In analyzing whether a C corporation’s payments to shareholder-employees were compensation or “disguised” dividends, the Internal Revenue Service and courts consider whether dividends were paid by the corporations.
The Regulations say it is “likely” that a compensation payment is in fact a dividend distribution when excessive payments correspond to or bear a close relationship to the recipient’s stockholdings in the company. Treas. Reg. § 1.162-7(b)(1) and 1.162-8. On the other hand, the lack of relationship between a recipient’s stockholdings and the proportion of the payment received (compared to other shareholder-employees) has been considered as evidence of compensation. But neither situation is conclusive. See Kennedy v. Commissioner, 671 F.2d 167, 175 (6th Cir. 1982).
The fact that a C corporation paid (or did not pay) a dividend is not solely determinative of whether shareholder-employee compensation was actually a disguised dividend. The Service does not argue that the lack of dividend payments, irrespective of other factors, must result in a determination of some amount as a disguised dividend. In Rev. Rul. 79-8, 1979-1 C.B. 92, the IRS said that “deductions for such compensation under section 162(a) of the Code will not be denied on the sole ground that the corporation has not paid more than an insubstantial portion of its earnings as dividends on its outstanding stock.” The Ninth Circuit rejected the automatic dividend rule in Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1244 (9th Cir. 1983).
However, the IRS often considers a company’s dividend history when selecting companies for audit on the unreasonable compensation issue. Therefore, owners of profitable C corporations should remember that the lack of any dividends may be a “red flag.” Some companies have, however, successfully rebutted a disguised dividend argument even though they had paid little or no dividends. They did so by showing legitimate business reasons for paying minimal or no dividends, such as the need for funds for future growth of the business or capital improvements.