IRS Notice of Proposed Adjustment

Accounting

A Notice of Proposed Adjustment is sent by the Internal Revenue Service (IRS) regarding an adjustment that it made to a tax return. The subject of the return can then challenge the claim made by the IRS, should they feel that the IRS' adjustment is unwarranted or erroneous (IRS.gov, 2016). On this notice, there are three issues that have been identified.

The first issue is the unreasonable compensation. The fact is that the owner took $5 million in salary, and then a further $5 million from the company based on gross revenue. There is nothing in the taxpayer's claim that argues the purpose of that second $5 million payment. The IRS is claiming the second $5 million payment is a constructive dividend. A constructive dividend is usually in the form a loan from the company to the shareholder, but in this case was just a payout. The key for the IRS is that this is not counted as salary (an expense) but rather as a constructive dividend, which would increase the taxable revenue for the company, since dividends are paid out on an after-tax basis (Investopedia, 2016). At issue here is what the IRS considers to be reasonable salary for the client. This appears to be entirely discretionary on the part of the IRS. The payout here, however structured, is viewed as excessive by the IRS.

This will be difficult under current law to defend against. It is possible that the company could argue that it did not earn enough money for this distribution to be classed as a dividend. However, we know that the company had $300 million in revenue. The company's net income is not known, but the revenue is enough to sustain the salary. There is room to argue that a company of that size would normally pay that sort of salary/bonus to its CEO. Some evidence might be required to demonstrate that this level of payment is the industry norm. If such evidence is not forthcoming, then the IRS ruling on the matter of the constructive dividend will likely stand.

The second issue is the stock redemptions. The facts are as follows. The case states that the NPA was related to the building supply business, but this one actually relates to the construction company. The construction company redeemed during the audit period 50% of the outstanding stock owned by the client, and 50% of the outstanding stock owned by the client's son. The IRS is considering this to a be a stock redemption. The case does not clarify what type of stock, but is written in a way that makes it seem as though the stock is common.

A stock redemption is reserved for preferred stock, not common stock. If common stock is purchased, that would be considered a buyback. One of the main distinctions between a redemption and a buyback is that with a buyback, the shares still exist, and they can be resold at a later date. If preferred shares are being reduced, this is not necessarily the case (Investopedia, 2016).

If the corporation only has one class of stock, then the distribution will be considered as a 301 distribution, according to section 302 of the IRC. This section states clearly as follows:

"The redemption of all of one class of stock (except section 306 stock) either at one time or in a series of redemptions generally will be considered as a distribution under section 301 if all classes of stock outstanding at the time of the redemption are held in the same proportion."

This makes it clear that these distributions will be considered as 301 distributions. These distributions were not for preferred stock, but the law does not distinguish between preferred and common stock in the way that most of the literature on the subject does. The law notes that where there is one class of stock, distributions are usually going to be classed on 301.

The third issue is that of rental loss. This stems from a building that was rented by the construction company to the owner and his son. No other details are provided. However, the research on the constructive dividend showed that when an exchange below fair market value is likely to be taxed as a constructive dividend. This can be either to the owner or to a family member of the owner. Renting a building at below market value, so as to incur a loss, is going to be viewed by the IRS as a constructive dividend, and taxed as such. Any conveyance of value from the corporation to the client or client's family is going to be viewed this way. Paying their rent would qualify, and so would renting a building at a loss.

It is likely that in this case -- and given that we know basically nothing about the transaction -- that the IRS is going to have this classed as a constructive dividend. There is little in the way of defense without any facts that would show a reason why the building was rented below fair market value, or below its cost basis.

Recommendations to the Client

There are three issues here. The first issue is the claim of constructive dividends regarding the $5 million payment based on gross revenue. The client might have a defense here. In general, the IRS will treat payments such as these as constructive dividends. However, the claim is that this is unreasonable compensation. If the client can argue successfully that a $5 million bonus is reasonable within this industry for a company of this size, then this claim might be defended. It is recommended that information is gathered to evaluate whether or not an appeal might be warranted here. If there is reason to make a case that this compensation is in the range of industry norms, then the claim of unreasonable compensation might be dismissed.. The amount is basically a bonus, and tied to performance. Performance-based bonuses paid to executives are not normally classed as unreasonable compensation. More information needs to be gathered, but there is reason to believe that this can be appealed.

The second issues is the stock redemptions. The wording of section 302 makes this fairly clear that such payments are to be considered 301 redemptions. Based on what we know, there is only one type of stock, and as such this is likely going to stand. It is hard to argue that this is not a redemption.

The third issue is that of the rental loss. This is certainly well within the definition of constructive dividend, because the business is conveying value to the owner and the owner's family in an undeclared dividend. There is little point in appealing this decision.