Category: Corporations
Subject: Constructive Dividends
Title: Divorcing Couple Selling Closely-Held C Corporation
IRC Sections: 301
Filename: 1065.html
Date Produced: 9/97

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Background
Taxpayer is a 50% shareholder of a closely-held C corporation. Taxpayer's husband owns the remaining 50%. The corporation was recently valued at $800,000. Taxpayer and spouse are getting a divorce. Taxpayer will buy the stock owned by her spouse for $123,400. In addition, the corporation will pay the husband $150,000 in severance pay and $165,000 for a non-compete agreement.

Comments
It seems very strongly to me that the situation described above is quite vulnerable to attack on the grounds that the non-compete and the severance amounts represent corporate payments to settle the Taxpayer's marital obligation to her former spouse. As such, these amounts would not be deductible by the corporation and instead be treated as constructive dividends to the Taxpayer.

As I understand it, the parties commissioned an appraisal of the corporate stock in connection with the divorce. I understand also that as part to the divorce negotiations, the husband argued his stock is worth even more than $400,000.

Since the earliest days of our income tax laws, the courts have repeatedly held that it is the substance rather than the form of a transaction that controls its tax consequences. It is clear that the IRS has ample authority to look through the various formalities and labels a taxpayer might create in arranging a transaction and determine the tax consequences based on economic realities, ignoring whatever artifices the taxpayer may have created to achieve a different result. See, for example, Gregory v. Helvering, 293 U.S. 465, 35-1 USTC ¶9043; Commissioner v. Court Holding Co., 324 U.S. 331, 45-1 USTC ¶9215; Commissioner v. Tower, 327 U.S. 280, 291, 46-1 USTC ¶9189. Helvering v. Lazarus & Co., 308 U.S. 252, 255, 39-2 USTC ¶9793.

With closely-held corporations, it is often necessary to determine whether a corporate expenditure is for the benefit of the corporation or for the shareholder. If a corporate taxpayer fails to bear the burden of proving that a corporate expenditure is for corporate rather than shareholder benefit, then the expenditure is treated as a constructive dividend to the shareholder rather than a deductible corporate expenditure. See, for example, Old Colony Trust Co. v. CIR, 279 US 716 (1929); Herbert Enoch, 57 TC 781 (1972) (acq. and nonacq.) (constructive dividend where corporation discharged shareholder's personal liability on debt; shareholder, rather than corporation, was true borrower; Joseph Creel, 72 TC 1173 (1979) (where corporation borrowed from third party in order to lend to shareholder without interest, corporate interest payments were constructive distributions), aff'd on other grounds sub nom. Martin v. CIR, 649 F2d 1133 (5th Cir. 1981). Compare Falkoff v. US, 604 F2d 1045 (7th Cir. 1979). See also Rev. Rul. 75-421, 1975-2 CB 108 (corporate payment of shareholder's expenses for financial and accounting services to determine value of shareholder's stock in pending reorganization exchange was held to be taxable dividend); Dolese v. US, 605 F2d 1146 (10th Cir. 1979), cert. denied, 445 US 961 (1980) (payment of costs of shareholder's divorce litigation was partly personal, and hence a dividend, and partly for corporate business purpose); Tennessee Sec., Inc. v. CIR, 674 F2d 570 (6th Cir. 1982) (corporation's payment of shareholders' personal guaranty liability held to be constructive dividend to shareholder-guarantors); and Gulf Oil Corp., 89 TC 1010 (1987), aff'd, 914 F2d 396 (3d Cir. 1990) (payments were for payor corporation's benefit, and so no dividend).

Bearing in mind that deductions are a matter of legislative grace and that taxpayers bear the burden of proving their entitlement to them, the corporation would, in order to sustain the deductibility of the amounts paid for the non-compete agreement and the severance package, bear the burden of proving the following:

A) there is no connection between the corporate payments and the fact that the Taxpayer's husband accepted $123,400 for stock worth $400,000 (in essence the non-compete and the severance payments were made purely for corporate purposes);

B) the severance payment are reasonable in relation to the services the husband provided;

C) the risk of having the husband open a competing business is significant enough to warrant such a payment for a non-compete agreement (even in light of the fact that the business functions principally from the Taxpayer's, not the husband's,x business connections and contacts); and

B) it is mere coincidence that as part of the very same agreement dealing with the stock purchase, the husband was awarded sums from the corporation aggregating $315,000, roughly the difference between the fair market value of the stock and the amount the husband accepted for it.

I find it rather difficult imagine that the corporation could successfully bear its factual burden if the IRS or a court were in possession of the divorce agreement and knowledge of the stock appraisal. I think the inference that the non-compete and the severance package were quid pro quo for the lower stock price is so strong and so obvious as to be virtually insurmountable.

Regarding deductions as a matter of legislative grace and the taxpayer's burden of proof, see Deputy v. Du Pont [40-1 USTC ¶9161], 308 U.S. 488 (1940); New Colonial Ice Co. v. Helvering [4 USTC¶1292], 292 U.S. 435; (1934); Welch v. Helvering [3 USTC ¶1164], 290 U.S. 111 (1933);