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Wednesday, May 28, 2008


Generally, a taxpayer entitled to income cannot simply say "don't pay me" and avoid being taxed on the income. In that situation, under the doctrine of constructive receipt the taxpayer will have to report the income, and then further account for the disposition of the income that they should have received - for example, such forfeited income could be treated as a gift.

A recent private letter ruling illustrates an exception to this rule that is not widely known or applied. This relates to the waiver of corporate dividends.

In the ruling, a corporation desired to increase its dividends to its public shareholders. However, if it had to pay the increased dividends to the nonpublic shareholders, then there would not be enough cash available to bring the dividend to the desired level for the public shareholders. The other shareholders agreed to waive the payment to them of the dividend to the extent it exceeds the current dividend level. A private letter ruling was sought that the waiving shareholders would not have to report the unpaid dividend income under the constructive receipt doctrine.

Going back to 1953, the IRS has provided guidance to the effect that a waiver of dividends by a majority shareholder would be respected if the resulting increased dividend to minority shareholders was not payable to shareholders who had a direct family or business relationship with the waiving shareholder, and a valid business purpose existed for the waiver. In Rev.Proc. 67-14, 1967-1 CB 591, the IRS listed four "safe harbor" criteria that must be met before the IRS will issue a favorable ruling on a dividend waiver. The criteria are:

(1) A bona fide business reason must exist for the waiver;

(2) The relatives (e.g., brothers, sisters, spouse, ancestors, and lineal descendants) of the waiving shareholder must not be in a position to receive more than 20% of the total dividends distributed to the nonwaiving shareholders;

(3) The ruling is not effective if any change in stock ownership (other than death) enables nonwaiving relatives to receive more than 20% of the dividend; and

(4) A ruling issued on a proposed waiver won't be effective for a period longer than three years from the date of the ruling.

The IRS ruled favorably in the private letter ruling. The ruling is helpful by providing examples of business reasons that are sufficient for the IRS. In the ruling, the IRS noted the waiver will enhance the market value of the corporation and will thus will provide it with greater access to capital markets for future equity offerings, and will further permit the corporation to maintain adequate capital to support its operations and expand its business.

PLR 200820019

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