Repayments to wife carry no presumption of constructive dividend to shareholder-husband

In a setback for the IRS and a victory for family businesses, the Tax Court has found that payments by a corporation to a married couple were repayments of a loan by the wife and not constructive distributions to the shareholder-husband. The court rejected the IRS's argument that the corporation's repayments to the wife were made only to satisfy personal moral obligation of the shareholder-husband.

The Tax Court in effect ruled in this case that such a close relationship will far from create a presumption that a constructive dividend is received. To win, the IRS must show from all the facts much more than the mere existence of a suspect relationship.

What happened

The wife made a loan to Corp. X in which her husband was a shareholder. Corp. X subsequently dissolved and a new corporation, Y, was formed to succeed to, and continue, the business. Corp. X transferred its working model of a new software design to Corp. Y. Corp. X never made any repayments of the loan it received from the shareholder's wife; nor did the wife make a claim for repayment upon its dissolution.

In 2001, Corp. Y issued a check for $95,000 to the wife. It issued her a check for $70,000 in 2002. The couple treated a portion of the payments as taxable interest income and the balance as a nontaxable repayment of the funds that the wife loaned to Corp. X. The IRS, however, maintained that the payments made to the wife were nondeductible constructive dividends to her husband.

First "prove it," court tells IRS

According to the IRS, Corp. Y had no legal obligation to make the payments on the wife's loan to Corp. X. Corp. Y did so "only on the basis of a personal moral obligations of her husband to repay his wife." The court disagreed.

Corp. Y did not execute a written loan assumption agreement with regard to Corp. X's obligation to repay the loan to the shareholder's wife. However, it effectively purchased the software working model from Corp. X. The working model had been developed with the funds borrowed from the wife. Corp. Y, the court found, would be unjustly enriched if it did not repay the loan. Moreover, Corp. Y reported to the couple that the 2001 payment represented interest and principal on the wife's loan. Consequently, no portion of the payments made to the wife would be treated as constructive corporate dividends to her husband.

Beckley, 130 T.C. No. 18