It’s very tempting for contractors to divert materials from their business to, say, build a new addition. The business deducts the cost of the materials, and the IRS helps to subsidize the bigger house. The IRS caught up to this sort of fraud long ago, and its audit programs look for it.
Mr. Welle, a North Dakota contractor, went about things the right way. When he used materials from his C corporation, TWC, to build a lake home, he kept careful records and repaid the corporation out of his own funds for the actual costs of the materials.
That didn’t satisfy the IRS. They said that the corporation should have marked up the materials by its customary 6% margin, and they assessed the owner taxes on a “constructive dividend” for the foregone markup.
Constructive dividends are an old feature of C corporation tax law. Taxpayers often try to get things from corporations in funky ways to avoid incurring taxable dividends. Things that can trigger constructive dividends can include use of corporate property, excessive compensation, and excessive rents, among other things. But this is the first case I know of where the IRS said that failure to take a markup on goods sold to an owner triggered a dividend.
And with luck, it might be the last. The Tax Court yesterday wasn’t buying the IRS argument:
The most that can be said about Mr. Welle’s use of TWC is that he used the corporation as a conduit in paying subcontractors and vendors and that he obtained some limited services from corporate employees. Mr. Welle fully reimbursed the corporation for all costs, including overhead, associated with those services, and TWC did not divert actual value otherwise available to it by failing to apply its customary profit margin in determining the amount Mr. Welle had to reimburse the corporation. We therefore conclude that this arrangement did not operate as a vehicle for the distribution of TWC’s current or accumulated earnings and profits within the meaning of section 316(a).
Even though the IRS was making an unprecedented (and losing) argument, it also asserted that the taxpayer should pay an “accuracy-related penalty” on the asserted deficiency for not anticipating this novel IRS argument. This is one more data point in favor of my “sauce for the gander” plan for IRS penalties, where the IRS is subject to the same penalties for unsupportable audit positions as taxpayers, with the penalties payable to the winning taxpayer.
Cite: Welle, 140 TC No. 19