Mr. & Mrs. Tyson operate a painting business and a Shaklee distributorship out of RS Tyson, a C-corporation. The Tysons each owned 50% of the Corporation's outstanding shares.
During 2003, RS Tyson deducted rent expense, employee benefit expense, laundry expenses, travel, meals and entertainment, and automobile expenses. The IRS disallowed all deductions, and the Tax Court agreed.
RS Tyson paid $24,000 in rent expense to the Tysons for use of their home in carrying on the Shaklee distributorship. The Tysons reported rental income on their Schedule E. The amount of rent was based on the number of hours per month RS Tyson would use the Tyson's home, times an amount per hour charged by local hotels for meeting space.
The Tax Court disregards the rent agreement because it was not an arm’s-length agreement, it lacked economic substance, and the monthly rental amount was little more than a guess.
Employee Benefit Expense
RS Tyson deducted $8,919 for employee benefit expenses, e.g. health insurance, paid on behalf of Mr. & Mrs. Tyson. Unfortunately, there was no proof that Mr. & Mrs. Tyson were employees of RS Tyson. During 2003, the Company did not pay any wages to either Mr. or Mrs. Tyson, there were no employee agreements, and RS Tyson reported no officer compensation on its tax return. Accordingly, the deduction for employee benefit expenses was denied.
The Tax Court denied almost all of RS Tyson’s laundry, travel, meals and entertainment, and auto expenses because there were no adequate records substantiating the amounts or the business purpose.
Because RS Tyson’s expenses were disallowed, and the expenses were paid to or on behalf of Mr. and Mrs. Tyson, the payments are considered constructive dividends to the Tysons.
Generally, where a shareholder diverts corporate funds to his own use, those funds constitute constructive dividends to him and are ordinary income to the extent of the corporation’s earnings and profits. Where a corporation provides an economic benefit to a shareholder with no expectation of reimbursement, the benefit is a ‘constructive dividend’ and is taxable income.
Consequently, RS Tyson’s deductions are disallowed, and Mr. & Mrs. Tyson have dividend income.
The Tax Court makes note that the Tysons did not call their tax preparer as a witness at trial. Accordingly, the Court can infer the preparer’s testimony would have been unfavorable. Pro se taxpayers, and attorneys, should be aware of this inference in proceedings before the Tax Court.
The transactions entered into between RS Tyson and their shareholders make very little sense. The Tysons would be much better off simply taking a home office deduction rather than concocting a rental agreement. In the case of the disregarded rental agreement, RS Tyson has income, via disallowed expenses, taxed at corporate rates, and the Tysons have dividend income taxed at prevailing dividend tax rates. Because the rental agreement is disallowed, the Tysons end up paying two taxes: the first is the corporate tax paid by RS Tyson, the second is the dividend tax paid on the constructive dividends.
The real problem here is that RS Tyson is a C-corporation. As such, RS Tyson pays taxes on its income at corporate tax rates. Then, when RS Tyson pays dividends, Mr. & Mrs. Tyson have dividend income taxed at the then prevailing dividend tax rates. This is referred to as double-taxation associated with C-corporations, which is why very few small businesses operate as C-corporations. In fact, most large businesses do not operate as C-corporations.
My advice to the Tysons would be to convert their C-corporation to an S-corporation. This would avoid the dividend tax, and allow them to take tax-free distributions. Of course, they would have to start paying themselves a reasonable salary and they would be taxed on the S-corporation’s net income each year. But this is a more sensible way to run their businesses.