The IRS closely scrutinizes all related party transactions. In addition to verifying that the items involved are stated at fair market value, it checks to make sure the transaction is properly classified. Recently, the Tax Court considered the correct classification of a corporation/shareholder transaction.
Lenward Hood created Hood’s Institutional Foods (HIF) in 1978 as a sole proprietorship. In 1988 he incorporated the business and became the sole shareholder and principal employee. In 1990 Hood was indicted for criminal tax evasion with respect to HIF’s income before its incorporation. He was acquitted on all counts in 1991. The corporation paid—and deducted—$103,188 for Hood’s legal fees. The IRS denied the deduction and reclassified the payment as a constructive dividend to Hood. He appealed.
Result. For the IRS. Hood argued that HIF was entitled to the deduction based on the Tax Court’s decision in Jack’s Maintenance Contractors, TC Memo 1981-349. In that case—on almost identical facts—the court held that the corporation could deduct the legal fees it paid for an indispensable shareholder-employee based on Lohrke, 48 TC 679. In Lohrke, the court held that one taxpayer can deduct the expenses of another if it can show the expenditure was necessary to assure its continuation as a business. The IRS argued the expenditure was a constructive dividend based on the Fifth Circuit Court of Appeals reversal of the Tax Court decision in Jack’s.
The Tax Court decided to follow the Fifth Circuit decision rather than its own prior decision because, at the time, it had failed to properly evaluate the possibility of a constructive dividend in Jack’s. If a corporation pays a shareholder’s expenses, the payment first must be examined for constructive dividend treatment. If the shareholder is the primary beneficiary of the payment, as was so in this case, the IRS will reclassify it as a constructive dividend and deny the corporation a deduction.
Even if the expenditure is not a constructive dividend, it will be deductible only if the taxpayer can prove it is an ordinary and necessary expense. In other words, the expenditure must be necessary to protect or promote the payer’s business. According to the Fifth Circuit—and now the Tax Court—paying a shareholder’s medical or legal expenses is never necessary for a corporation’s survival—even if the shareholder performs critical services. Therefore the corporation cannot deduct them. Applying these rules to the current case, the shareholder must report as income a constructive dividend equal to the legal fees paid and the corporation is not permitted to deduct or capitalize the expenditure.
Lohrke is easily distinguishable from the current case. In Lohrke it was the shareholder who paid corporate expenses when the corporation was insolvent and unable to pay the amounts due. As a result of the decision in Hood, taxpayers will find it more difficult to claim a corporate deduction for any shareholder expenses. On the other hand, a shareholder may be able to deduct corporate expenses if the corporation is insolvent and he or she can prove the payment is necessary to continue the business.
Lenward C. Hood v. Commissioner, 115 TC no. 14.