Paying Personal Expenses from Corporate Bank Account

Published Categorized as Business Tax, Tax
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Can you avoid paying tax by paying your personal expenses from your corporate bank account? Is avoiding tax that easy? No, our system doesn’t work that way. The Moacir Santos v. Commissioner, T.C. Memo. 2019-148 explains how the IRS handles these situations.

Facts & Procedural History

The taxpayer owns a engineering and paving company. It is taxed as a C corporation.

In 2010, the taxpayer used the business checking account for his personal expenses. He made cash withdrawals, electronic transfers to his personal bank account, and payments of his personal expenses.

He did not file his 2010 tax return, so the IRS prepared a substitute for return (SFR) for him. The taxpayer filed a petition with the U.S. Tax Court in response to the SFR.

During the tax litigation process, the taxpayer asserted that the income belonged to his C corporation and that he was entitled to additional offsetting expenses. The IRS agreed and argued that the amounts taken out of the company were “constructive dividends” and taxable to the taxpayer.

The court was tasked with determining whether the taxpayer received constructive dividends.

About Constructive Dividends

Constructive dividends usually only come up in cases like this. They are amounts taken out of a C corporation for the personal benefit of the shareholder. They are amounts the IRS identifies as being corporate earnings taken out of a C corporation for the shareholder’s personal benefit.

The court describes constructive dividends as follows:

A constructive dividend arises ‘[w]here a corporation confers an economic benefit on a shareholder without the expectation of repayment, * * * even though neither the corporation nor the shareholder intended a dividend.’

C corporations pay their own tax separate from the shareholder. This corporate level tax is currently set at a flat 21% rate. Amounts taken out by the shareholder that are not wages (and deductible as wages by the corporation) or as loans to the shareholder are generally treated as dividends. At least that is often the IRS’s view.

Dividends are not deductible to the corporation (leaving more income subject to the corporate level tax) and are taxable as income to the shareholder personally. They are taxed to the shareholder at ordinary tax rates (which are currently in excess of 35%). This double tax increases the amount owed to the IRS, which is why this issue is frequently raised by IRS agents on audit.

Details Matter for Constructive Dividends

But not all amounts transferred to the taxpayer are constructive dividends. As noted by the court, to be a constructive dividend:

only if (1) the expenditures do not give rise to a deduction on behalf of the corporation, and (2) the expenditures create ‘economic gain, benefit, or income to the owner-taxpayer.’

The payments also have to be out of the corporate earnings in excess of profits. This means that the corporation has to have profits.

Courts have allowed some transfers to the shareholder to escape constructive dividend treatment using these rules.

No Deduction for the Corporation

Applying these rules in this case, the court had little difficulty in finding that the deposits into the taxpayer’s personal accounts were constructive dividends. The taxpayer admitted that they were personal expenses–which are not deductible by the corporation.

The court also considered the business expenses the taxpayer identified. The taxpayer provided the IRS and court with receipts in excess of the amount of expenses he identified.

The court took issue with the receipts:

It appears that he fabricated the receipts before he settled on his final story and did not notice the discrepancy. … Mr. Santos’s testimony about the authenticity of the receipts was vague and inconsistent, and the receipts raised many more questions than they answered. Rather than substantiating a deductible business purpose for the cash withdrawals, these manifestly bogus receipts revealed a deceptive intention and showed that the actual purpose of the cash withdrawals was other than
 the false proffered business purpose.

The result was that the court found the additional amounts were not deductible for the corporation.

Dividends Paid out of Corporate Profits

Dividends are those paid out of earnings in excess of expenses. They are the corporate profits. This includes current year profits or prior year profits that were retained.

In this case, the IRS prepared two calculations for the corporate profits for 2010. The calculations were based on the corporations 2010 profit and loss statement and the Schedule C, adjusted for various items.

The taxpayer could have hired a tax attorney (such as our Sugar Land tax attorneys) to prepare his own tax calculations. But he didn’t. The taxpayer didn’t present any evidence to rebut the IRS’s numbers. Thus, the court concluded that the distributions were constructive dividends paid out of the corporate profits.

Avoiding Constructive Dividends

The takeaway for those with corporate entities have to be careful about paying personal expenses. To do so, the corporation may need to adopt employee benefit plans. These plans are allowed by the code. With advance tax planning, the taxpayer may be able to avoid a situation where they are subject to the IRS’s constructive dividend arguments.