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CASE STUDY

the children are not subject to the kid- at the corporate level with an intent to the election, the election should not
die tax rules of Sec. 1(g) (under age 18, avoid tax at the shareholder level (Sec. be made.
or age 18–23 if certain requirements 531). The personal holding company
are met), any dividends they receive (PHC) tax penalizes the use of a cor- Paying a constructive
will completely escape tax. In addition, poration to hold an individual’s invest- dividend
having a group of new shareholders ments. The calculation of the PHC tax A payment made by the corporation pri-
who are not employees makes it seem is objective, requiring the use of specific marily for the benefit of a shareholder,
more reasonable to pay meaningful quantitative tests (Sec. 541). as opposed to the business interests of
dividends when little or none have been A corporation classified as a PHC the corporation, will often be treated by
paid before. can reduce the penalty tax by paying the IRS as a constructive dividend. Con-
dividends. Several types of dividends can structive dividends are generally found
Distributing appreciating assets be deducted, including dividends paid in closely held corporations where deal-
to shareholders during the year or within 3½ months of ings with shareholders may be informal.
A C corporation’s distribution of appre- year end, consent dividends, and liqui- The issue of constructive dividends
ciated corporate assets to its sharehold- dating dividends. The dividends-paid is governed mostly by case law. For ex-
ers can trigger double taxation. However, deduction for AET purposes generally ample, many cases have held that share-
the double-tax consequences are less follows the same rules that apply to the holder expenses paid by the corporation
severe under the 15% or 20% maximum PHC dividends-paid deduction. without an expectation of repayment
individual federal income tax rate on are constructive dividends in an amount
qualified dividends (including dividends Treating qualified dividends equal to the fair market value of the
paid in the form of appreciated cor- as investment income benefit received. A constructive dividend
porate assets). Therefore, corporations Investment interest expense is deduct- has the same general tax consequences
should consider distributing appreciated ible generally only to the extent of net as a true dividend. It is income to the
corporate assets, especially when the investment income (Sec. 163(d)(1)). shareholder and is not deductible by
corporation has losses to offset some or Qualified dividend income is not treated the corporation.
all of the corporate-level gains triggered as investment income for purposes of
by the distribution. Another idea is to Sec. 163 (Sec. 1(h)(11)(D)(i)). However, Example 2. Paying a constructive
distribute corporate assets that have not taxpayers can elect to treat qualified dividend: J is president and sole
appreciated substantially but that are dividend income as investment income shareholder of JJI Inc. In addition
likely to do so. (Sec. 163(d)(4)(B)). If the election to paying J a reasonable salary, JJI
is made, the dividends treated as in- makes the mortgage payments on J’s
Reducing earnings and profits vestment income will not qualify for residence as well as paying for the
Many closely held C corporations have taxation at the reduced rates. This gives utilities. JJI also pays other personal
built up substantial accumulated E&P taxpayers the choice of applying the living expenses of J and his family.
balances over the years, mainly because favorable tax rates to qualified dividend These payments constitute construc-
paying dividends would have resulted income or using qualified dividend tive dividends that will be taxable
in double-taxation consequences. These income to offset investment interest to J and are not deductible by the
corporations should now consider expense. It may be possible to save taxes corporation. ■
draining away E&P balances by paying by electing to treat qualified dividends
qualified dividends that will be taxed at as investment income in lieu of using
no more than 15% or 20%, while also the reduced net capital gain tax rate,
keeping in mind the impact of the 3.8% because there may be a better tax benefit
tax on net investment income. to having a larger investment interest
deduction than having a lower qualified
Avoiding corporate-level penalty dividend tax rate. The election should Contributor
taxes be considered if the taxpayer’s invest- Trenda B. Hackett, CPA, is an executive
The accumulated earnings tax (AET) ment interest deduction is limited editor with Thomson Reuters Checkpoint.
penalizes the unnecessary accumulation because the interest exceeds the For more information about this column,
of income within a corporation. The ap- amount of the net investment income. contact thetaxadviser@aicpa.org.
plication of the AET is subjective, as it However, if the taxpayer’s investment
is based on the accumulation of income interest would be deductible without

40 September 2022 The Tax Adviser