Business Expenses Personal or Deductible? Don’t Get Caught

Diane Glover

Jun 12, 2017

To be deductible, business expenses must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that’s helpful and appropriate for your business.

No Deduction for Dividends

The IRS sometimes challenges deductions claimed for certain types of business expenses. In doing so, an examiner might claim that payments made by a corporation to a shareholder for personal items or that are above or below fair market value constitute “constructive dividends.” Reclassifying business expenses as dividends has adverse tax consequences.

Typically, a successful corporation pays out dividends to its shareholders, based on earnings for the year. The exact amount of dividends a shareholder receives depends on his or her proportionate share in the company. These dividends are declared by the company on a specified date and then paid out in cash or reinvested in more shares for the shareholder.

However, a corporation may make other payments to one or more shareholders, which the IRS might classify as “constructive dividends.” This often happens when owners of a closely held business use corporate funds to pay personal expenses. But it can also occur at multibillion-dollar conglomerates, and it may involve more than just running personal expenses through the business. (See “Beyond Personal Expenses” at bottom.)

The crux of the matter is: Owning all (or part) of a company doesn’t give you the unrestricted right to pay and record expenses in the manner in which you see fit. Notably, there are tax rules and restrictions that must be followed.

Tax Consequences

From an income tax perspective, dividends paid out by corporations are taxable to shareholders at the personal level. Qualified dividends received by a C corporation shareholder are taxable at the same preferential tax rates as long-term capital gains. Currently, the maximum tax rate for qualified dividends is 15% (20% if you’re in the top ordinary income tax bracket).

On the downside, dividends can’t be deducted by the corporation. So, dividends are paid using after-tax dollars, meaning they’re effectively taxed twice.

Compensation and most other types of payment (such as consulting or management fees) are taxable to shareholders at ordinary income tax rates. However, these legitimate expenses are usually fully deductible by the company (unless they aren’t at arm’s length). As a result, depending on its circumstances, a corporation may try to disguise dividends as compensation or some other type of payment.

This is where the IRS could jump into the fray. If it treats a payment as a constructive dividend, the business deduction the corporation tried to claim for that payment (for example, a compensation deduction) is disallowed, thereby increasing its tax liability. Furthermore, the IRS may impose penalties and interest for tax underpayments. And, if the company’s owners purposely evaded their tax responsibilities, they may face criminal sanctions.

For the shareholders, constructive dividends are taxable as ordinary income. However, unlike compensation, a dividend payment isn’t subject to payroll taxes. Therefore, the overall tax results for shareholders will vary.

The Bottom Line

It’s easy to run afoul of the IRS on this issue. So, businesses always should keep detailed, contemporaneous records to support deductions and other tax positions, especially when it comes to transactions with related parties. The IRS generally won’t, for example, treat a payment as a constructive dividend if the company can demonstrate that it lacked sufficient earnings to pay dividends or that a payment was, in fact, used to pay ordinary and necessary business expenses, rather than personal expenses.

In some instances, expenses may fall into a “gray area” where you’re unsure of the appropriate tax treatment. If you have questions or concerns about your situation, contact us for help at (513)858-6040

Beyond Personal Expenses

Constructive dividends can come in many shapes and sizes. The most common example is when a shareholder mistakenly tries to claim personal expenses — such as medical, vehicle or housing costs — as business expenses. Other types of related-party transactions that the IRS may reclassify as constructive dividends include:

An excessive payment for corporate use of a shareholder’s personal property, such as rental payments for the company’s office or warehouse space,

A purchase or lease by a shareholder of company property at a price that’s significantly below fair market value,

A purchase or lease by the company of a shareholder’s property at a price that far exceeds fair market value,

Excessive compensation paid to shareholders or their family members,

Use of company-owned vehicles and other company property by shareholders (or their family members) without paying fair market value, and

A corporate loan (often at a below-market interest rate) made to a shareholder to fund personal items, where there’s no reasonable expectation of repayment.