenses of another if it can show the expenditure was necessary to assure its continuation as a business. The IRS argued the expenditure was a constructive dividend based on the Fifth Circuit Court of Appeals reversal of the Tax Court decision in Jack's.

The Tax Court decided to follow the Fifth Circuit decision rather than its own prior decision because, at the time, it had failed to properly evaluate the possibility of a constructive dividend in Jack's. If a corporation pays a shareholder's expenses, the payment first must be examined for constructive dividend treatment. …

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