Shareholders Deemed to Receive Constructive Dividend Based on Payments to Partnership of S Corporations

The taxpayers in the case of Pacific Management Group et al. v. Commissioner, TC Memo 2018-131, were upset that they were being taxed twice on the income of their C corporation, once at the corporate level and a second time if the earnings were distributed to the shareholders.  But the IRS and, eventually, the Tax Court found the solution they were sold was too good to be true.

The Tax Court summarized the program as follows:

Reduced to its essentials, the scheme worked as follows. The partnership extracted cash from the C corporations in the form of alleged “factoring fees” and “management fees.” The C corporations claimed deductions for these payments, wiping out substantial portions of their taxable income.

The partnership distributed much of this cash to its five partners, each of which was an S corporation formed by one of the five individuals. The distributions to each S corporation were made ratably on the basis of the corresponding individual’s ownership interest in the C corporations. Each individual received from his S corporation a salary, in whatever amount he believed necessary to support his anticipated living expenses. The individuals reported those amounts as taxable income; the S corporations retained the rest of the cash and (after paying certain expenses) invested it for the individuals’ benefit.

All of the stock of each S corporation was owned by an ESOP. The sole participant in (and beneficiary of) each ESOP was the individual who had formed the S corporation. Because the ESOPs were tax exempt, the distributions the S corporations received from the partnership (net of the salaries and benefits paid to the individuals) were purportedly exempt from current Federal income taxation. The desired end result, therefore, was largely to eliminate taxation of the operating profits at the C corporation level and defer indefinitely any taxation of those profits at the individual shareholder level, even though the profits had been distributed ratably for each shareholder’s benefit.

The program had been designed by a person (Mr. Ryder) who was an attorney with a practice focused on employee benefit plans.  Mr. Ryder

…agreed to design a structure that would achieve petitioners’ tax goals by creating “5 corporations, 5 ESOPs, 2 or more Partnerships, 2 or more Management Service Agreements, and 2 or More Master Factoring Arrangements.” He agreed to supply an opinion letter on the purported validity of the structure and represent petitioners should the structure be challenged by the IRS. As compensation for his efforts, the Water Companies agreed to pay Mr. Ryder a $50,000 documentation fee and an annual fee computed as 6.33% of “the income earned by the S corporations that is not subject to immediate taxation.”

The income of the C corporation was effectively drained out by a combination of the various management and factoring fees charged by the partnership, which then made distributions to the S corporations.

However, the Court found real problems these fees paid by the C corporation, finding that the alleged services were not what they claimed to be. 

The Court began by looking at the factoring purportedly undertaken by the partnership in which the various S corporations were partners.  The Court noted that normally an organization factors receivables to obtain immediate cash, improving cash flow, by receiving cash from a third party.  But in this case the partnership that was going to undertake the factoring began life with no cash.  As the opinion, discussing the report of the IRS’s factoring expert (Mr. Zadek), noted:

PMG, the supposed factor, initially had no meaningful capital; the total capital contributed by its five partners was only $2,087. Because lack of capital prevented it from engaging in “factoring” for the first 10 months of its existence, it did not start “factoring” until October 2000, by which time it had received sufficient “management fees” from the Water Companies to supply it with the requisite cash.

In a true factoring relationship, the factor supplies working capital and liquidity to the client. Here the opposite was true: The client provided working capital to the factor to enable the factor to do the factoring. There is no factual basis whatever for petitioners’ assertion that the factoring arrangement “facilitated working capital.” The scheme was a circular flow of funds whereby the Water Companies supplied liquidity to themselves.

The IRS’s expert also noted that the Water Companies did no due diligence to look at other factoring options and, in fact, ended up paying a rather steep factoring fee:

He first noted that the Water Companies, before embracing Mr. Ryder’s proposal, did no due diligence to investigate the costs and benefits of factoring. They did not compare the cost of factoring to the cost of securing working capital via bank loans. They did no comparison shopping to ascertain whether more advantageous factoring terms could be obtained from an independent company. And they did not bother to calculate the economic cost of the arrangement Mr. Ryder proposed.

Mr. Zadek determined that the factoring fees the Water Companies paid (4% or 5% of the receivables’ face value), coupled with the expected turnaround time for collection, yielded an effective annual percentage rate (APR) of 52%. He concluded that this rate was at the high end of (or above) the range of APRs that independent factors would have charged. The five principals’ insensitivity to price suggests that their true objective was not to obtain low-cost working capital for the Water Companies but rather (as Mr. Ryder proposed) to “convert a portion of their regular monthly business income into profits of a tax-free factoring entity.”

The fact that the party being charged the factoring fee didn’t bother to negotiate a reasonable fee is strong evidence that this is only a paper transaction whose goals was not that of a traditional factoring arrangement.  Rather, overpaying would be an advantage only if the arrangement was truly a method to shift income from the C corporation to, eventually, a nontaxable entity (the S corporations whose stock was held by the ESOPs).

The expert also noted that the payments being made for receivables (the justification for factoring to begin with) were not made immediately upon transferring the receivables in many cases:

In an arm’s-length factoring arrangement, the factor typically: (1) receives an assignment of accounts receivable from the client, (2) verifies the genuineness of the accounts and balances shown, and (3) immediately pays the client a lump sum equal to the face amount of the receivables less the agreed-upon discount. Mr. Zadek observed that PMG’s payment practices were erratic and regularly flouted these norms. On some occasions PMG would make payment before receiving executed assignments of the receivables and without verifying the account balances. On other occasions PMG would not make the stipulated upfront payment but would instead pay for the receivables in installments, sometimes in seven or eight tranches spread over many months. This was contrary to standard factoring practice, which aims to provide the client with immediate liquidity. The trial evidence supported Mr. Zadek’s conclusion that the timing of the supposed “factoring” payments was largely dictated, not by the terms of the MFAs, but by “when there was money in the bank to do it,” as Ms. Quarry testified.

As well, the factoring company did not take over collection of the accounts—rather, the CFO of the Water Companies continued to handle this detail because “the Water Companies did not wish their clients to know that their accounts had been ‘sold.’”  The Water Companies were supposed to be paid for this collection work on behalf of the factoring company, but there were issues there:

But there is no evidence in the record that such reimbursements were ever made. Nor is there any evidence to establish how such reimbursements were supposed to have been calculated. Notwithstanding the “factoring” arrangement, the Water Companies remained 100% responsible for collection activity and bore 100% of the costs of collection. They thus derived no benefits from the “factoring” arrangement in this respect.

Ultimately the Court agreed with the IRS’s expert that this was not a true factoring arrangement and that any economic benefit to the Water Companies was minimal.  On this issue the Court concluded:

Even if the Water Companies were deemed to have derived some marginal economic benefit from the factoring arrangement, petitioners have not shown that the fees they paid were “ordinary and necessary” expenses under section 162. Assuming arguendo that factoring were regarded as customary or “ordinary” within their industry, petitioners have failed to prove that expending $3.5 million for this purpose was “appropriate and helpful” to the operation of the Water Companies’ businesses. See Tellier, 383 U.S. at 689; Carbine, 83 T.C. at 363. Nor have they substantiated what lesser amount would have satisfied this test. Petitioners have thus failed to carry their burden of proof. See INDOPCO, Inc., 503 U.S. at 84.

The management fees were subjected to similar scrutiny.  As the Court began in its analysis of the transactions:

In form, the Water Companies paid management fees to PMG. PMG was a paper entity, and its partners — the five S corporations — were likewise paper entities. Neither PMG nor the S corporations provided the Water Companies with actual management services of any kind. Rather, they were simply vehicles for supplying the personal services of the five principals, who performed for the Water Companies during 2002-2005 essentially the same services they had performed as direct employees of the Water Companies previously. In assessing the reasonableness of the “management fees,” therefore, the question is whether those sums represented reasonable compensation for the personal services rendered by five principals or instead represented (at least in part) nondeductible distributions of corporate profits.

The Court analyzed the compensation paid using the factors outlined by the Ninth Circuit Court of Appeals for determining reasonable compensation paid by a C corporation, the Circuit that would hear any eventual appeal of this decision.

The Court of Appeals for the Ninth Circuit, the appellate venue in these cases absent stipulation to the contrary, applies five factors to determine the reasonableness of compensation: (1) the employee's role in the company, (2) a comparison of the employee's salary with salaries paid by similar companies for similar services, (3) the character and condition of the company, (4) potential conflicts of interest, and (5) the internal consistency of the company's compensation arrangement. Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-1247 (9th Cir. 1983), rev'g and remanding T.C. Memo. 1980-282. The Ninth Circuit also considers whether the amounts paid would be regarded as reasonable by a hypothetical independent investor. See Metro Leasing & Dev. Corp. v. Commissioner, 376 F.3d 1015, 1019 (9th Cir. 2004), aff'g 119 T.C. 8 (2002); Elliotts Inc., 716 F.2d at 1247 (“If the bulk of the corporation's earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder's equity in the corporation, then an independent shareholder would probably not approve of the compensation arrangement.”).

The IRS had not disallowed the amounts taken that were equal to the regular compensation received by the owners, but disputed the deduction of the bonus amounts, arguing they were used to simply eliminate the C corporation earnings and transfer them to the S corporations where the earnings that weren’t taken out by the owners as their salaries for personal spending would be exempt from tax.

One problem with the bonus program was that while a structured bonus program existed for the rank and file employees each year, the bonuses for the owners had no real structure:

The Water Companies had a consistently applied bonus program for rank and-file employees, who received bonuses according to a fixed schedule when funds were available. Under Mr. Ryder’s scheme, however, the Water Companies had no plan of any sort for paying bonuses to the five principals.

None of the principals who testified at trial could explain how the bonus plan worked or what standards were applied. Mr. Krebs testified that there was no set formula or schedule for determining the principals’ bonuses. There is no evidence that bonuses were paid according to any regular schedule or were actually designed to reflect the value of the principals’ services. And petitioners offered no evidence as to how the principals’ bonuses (if any) were determined for years before 2000, when Mr. Ryder’s scheme was put into effect.

However, considering the various factors, including a reasonable return on investment, the Tax Court concluded some of the bonus was reasonable in this case, but the allowance was not terribly generous.

Given the absence of any structured bonus plan for the five principals, the existence of conflicts of interest, and the principals’ clear intention “to disguise nondeductible corporate distributions of income as [deductible] salary expenditures,” Elliotts, Inc., 716 F.2d at 1246, we conclude that PACE is entitled to deduct bonus costs that are in the lowest quartile of similarly situated engineering firms. … Allowing bonuses of this magnitude leaves sufficient profits in PACE to provide shareholder returns on equity of 17.2%, 11.3%, and 11.4% for 2003, 2004, and 2005, respectively. The data supplied by Mr. Atkins suggest that these returns would be deemed adequate by a hypothetical investor in a company like PACE.

Since the funds had left the C corporation, the Tax Court determined that the disallowed deductions represented constructive dividends to the shareholders.  Such constructive dividends exist in the following situations described by the Court:

Dividends may be formally declared or constructive. A constructive dividend is an economic benefit conferred upon a shareholder by a corporation without an expectation of repayment. Truesdell, 89 T.C. at 1295 (citing Noble v. Commissioner, 368 F.2d 439, 443 (9th Cir. 1966), aff'g T.C. Memo. 1965-84). “Corporate expenditures constitute constructive dividends 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.'” P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084, 1088 (9th. Cir. 1987) (quoting Meridian Wood Prods. Co. v. United States, 725 F.2d 1183, 1191 (9th Cir. 1984)), aff'g T.C. Memo. 1984-549.

Corporate payments to third parties may constitute constructive dividends if they are made on behalf of a shareholder or for his economic benefit. United States v. Mews, 923 F.2d 67, 68 (7th Cir. 1991); see, e.g., Grossman v. Commissioner, 182 F.3d 275 (4th Cir. 1999) (corporate payments for family vacations), aff'g T.C. Memo. 1996-452; Noble, 368 F.2d at 441 (corporate payment for repairs and painting of shareholder's residence and for shareholder's travel expenses). The amount of the constructive dividend equals the fair market value of the benefit received. Challenge Mfg. Co. v. Commissioner, 37 T.C. 650, 663 (1962); Schank v. Commissioner, T.C. Memo. 2015-235, 110 T.C.M. (CCH) 542, 548. Whether corporate expenditures are disguised dividends presents a question of fact. DKD Enters. v. Commissioner, 685 F.3d 730, 735 (8th Cir. 2012), aff'g in part, rev'g in part, T.C. Memo. 2011-29; Schank, 110 T.C.M. (CCH) at 548.

So even though the shareholders did not directly receive the payments from the corporation, they were paid for their benefit to the partnership which then routed them to S corporations controlled by each shareholder.  This created the constructive dividend for which no deduction would be allowed to the C corporation, but which would be taxable to each shareholder—thus triggering in full the eventual double tax the arrangement had been meant to avoid.

This case represents a classic substance over form issue—the various structures did not stand up to the Court scrutiny looking for a true economic transaction aside from a method focused solely on reducing the taxes paid.