A corporation can pay a dividend without ever declaring one. If the corporation pays a shareholder’s personal obligation, the IRS may treat it as a constructive dividend – taxable to the shareholder and not deductible by the corporation.
Sullivan v. United States, 363 F.2d 724 (8th Cir. 1966), is a classic example. Sullivan had an unconditional obligation to buy stock from another shareholder, Nelson. Instead of buying it himself, Sullivan caused the corporation to buy it. The IRS said the corporation’s payment was a constructive dividend to Sullivan because it discharged his personal obligation.
The Eighth Circuit agreed. The court applied a simple test: if the shareholder receives an economic benefit from the corporation, that’s a dividend. It doesn’t matter that Sullivan’s net worth was the same before and after – he was relieved of a personal debt, which is a taxable benefit.
Rev. Rul. 69‑608, 1969‑2 C.B. 42, provides important guidance. If a continuing shareholder assigns a stock purchase contract to the corporation before he has a primary and unconditional obligation to purchase, no dividend results. But if he assigns it after he’s already obligated, the corporation’s payment is a constructive dividend to him.
So if you’re planning a shareholder buyout, think carefully about who bears the obligation. If possible, have the corporation agree to buy the shares from the start, rather than having the shareholder personally obligate himself and then assigning the obligation.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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