Constructive Dividend: Example Of Expense Paid By Corporation Becoming Taxable To Shareholder

Legal Fees Paid by Firm in Criminal Case Against Sole Shareholder Not Deductible

Capital Video Corp. v. Comr., No. 02-1564 (1st Cir. 11/27/02): Legal fees paid out of corporate funds for defending criminal charges against corporation's sole shareholder are not deductible by corporation as business expenses.

Facts: G, sole shareholder of CV, incorporated CV in 1979 to distribute pornographic videotapes. G was associated with R, a captain in the Gb crime family. G was concerned that members of other organized crime families would extort money from, or take over, his multimillion dollar business. He also worried that organized crime would interfere with his other business ventures, including a show at the D Hotel and Casino, and a precious metals business in New England.

In 1979, G began to pay "tribute" to R to fend off extortion attempts and to assist G with other business matters where R's influence might benefit G. The payments averaged between $8,000 and $10,000 twice per month, and for the period of July 1985 to September 1995 these payments totaled at least $1,728,000. R and G made arrangements to conceal the tribute payments from the IRS, and the payments were always made in cash.

In August 1995, G and R were indicted by a federal grand jury on several counts. Count one alleged a conspiracy to evade federal income taxes owed by R. Count two alleged a conspiracy to bribe an official of the stagehands union in connection with G's show. G and R also were indicted on several counts of interstate transportation of obscene material. In January 1997, G, as part of a plea agreement, pled guilty only to the charge of conspiracy to evade taxes.

CV was a Subchapter C corporation whose fiscal year began on March 1. On March 1, 1996, CV elected to be treated as a Subchapter S corporation. As a result, CV's first fiscal year as a Subchapter S corporation was a short one, lasting from March 1 to December 31, 1996.

During the calendar years 1995 and 1996, CV, out of its corporate funds, paid a total of $767,072 for all of the legal defense fees for G stemming from his indictment. Of that amount, CV spent $343,971 while it was still a C corporation, and it deducted that amount on its return. CV spent the remaining $423,101 between March 1 and December 1, 1996, the short fiscal year following its conversion to an S corporation. G failed to report the payment of these legal fees as income. The IRS disallowed the deductions claimed by CV and increased G's personal income by the amount of these fees. The Tax Court upheld the IRS's determination, and petitioners appealed.

Holding: The First Circuit, affirming the decision of the Tax Court, held that the criminal charges against G were not sufficiently related to the operation of CV, and therefore the legal fees were not deductible as business expenses by CV and were properly included in G's gross income. The court stated that there was a fatal lack of evidence regarding the relationship between the tribute payments, the tax conspiracy, and CV. While CV may have benefited from R's protection, the court explained, there was no evidence presented as to what services R provided CV. It is impossible to ascertain from the record whether CV was a primary or even a significant beneficiary of the services, if any, exchanged for the tribute payments. Furthermore, no evidence was introduced that the effectiveness of the tribute payments depended on the resulting tax conspiracy, the court noted.

Moreover, the court stated that once it is determined that the legal fees were not deductible business expenses, CV's S corporation taxable income is increased by $423,101. G, as the sole shareholder, must pay taxes on that amount as personal income. This result depends not on whether that money was spent for his benefit; instead, it flows directly from the pass-through nature of S corporation status. In addition, the court determined that the $93,936 in legal fees paid during calendar year 1996 while CV was a subchapter C corporation should be construed as a constructive dividend to G, citing §61(a)(7).

There are literally thousands of examples in case law of constructive dividends to shareholders. Most are civil cases, but when a willful intent to evade tax is demonstrated by evidence of affirmative acts by the shareholder to conceal transactions from tax returns that would show personal income tax if they were disclosed, a criminal investigation may develop. See this site for "burdens of proof."