taxation law services

IRS Audit and the Constructive Dividends Trap

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Do you own or work for a closely-held corporation? Do you make frequent payments between your small C corporation and your shareholders? Then you should be especially careful about the constructive dividend rules. Under these rules, the IRS can deem certain payments made to or on behalf of its shareholders as dividends, even though they have not been officially declared as dividends. In such cases, both the corporation and the shareholder may face steep additional tax liabilities, as well as significant penalties and interest on the resulting liabilities.

This article will explain the basics of constructive dividends. It is not intended to constitute tax or legal advice.

Corporate taxation can involve many complex tax and legal issues, so it may be advisable to seek an experienced attorney in these matters. Failure to do proper tax planning can result in significant adverse tax consequences. Sherayzen Law Office, Ltd. can assist you in all of your tax and legal needs, and help you avoid making costly mistakes.

Constructive Dividends

In general, a constructive dividend can be any type of economic benefit made to the shareholders by a corporation without an expectation of repayment that represents an undeclared dividend. If the economic benefits were primarily of a personal nature rather than business–related interests to the corporation, they will likely be treated as constructive dividends. Constructive dividends, as with declared dividends, can thus be distributions of cash and/or property as well as other types of payments that provide an economic benefit to the shareholder(s).

Because of the greater potential for self-dealing in closely-held and family-owned small corporations, the IRS is especially vigilant when it comes to possible constructive dividend situations in such entities. Shareholder-owners will often run afoul of tax laws if they attempt to have the corporation make payments for their personal, non-corporate related expenses, of if they try to distribute corporate profits to themselves by having the corporation report illegitimate expenses, rather than by paying a dividend.

Types of Constructive Dividends

There are numerous types of payments or economic benefits to shareholders that can be re-characterized as constructive dividends. If you are a shareholder in a closely-held corporation you should be aware of the possibilities.

One common constructive dividend is unreasonable compensation paid by a corporation to a shareholder-employee. Frequently, members of family-owned corporations will try to shift income by having their corporations pay excessive salaries (compared to the work actually performed) to family members who pay at lower tax rates, thereby reducing corporate net income at the same time. Because of the potential for tax abuse, shareholder-owners of small corporations will need to be able to show that the salaries paid were legitimate. Some factors to consider, among others, will be the nature and complexity of the work performed by the employee, the employee’s qualifications for the job, a comparison of salary paid by the corporation to prevailing salaries for similar jobs, as well as the ratio of dividends paid to salary by the corporation.

Bargain sales or rentals of property by the corporation to its shareholder(s) will also likely be deemed to be constructive dividends, depending upon the circumstances. For example, if a shareholder purchases property at a bargain rate below its true fair market value, a constructive dividend will arise on the amount of difference between what the property was purchased for and its actual value. Thus, if you are making such transactions, you should have a legitimate appraisal of the property and treat the sale at arm’s length in order to decrease the potential for a constructive dividend to be declared.

A constructive dividend can also arise when a corporation makes payments on behalf of its shareholder-employees personal expenses, or if the shareholder-employees use corporate property for personal use. An example of the latter situation may occur when shareholders use a company car or plane for non-corporate reasons without adequate payment to the corporation for personal use.

Constructive dividends may also be deemed by the IRS to be paid when a corporation makes payments to shareholders that are not bona fide loans. The determination of whether a payment was in fact a bona fide loan is a very complex tax issue that involves numerous factors, such as whether interest was actually paid by the shareholder to the corporation, and whether a loan agreement existed.

Proper Tax Planning is Required To Reduce the Probability of Constructive Dividend Classification During IRS Audit

While representing clients in IRS audits, I see that the widespread use of constructive dividends by the IRS. While this is a fairly common audit issue, it is appalling to see that this problem may have been prevented through timely tax planning by the taxpayers or their accountants.

This is why it is important to resolve this issue before the IRS audit begins, even if it means amending already filed tax returns. However, this is a job for an experienced tax attorney; I would strongly advise against doing the tax planning for such complex issues by yourself.

Contact Sherayzen Law Office for Help With Tax Planning

This is why you should contact Sherayzen Law Office before the IRS finds you. Attorney Eugene Sherayzen constantly deals with the IRS, and knows what to look for and where potential problems may arise, and we can use this knowledge to help you.

Termination of a Partnership

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Because partnerships have many different features from corporations, a question is frequently asked concerning partnerships: when do they officially end? While corporations theoretically have an indefinite life and identifying the closure of a corporation may sometimes be regarded as relatively easy, it may not always be as apparent when a partnership has terminated.

This article will explain the basics of partnership termination for U.S. federal tax purposes only (please, consult specific state statutes for relevant partnership termination provisions). Remember that there are numerous exceptions to and modifications of these basic rules on state and federal levels. This article is not intended to constitute tax or legal advice.

Partnerships can involve many complex tax and legal issues, so it may be advisable to seek an experienced attorney in these matters. Failure to do proper tax planning can result in significant adverse tax consequences. Sherayzen Law Office, Ltd. can assist you in all of your partnership tax and legal needs, and help you avoid making costly mistakes.

Termination of a Partnership

There are many ways in which a partnership can be terminated; this article will focus only on several common situations. First, as should be obvious from the definition of a partnership, a partnership will end when it no longer has at least two partners. This may occur, for instance, when one partner purchases the other partner’s complete interest in a two-person partnership, thus creating a new sole proprietorship.

A partnership may also terminate if none of its partners continues to carry on the partnership’s business. This may occur, for example, because of a partnership liquidation.

The third way a partnership may terminate is if there is a sale or exchange of 50% or more of the total partnership capital and profits interest within a twelve-month period. In such a case, the IRS is likely to treat such situation as a formation of a new partnership. It is important to remember that multiple sales of shares of the same partnership interest with percentages less than 50% will not be aggregated. For example, assume that partner A in an equally-owned four person partnership ABCD sells his partnership share to a new partner, who subsequently sells this 25% share again to yet another new partner. In this case, the original ABCD partnership is likely to be treated as still existing (barring any other circumstance that forces the termination of a partnership). In most cases, a partnership will not be terminated simply because of the admittance of a new partner to the partnership.

Furthermore, the death or liquidation of a partner normally is not likely to terminate a partnership where a partner owns a minority partnership interest (unless, for example, it involves a two-person partnership). While the partnership itself may not be terminated, for the deceased or liquidated partner, the partnership tax year will end at that point. The share of partnership profits or loss will be determined as of the date of death or liquidation for that partner, and will be reported for tax purposes in the year the event occurs.

The examples above state the general law and it is highly important to remember that a partnership agreement may modify the application of this law to specific partnership. While, unless the law expressly permits so, a partnership agreement cannot override the law, it may add to it (for example, a death of a partner can be made a termination event in a partnership agreement even if this partner owned a very small percentage of the partnership interest). Therefore, you should always make sure to consult the existing partnership agreements before arriving to a legal conclusion. In such complex situations, it is highly advisable to retain an experienced attorney.

Partnership Mergers

When two partnerships merge, partnership terminations may also arise, depending upon the circumstances. An interesting situation may occur under federal tax law where the IRS may deem the partnership of any partners who have more than a 50% interest in the newly-formed partnership to be continued. For instance, if partnership AB merges with partnership CD, and the partners of CD own more than a 50% interest in the new resulting partnership, partnership ABCD may be treated as a termination of partnership AB, and continuation of partnership CD.

Contact Sherayzen Law Office for Partnership Legal and Tax Help

If you own a partnership interest and would like to receive a legal and tax advice with respect such ownership, contact the experienced tax firm of Sherayzen Law Office.

IRS Audit Reconsideration

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Have your tax returns been subject to an IRS audit? You should be aware that IRS procedures may allow you to contest the findings through IRS Audit Reconsideration, provided that you meet certain requirements. If the amount is significant or you believe that the IRS was erroneous in its determination, you contact Sherayzen Law Office, PLLC.  Our experienced law firm can assist you with your IRS Audit Reconsideration and help you avoid making costly mistakes.

This article will explain the basics of audit reconsideration. It is not intended to constitute tax or legal advice.

IRS Audit Reconsideration: Reasons the IRS May Reconsider an Audit

There are various reasons for which you may request IRS Audit Reconsideration. For example, if you were not able to appear for your audit, or if you moved during the audit and did not receive correspondence from the IRS, the IRS may grant the request. Additionally, if you believe that you have additional important information to substantiate your case that was not available to you during the audit, you may be allowed to have the IRS reconsider the audit. Further, if you disagree with the assessment from the audit, a request may be granted, depending upon the IRS’ discretion. You are well-advised not to make the determination by yourself about whether you have a sufficient reason for IRS Audit Reconsideration; this is a question for an experienced tax attorney.

Process for Requesting IRS Audit Reconsideration

In general, there are several steps you will need to take if you are requesting IRS Audit Reconsideration. If you are planning upon making the claim that you are presenting new evidence that you did not present before at the audit, you usually should first obtain all the necessary documentation that you will need to substantiate your claim and make sure that the evidence supports the correct tax years in question. You will then need to file a letter explaining your request for reconsideration, along with photocopies (originals will not be returned to you) of the evidence supporting your new claim.

The IRS notes that, provided you meet certain requirements, your IRS Audit Reconsideration request may be granted if: “You submit information that we have not considered previously. You filed a return after the IRS completed a return for you. You believe the IRS made a computational or processing error in assessing your tax. The liability is unpaid or credits are denied.” On the other hand, the IRS usually will not accept IRS Audit Reconsideration request if you signed an agreement agreeing to pay your amount of tax liability (such as a Form 906, Closing Agreement; a Compromise agreement; or an agreement on Form 870-AD with IRS Appeals), if the amount of tax you owe is due to the result of final partnership item adjustments under the Tax Equity Fiscal Responsibility Act (TEFRA), or if the United States Tax Court, or another court, has rendered a final determination on your tax liability.

Once the documentation for the IRS Audit Reconsideration is received by the IRS, the IRS may send you a letter requesting follow-up information regarding your request. The IRS may delay collection activity once your initial letter is received; however, collection activity will resume if you fail to respond to request from the IRS for additional information within 30 calendar days, or if the IRS deems your documentation insufficient to support your claim.

Once the IRS has completed its review of your IRS Audit Reconsideration request, you will be notified as to whether your position was accepted or rejected. If you position was accepted, the IRS may either abate your assessed tax, or partially abate the tax, depending upon the circumstances. If your position is rejected, your assessed tax will stand. If you disagree with the results you may either pay the amount (either in full, or by making other payment arrangements), or by seeking certain other remedies. In future articles, we will explain other options you may have at that point.

Contact Sherayzen Law Office for Help With An IRS Audit

If you are currently being audited or the IRS already rendered its decision and you are looking for a way to challenge it, contact Sherayzen Law Office for professional legal help. Our experienced legal team will thoroughly analyze your case, determine the available options, implement the chosen course of action (including preparation of any tax forms) and rigorously defend your interests during IRS negotiations.

Sales or Exchanges between a Partner and a Controlled Partnership

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In general, when a non-controlling partner makes a transaction with his or her partnership in a non-partner capacity, any resulting gain or loss is likely be recognized, because the transaction is treated as at arm’s length and occurring with a third party. Such transactions may involve sales, loans, rental payments, services provided and other related items to or from the partnership. However, special rules apply when the transaction takes place between a partner who owns more than 50% of the partnership capital or profits (applying both direct and indirect ownership rules) and his or her partnership.

This article will explain the basics of sales or exchanges between partners and controlled partnerships under Internal revenue Code Section 707. It is not intended to constitute tax or legal advice.

Partnership taxation can involve many complex tax and legal issues, so it may be advisable to seek an experienced attorney in these matters. Failure to do proper tax planning can result in significant adverse tax consequences. Sherayzen Law Office, Ltd. can assist you in all of your tax and legal needs, and help you avoid making costly mistakes.

Disallowed Losses on Sales or Exchanges between a Partner and the Controlled Partnership

If a partner owns (directly or indirectly) more than a 50% of the capital or profits interest of the partnership, under IRS Section 707, losses from a sale or exchange between the partner and the partnership will be disallowed. However, if the partnership eventually sells the property to a third party, any gain realized on the sale may not be recognized to the extent of the disallowed loss. In other words, the disallowed loss may reduce the gain that would otherwise need to have been recognized.

If a sale or exchange takes place between an individual or entity who does not own 50% or more of the capital or profits (directly or indirectly) of a partnership, but is related to a partner, the sale or exchange is likely to be treated as occurring separately between the various partners of a partnership, and the disallowed loss will be determined accordingly. For example, assume partner A in a five-person partnership (with each partner owning 20%) also owns 100% of a corporation. If the corporation has a loss resulting from a transaction with the controlled partnership, the transaction is likely to be treated as if occurring individually between the partners, and 20% of the loss may be disallowed for the corporation (because of partner A’s ownership).

Treatment of Certain Gains Recognized on Sales or Exchanges between a Partner and the Controlled Partnership

Unless an asset is a capital asset to both the seller and purchaser, in a sale or exchange between a partner owning more than a 50% capital or profits interest (directly or indirectly) and a controlled partnership, any gain recognized is likely to be treated as ordinary income. IRS Regulation §1.707-1, transactions between partner and partnership, broadly defines non-capital assets: “[P]roperty other than a capital asset includes (but is not limited to) trade accounts receivable, inventory, stock in trade, and depreciable or real property used in the trade or business.” This can have serious unexpected tax consequences for those taxpayers who do not fully understand the applicable tax laws when making such transactions.

Additionally, if an asset is depreciable property in the hands of a transferee, any gain recognized on a sale of exchange between a partner owning more than a 50% capital or profits interest (directly or indirectly) and a controlled partnership, is also likely to be treated as ordinary income.

Tax Planning is Essential for Controlled Partnership Transactions

It is very easy to misunderstand or misapply the controlled-partnership transactions. The consequences of such actions may be dire and may lead to an unexpected jump in your tax liability (especially, if the re-classification of gain or disallowance of a loss occurs in the context of an IRS audit).

This is why it is essential to conduct comprehensive tax planning with respect to any controlled-partnership transactions. Sherayzen Law Office can help; Mr. Eugene Sherayzen, an experienced tax attorney will thoroughly analyze your partnership transactions, determine potential tax consequences and propose a comprehensive solution aimed to protect you from over-paying taxes to the IRS.

Opting-Out of OVDI or OVDP: Escaping Your Accountant’s Mistakes

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The rise in the voluntary disclosures of offshore assets caught the accounting profession by surprise. The great majority of the accountants were not trained in international tax matters and learned about the existence of FinCEN Form 114 formerly known as TD F 90-22.1 (commonly known as “FBAR”) from their clients.

However, in their ignorance of the matters involved, these accountants simply treated the FBAR disclosure as a regular accounting matter and herded their clients into the IRS voluntary disclosure programs (like 2009 OVDP, 2011 OVDI and 2012 OVDP) without much consideration of complex legal issues involved, without any attempt to analyze the individual facts of each case, and, often, without the understanding of the terms of these official voluntary disclosure matters.

Unfortunately, a lot of individuals ended up paying outrageous Offshore Penalties and unnecessary legal and accounting fees in these programs. Some of these individuals were not even told by their accountants of the consequences of entering into the 2011 OVDI or 2012 OVDP. Still more participants of these programs were not even told about the modified voluntary disclosure alternative (also known as “noisy disclosure” and “reasonable cause disclosure”).

For the individuals who are currently in the 2011 OVDI and 2012 OVDP programs and who have not signed the Closing Agreements, there is still a chance to see if they can escape the unnecessary penalties.

The escape route is known as the “opt-out” of the program. This route should only be taken after you consulted with an experienced international tax attorney who thoroughly analyzed your case; do NOT try to do it on your own, because there is no turning back – once you are out of the OVDI or OVDP, you cannot re-enter the program later.

Contact Sherayzen Law Office to Discuss Your Opt-Out of OVDI/OVDP Options

This article is intended for educational purposes only and does not constitute legal advice. Make sure that you discuss your opt-out options with an experienced international tax attorney before taking any action.

If you are currently in the OVDI or OVDP programs and you would like to understand the consequences of opting-out of the OVDI or OVDP, contact Sherayzen Law Office NOW.

Our experienced international tax firm will thoroughly analyze your case and describe to you the potential consequences of the opt-out of the OVDI or OVDP.

Call or email our experienced voluntary disclosure team!

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.