To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that’s helpful and appropriate for your business.
No Deduction for Dividends

Beyond Personal Expenses

Constructive dividends can come in many shapes and sizes. The most common example is when a shareholder mistakenly tries to claim personal expenses — such as medical, vehicle or housing costs — as business expenses. Other types of related-party transactions that the IRS may reclassify as constructive dividends include:

• An excessive payment for corporate use of a shareholder’s personal property, such as rental payments for the company’s office or warehouse space,
• A purchase or lease by a shareholder of company property at a price that’s significantly below fair market value,
• A purchase or lease by the company of a shareholder’s property at a price that far exceeds fair market value,
• Excessive compensation paid to shareholders or their family members,
• Use of company-owned vehicles and other company property by shareholders (or their family members) without paying fair market value, and
• A corporate loan (often at a below-market interest rate) made to a shareholder to fund personal items, where there’s no reasonable expectation of repayment.

The IRS sometimes challenges deductions claimed for certain types of business expenses. In doing so, an examiner might claim that payments made by a corporation to a shareholder for personal items or that are above or below fair market value constitute “constructive dividends.” Reclassifying business expenses as dividends has adverse tax consequences, as a recent case demonstrates.

Typically, a successful corporation pays out dividends to its shareholders, based on earnings for the year. The exact amount of dividends a shareholder receives depends on his or her proportionate share in the company. These dividends are declared by the company on a specified date and then paid out in cash or reinvested in more shares for the shareholder.

However, a corporation may make other payments to one or more shareholders, which the IRS might classify as “constructive dividends.” This often happens when owners of a closely held business use corporate funds to pay personal expenses. But it can also occur at multibillion-dollar conglomerates, and it may involve more than just running personal expenses through the business. (See “Beyond Personal Expenses” at right.)

The crux of the matter is: Owning all (or part) of a company doesn’t give you the unrestricted right to pay and record expenses in the manner in which you see fit. Notably, there are tax rules and restrictions that must be followed.

Tax Consequences

From an income tax perspective, dividends paid out by corporations are taxable to shareholders at the personal level. Qualified dividends received by a C corporation shareholder are taxable at the same preferential tax rates as long-term capital gains. Currently, the maximum tax rate for qualified dividends is 15% (20% if you’re in the top ordinary income tax bracket).

On the downside, dividends can’t be deducted by the corporation. So, dividends are paid using after-tax dollars, meaning they’re effectively taxed twice.

Compensation and most other types of payment (such as consulting or management fees) are taxable to shareholders at ordinary income tax rates. However, these legitimate expenses are usually fully deductible by the company (unless they aren’t at arm’s length). As a result, depending on its circumstances, a corporation may try to disguise dividends as compensation or some other type of payment.

This is where the IRS could jump into the fray. If it treats a payment as a constructive dividend, the business deduction the corporation tried to claim for that payment (for example, a compensation deduction) is disallowed, thereby increasing its tax liability. Furthermore, the IRS may impose penalties and interest for tax underpayments. And, if the company’s owners purposely evaded their tax responsibilities, they may face criminal sanctions.

For the shareholders, constructive dividends are taxable as ordinary income. However, unlike compensation, a dividend payment isn’t subject to payroll taxes. Therefore, the overall tax results for shareholders will vary.

Case in Point

The IRS is likely to step in if it perceives that a company is paying personal expenses on behalf of shareholders. That was the main issue presented to the U.S. Tax Court in a recent case. (Luczaj & Associates v. Commissioner, T.C. Memo 2017-42, March 8, 2017)

The taxpayers, a married couple residing in California, owned a C corporation. The husband held 51% of the stock, and the wife owned 49%. The wife was the company’s sole employee during the tax years in question, while the husband worked full-time as a high school adult transition coordinator, supervising and teaching special needs students.

The corporation was engaged in the business of originating home mortgages, acting as an independent contractor for California Mortgage Group (CMG). Its main function was to solicit clients for CMG. After the company referred clients to CMG, those individuals were offered loans to help purchase homes.

The wife’s sole responsibility was client recruitment for CMG. She had a desk in CMG’s main office in California, where she worked at least two days a week. She testified at trial that she worked from home the rest of the week and typically met clients at home or in a public place.

For 2012 and 2013, the corporation claimed deductions for a wide variety of expenses, including travel and entertainment, insurance, telephone, advertising, gifts, medical expenses, utilities and maintenance, depreciation, and dues and subscriptions. Some of these expenses included repairs to the couple’s personal residences, swimming pool costs and personal entertainment expenditures.

The IRS contested most of the reported business expenses due to lack of substantiation or lack of business purpose. It argued that the payments constituted constructive dividends to the shareholders. Finally, the IRS imposed accuracy-related penalties for the tax years in question.

The Tax Court agreed with the IRS. The court determined that many of the expenses that were claimed as marketing and promotional expenses were actually payments of personal expenses that directly benefited the shareholders. For instance, the wife claimed 100% business use of two vehicles, but didn’t follow IRS procedures for documenting business use. The court also ruled that payments may be treated as constructive dividends without the corporation making a formal declaration of dividends.

The Bottom Line

It’s easy to run afoul of the IRS on this issue. So, businesses always should keep detailed, contemporaneous records to support deductions and other tax positions, especially when it comes to transactions with related parties.

The IRS generally won’t, for example, treat a payment as a constructive dividend if the company can demonstrate that it lacked sufficient earnings to pay dividends or that a payment was, in fact, used to pay ordinary and necessary business expenses, rather than personal expenses.

In some instances, expenses may fall into a “gray area” where you’re unsure of the appropriate tax treatment. If you have questions or concerns about your situation, ask your professional tax advisor for help.

If you agree to a contingent-fee arrangement with your attorney, you may wonder whether the expense is deductible for federal income tax purposes. Unfortunately, the guidance on this controversial issue isn’t favorable to taxpayers in most situations.

Beyond Taxable Recoveries to Individuals

The main article focuses on contingent fees related to taxable judgments or settlements collected by individual claimants in cases that aren’t business-related. Here’s an overview of the rules that apply to contingent fees for other types of recoveries.

Nontaxable Awards

An injured party can’t deduct attorneys’ fees incurred to collect a tax-free judgment or settlement, including a court-awarded recovery for a physical injury or sickness. In other words, no deductions are allowed for fees to collect tax-free compensation.

Punitive Damages

As a general rule, payments for punitive damages — which are designed specifically to punish the wrongdoer — and payments of interest are taxable even if they’re paid as part of the compensation for physical injuries or sickness. Therefore, contingent attorneys’ fees allocable to the collection of punitive damages or interest will be treated as miscellaneous itemized deductions. (See main article.)

Business-Related Payments

In cases involving business-related judgments or settlements, taxpayers are allowed to deduct all ordinary and necessary expenses incurred in carrying on an active business. Legal expenses constitute such ordinary and necessary expenses when they arise from an active business venture.

However, fees to acquire a business asset, such as real estate or a patent, must be capitalized as part of the cost of acquiring the asset and then depreciated or amortized. Finally, legal expenses incurred in connection with the business of being an employee are treated as miscellaneous itemized deductions, which can be unfavorable for the taxpayer. (See main article.)

Non-Contingent Attorneys’ Fees

In general, attorneys’ fees that aren’t contingent on the outcome of a case are treated in the same fashion as contingent fees. For example, non-contingent fees paid to collect a taxable non-business judgment or settlement would be treated as miscellaneous itemized deductions unless the above-the-line exception applies. (See main article.) And non-contingent fees paid to collect a tax-free judgment or settlement wouldn’t be deductible.

The federal income tax treatment of contingent fees paid to an attorney out of a taxable non-business judgment or settlement has been a source of confusion. Here’s an overview of the outcome of litigation between individual taxpayers and the IRS, along with a taxpayer-friendly exception to the general rule.

History Lesson

Some court decisions have concluded that an individual claimant must:

1. Include 100% of the taxable portion of a legal judgment or settlement in gross income, and
2. Treat the related contingent attorneys’ fee as a miscellaneous itemized deduction.

Taxpayers don’t generally favor this treatment, because miscellaneous itemized deductions are subject to a 2%-of-adjusted-gross-income threshold under the regular federal income tax rules. Additional miscellaneous itemized deductions are completely disallowed under the alternative minimum tax (AMT) rules. So, the actual allowable write-off for contingent fees is significantly reduced or maybe even completely disallowed if the taxpayer is subject to AMT.

Instead, taxpayers favor other court decisions that exclude contingent fees from the claimant’s gross income, because the fees are considered “owned” by the attorney rather than the claimant. This reasoning is consistent with the fact that the claimant never takes possession of the cash; rather, contingent fees go straight to the attorney.

Supreme Court Decision

Which treatment is correct: treating the fees as a miscellaneous itemized deduction or excluding them from gross income? The Supreme Court addressed this question in 2005, ruling that an individual taxpayer must include in gross income the portion of a taxable judgment or settlement that goes to the taxpayer’s attorney under a contingent-fee arrangement. (Commissioner v. Banks, II, 95 AFTR 2d 2005-659, Supreme Court 2005)

The decision was based on the Supreme Court’s review of Banks (a Sixth Circuit Court of Appeals decision) and Banaitis (a Ninth Circuit Court of Appeal decision). In both of those decisions, the appellate courts had reversed the U.S. Tax Court, concluding that the taxpayers could exclude from gross income amounts paid to their attorneys under contingent-fee arrangements.

The Supreme Court disagreed with these reversals, however. The Court ruled that, even though the value of taxpayers’ legal claims are speculative at the time they enter into a contingent-fee arrangement with an attorney, that factor doesn’t cause the arrangement to be properly characterized for tax purposes as a partnership or joint venture between taxpayer and attorney.

The Court concluded that the attorney-client relationship is more properly characterized as a principal-agent relationship. As such, the taxpayer (the principal) must include the entire taxable amount earned from the legal action in gross income and then hope to be able to claim a deduction for contingent fees paid to the attorney (the agent).

In essence, the Supreme Court’s decision reaffirmed one of the oldest principles in federal income taxation: A taxpayer can’t assign taxable income to someone else, even though the attempt to do so may occur before the income is actually earned. Instead, taxpayers must include the income on their return when it’s earned, and then hope to be able to deduct amounts that go to other parties (such as contingent fees paid to attorneys).

Taxpayer-Friendly Exception

The Supreme Court’s decision seems to close the door on any argument that contingent attorneys’ fees paid out of a taxable non-business judgment or settlement can be excluded from a claimant’s gross income. But Congress provided an exception that basically amounts to the same thing for certain taxpayers.

Specifically, the Internal Revenue Code permits an above-the-line deduction for attorneys’ fees and court costs paid in legal actions involving:

• Certain claims of unlawful discrimination,
• Certain claims against the federal government, and
• Private causes of action under the Medicare Secondary Payer statute.

Treating the expense as an above-the-line deduction means you don’t need to itemize deductions on your tax return to benefit. Under this treatment, contingent attorneys’ fees are effectively subtracted from taxable income on your return, so you don’t have to pay tax on money that went to your attorney. The Internal Revenue Code provides a list of legal actions that are defined to be for unlawful discrimination, including, but not limited to, claims of violations of:

• The Civil Rights Acts of 1964 and 1991,
• The Congressional Accountability Act of 1995,
• The National Labor Relations Act,
• The Family and Medical Leave Act of 1993,
• The Fair Housing Act,
• The Americans with Disabilities Act of 1990, and
• Various whistleblower statutes.

Important note: Above-the-line deduction treatment for qualifying contingent legal fees and related costs effectively allows you to directly subtract these expenses from the amount of the judgment or settlement that you claim. So, you pay taxes on only the amount you keep.

For More Information

Determining the proper tax treatment of an individual’s attorneys’ fees can be tricky. Your tax advisor can figure out the right answer. Get your advisor involved early in litigation, because he or she might be able to help you achieve a more tax-favorable result by planning ahead.

The U.S. Tax Court recently ruled that federal law doesn’t prohibit an employer looking to reduce its tax liability on misclassified workers from receiving information on whether the workers paid tax on the income.

Background

Businesses often prefer to treat workers as independent contractors to lower their costs and administrative burdens. But the IRS may challenge an employer’s classification. If an employer erroneously treats an employee as an independent contractor, the IRS may reclassify the worker. The employer could owe unpaid employment taxes, as well as interest and penalties, and may also be liable for employee benefits that should have been provided but were not. So, it’s important to get worker classification questions right.

Facts of the Recent Case

As part of an audit, the IRS reclassified many of the independent contractors in a New Mexico Native American tribe as employees. The tribe sought to avail itself of the relief provided in the Internal Revenue Code, which allows an employer who fails to deduct and withhold the tax on wages to escape tax liability if it can show that the workers paid income tax on their earnings.

To gather this information, the tribe asked each worker to complete IRS Form 4669 “Statement of Payments Received,” but it didn’t get the form back from many former workers who had moved, and from other workers who lived in hard-to-reach areas.

The tribe filed a lawsuit against the IRS asking the tax agency to provide information about whether 70 workers had reported the income on their personal income tax returns and paid their tax liabilities. If so, the IRS would have to reduce the tribe’s liability for failing to collect and pay withholding tax on the income.

The Law

The tax code provides a general rule that returns and return information should be kept confidential. The term “return information” includes the amount of an individual’s tax payments. The IRS argued that the tax code prohibits the disclosure of information on the workers’ income to the tribe.

There are, however, a number of exceptions to the general rule. One of those exceptions, states that: “A return or return information may be disclosed in a Federal or State judicial or administrative proceeding pertaining to tax administration, but only…(B) if the treatment of an item reflected on such return is directly related to the resolution of an issue in the proceeding; [or] (C) if such return or return information directly relates to a transactional relationship between a person who is a party to the proceeding and the taxpayer which directly affects the resolution of an issue in the proceeding.”

The Court’s Ruling

The Tax Court concluded that the tax code did permit the disclosure of the tax return information requested by the tribe. It analyzed the code in pieces. First it asked: “What is a transaction relationship?” The court stated that to “transact” means simply “to carry on business.” Citing a large number of cases that looked at that question, it added that the wide variety of business relationships that other courts have held are transactional relationships led it to hold that the relationship between an employer and his worker is one that pertains to the carrying on of a business.

Second, the court asked whether the return information that the tribe was asking for “directly relate[d]” to this relationship. The court concluded that it did since whether the tribe’s workers paid their tax liabilities in full is likely to show whether the workers considered themselves to be independent contractors or employees, and thus directly related to the workers’ relationship with the tribe.

Finally, as to the issue of whether the return information affected the resolution of an issue in the proceeding, the court stated that it did. “If the Tribe’s workers did indeed pay their tax liabilities, then the Tribe’s Code Sec. 3402(d) defense would be proved and would be entirely resolved,” it explained. (Mescalero Apache Tribe, 148 TC No. 11, 4/5/17)

The Implications

The court’s ruling could have wide-reaching effect because it can be difficult for businesses to obtain a signed Form 4669 from a worker because:

IRS audits often take place years after the relevant payroll tax returns are filed,
A business may have high turnover and not be able to locate workers, and
Even if a business does locate workers, they may not want to fill out the IRS forms — especially if they no longer work for the business.
Therefore, this court ruling could often make the difference between the business being forced to pay the withholding tax even when the worker has already paid the corresponding income tax, and the business not having to make that payment. If your business is involved in a payroll audit, your tax professional may request that the IRS provide information on the workers’ relevant tax payments. This court ruling can be used as support for this request.