IRS Notice of Proposed Adjustment: Tax Issues Explained

Introduction to the Notice of Proposed Adjustment

A Notice of Proposed Adjustment (NPA) is sent by the Internal Revenue Service (IRS) to inform a taxpayer of an adjustment made to their tax return. The subject of the return may then challenge the IRS's adjustment if they believe it is unwarranted or erroneous (IRS.gov, 2016). In the present case, the NPA identifies three distinct issues: unreasonable compensation, stock redemptions, and rental loss.

Issue One: Unreasonable Compensation

The first issue concerns unreasonable compensation. The owner received $5 million in salary, plus an additional $5 million from the company based on gross revenue. Nothing in the taxpayer's claim explains the purpose of the second $5 million payment. The IRS is characterizing this second payment as a constructive dividend. A constructive dividend typically takes the form of a loan from the company to a shareholder; in this case, however, it was a direct payout. The critical point for the IRS is that this amount is not counted as salary — and therefore not deductible as a business expense — but rather as a constructive dividend, which increases the company's taxable income since dividends are paid on an after-tax basis (Investopedia, 2016). The central question is what level of compensation the IRS considers reasonable. That determination appears to be largely discretionary. Regardless of how the payment was structured, the IRS views the total payout as excessive.

This issue will be difficult to defend under current law. The company could potentially argue that it did not earn sufficient net income for this distribution to be classified as a dividend; however, the company had $300 million in revenue, which is substantial enough to sustain the salary in question. There is room to argue that a company of that size would typically pay this level of salary and bonus to its CEO. Some evidence may be required to demonstrate that such compensation is the industry norm. If such evidence cannot be produced, the IRS's ruling that the second payment constitutes a constructive dividend will likely stand.

The second issue involves stock redemptions. Although the NPA was related to the building supply business, this particular issue concerns the construction company. During the audit period, the construction company redeemed 50% of the outstanding stock owned by the client and 50% of the outstanding stock owned by the client's son. The IRS is treating this as a stock redemption. The case does not clarify what type of stock is involved, but the language implies it is common stock.

Technically, a stock redemption is associated with preferred stock rather than common stock. When a company repurchases common stock, it is generally considered a buyback. One key distinction is that with a buyback, the shares continue to exist and may be resold at a later date, whereas redeemed preferred shares may not (Investopedia, 2016).

Issue Two: Stock Redemptions

If the corporation has only one class of stock, the distribution will be treated as a Section 301 distribution under IRC Section 302. That provision states clearly:

"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 clear that these distributions will be classified as Section 301 distributions. Although the distributions involved common rather than preferred stock, the law does not draw the same distinction between preferred and common stock that much of the financial literature does. Under 26 CFR 1.302-2, where there is only one class of stock, distributions are generally classified under Section 301.

The third issue concerns rental loss arising from a building rented by the construction company to the owner and his son. No further details are provided. However, research on the constructive dividend doctrine shows that any exchange conducted below fair market value is likely to be taxed as a constructive dividend — whether the transfer is made to the owner directly or to a family member. Renting a building at below-market rates, thereby generating a loss for the company, will be viewed by the IRS as a constructive dividend and taxed accordingly. Any conveyance of value from the corporation to the client or the client's family — including covering rent or renting property at a loss — will be treated in this manner.