New York Advisory Opinion TSB-H-80(519)I: How are constructive distributions to shareholder-officers characterized in the recipients' hands if a Department audit disallows claimed business expense deductions across several years with different earnings and profits levels?

Plain-English summary

PLA Standard Corporation was audited by the Department for its fiscal years ending June 30, 1975, 1976, and 1977. The auditor proposed disallowing certain claimed expense deductions for each of those years and recharacterizing them instead as constructive distributions to the corporate officers who were also shareholders and received the benefit. The corporation had no current earnings and profits for the first two years, but had current earnings and profits exceeding the proposed constructive distribution for the third year - and at no point did it have any accumulated earnings and profits. The corporation asked how these constructive distributions would be characterized in the recipients' hands if the auditor's proposed determination were adopted.

Federal law (26 U.S.C. section 316) defines a "dividend" as a distribution of property a corporation makes to shareholders out of earnings and profits, whether accumulated after February 28, 1913, or earned during the current taxable year. Section 301 lays out the ordering rule for characterizing any corporate distribution: first, the portion that qualifies as a dividend under section 316 is included in gross income; second, any remaining portion (not a dividend) reduces the shareholder's stock basis; third, any amount still left over once basis is exhausted is treated as gain from the sale or exchange of property.

Applying that framework: since the corporation had neither current nor accumulated earnings and profits in the first two years, any constructive distribution in those years would be a nontaxable return of capital up to the shareholder's stock basis, with anything beyond basis taxed as gain from a sale or exchange - not as dividend income. But because the corporation had current earnings and profits exceeding the proposed distribution in the third year, that year's constructive distribution would be treated entirely as taxable dividend income.

What this means for you

Corporate officers/shareholders facing an audit reclassifying expenses as constructive distributions

The tax character of a constructive distribution isn't automatic - it depends on the corporation's earnings and profits in the specific year the distribution is deemed to occur. A year with no earnings and profits produces return-of-capital (and potentially capital-gain) treatment, not dividend treatment, even for the exact same kind of disallowed expense.

Closely-held corporations undergoing an expense-disallowance audit

Track your corporation's current and accumulated earnings and profits year by year - the same audit adjustment can produce very different tax results for the recipient depending on which year it lands in.

Accountants representing shareholder-officers in a constructive-distribution dispute

Apply the federal section 301 ordering rule (dividend to the extent of earnings and profits, then basis reduction, then capital gain) separately for each year under audit, rather than assuming uniform dividend treatment across all years.

Common questions

Q: Is every constructive distribution automatically taxed as a dividend?
A: No - a distribution is a dividend only to the extent the corporation has current or accumulated earnings and profits for that year; without earnings and profits, it's treated as a return of capital (and potentially capital gain) instead.

Q: What happens to a constructive distribution in a year where the corporation has no earnings and profits at all?
A: It's treated as a nontaxable return of capital up to the shareholder's stock basis, with any amount exceeding that basis treated as gain from the sale or exchange of property.

Q: Does having earnings and profits in one audited year affect how other years in the same audit are treated?
A: No - this ruling's facts show each year is evaluated independently based on that specific year's own earnings and profits; a year with sufficient current earnings and profits produces dividend treatment for that year regardless of the other years' results.

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1980.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/h80_519i.pdf

Original ruling text

New York State Department of Taxation and Finance
TSB-H-80-(519)-I
Income Tax
March 2, 1981

Taxpayer Services Division
Technical Services Bureau
STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

PETITION NO. I800527A

On May 27, 1980 a Petition for Advisory Opinion was received from PLA
Standard Corporation, 4000 Veterans Memorial Highway, Bohemia, New York 11716.
The issue raised is whether certain constructive distributions to
shareholders constitute dividends or a return of capital and gain from the sale
or exchange of property.
In the course of an audit by the Department of Taxation and Finance
covering the years ending June 30, 1975, 1976 and 1977 it was proposed by an
auditor that certain expense deductions claimed for each of such years be
disallowed and charged instead as constructive distributions to the recipients,
corporate officers who are also shareholders. Petitioner had no current earnings
and profits for the first two of the three years in question, but for the third
such year had current earnings and profits in excess of the proposed constructive
distribution. At no time did Petitioner have accumulated earnings from which the
proposed constructive distributions could be deemed to have been made. Petitioner
requests an opinion as to the manner in which such distribution would be
characterized in the hands of the recipients, should the auditor's proposed
determination be adopted.
Section 316 of the Internal Revenue Code defines "dividends" as any
distribution of property made by a corporation to its shareholders out of its
earnings and profits accumulated after February 28, 1913, or out of its earnings
and profits of the taxable year, (and prior to the beginning of the taxable year
of the distribution).
Section 301 of the Code states that a distribution of property made by a
corporation to a shareholder with respect to its stock shall be treated as
follows:
1)

That portion of the distribution which is a dividend (as defined
in section 316) shall be included in gross income.

2)

That portion of the distribution which is not a dividend shall
be applied against and reduce the adjusted basis of the stock.

3)

...that portion of the distribution which is not a dividend, to
the extent that it exceeds the adjusted basis of the stock,
shall be treated as gain from the sale or exchange of property.

Accordingly, since Petitioner had neither current nor accumulated earnings
with respect to the first two years in question, any constructive distribution
made during such years would be treated as a return of capital to the extent of
the stock basis. Any excess would be treated as a gain from the sale or exchange
of property. The proposed constructive distribution made during the third year
would be treated as dividend income.
Dated: September 15, 1980

s/LOUIS ETLINGER
Deputy Director
Technical Services Bureau

JAMES H. TULLY, JR., COMMISSIONER
LOUIS M. JACOBSON, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR