Transfer of home to closely held shareholders was constructive dividend; penalties imposed RVJ Cezar Corporation et al, TC Memo 2010 –173 A new Tax Court decision illustrates the need for closely held corporations to be wary of constructive dividends when dealing with their owners. A closely held construction company's transfer of a home to its shareholders resulted in dividend/capital gain income to them, and taxable gain to the corporation. What's more, both the shareholders and the corporation were held liable for accuracy related penalties. Background. A dividend is a distribution of property from a corporation to its shareholders out of the corporation's earnings and profits. ( Code Sec. 316(a) ) The amount of the distribution equals the fair market value of the distributed property on the distribution date. ( Code Sec. 301(b)(1) , Code Sec. 301(b)(3) ) For dividends received before 2011, qualified dividend income is taxed at the same rates as long-term capital gain. ( Code Sec. 1(h)(11) ) After 2010, unless Congress changes the rules, dividend income will be taxed as ordinary income. The amount of a distribution that exceeds earnings and profits, and is therefore not a dividend, is taxable capital gain to the recipient. ( Code Sec. 301(c)(3) ) Under long-established case law, dividends may be formally declared or they may be constructive. A constructive dividend arises when a corporation confers a benefit on a shareholder by distributing available earnings and profits without expectation of repayment. A corporation that distributes appreciated property to a shareholder recognizes gain as if the property were sold to the shareholder at its fair market value. ( Code Sec. 311(b)(1) ) Gain is recognized to the extent that the property's fair market value exceeds the corporation's adjusted basis in the property. Taxpayers are liable for an accuracy-related penalty for any portion of an underpayment of income tax attributable to negligence or disregard of rules and regulations, unless they establish that there was reasonable cause for the underpayment and that they acted in good faith. ( Code Sec. 6662(a) , Code Sec. 6662(b)(1) , Code Sec. 6664(c)(1) ) Under Code Sec. 6662(b) , an accuracy related applies for a substantial understatement of income tax, i.e., the amount of the understatement exceeds the greater of 10% of the tax required to be shown on the return, or $10,000. Facts. Mr and Mrs. Cezar were the sole shareholders of RVJ Cezar Corporation, which built “spec” houses that it sold to the public. They paid $500 for their stock. Mr. Cezar, a general contractor, was the sole employee of the corporation. In 2001, Cezar Corp paid $150,000 for a lot, financing part of the purchase price with a mortgage, and spent $502,000 building an amenity-rich home approximately twice the size of its usual spec homes. Cezar Corp was listed as the sole owner of the spec home on the blueprints, permit, and notice of completion. Some of the construction materials were paid with a credit card issued in both Mr. Cezar's name and Cezar Corp, and the Cezars were unable to document most of the labor costs of building the home. The home was finished in 2004 and was offered for sale, but there were no takers. That year, Cezar Corp transferred the lot and improvements to the Cezars by quitclaim deed; they assumed the outstanding mortgage of $57,227. At the time of the transfer the lot and improvements had a total fair market value of $920,000. The transfer of ownership report filed with the Assessor's Office did not indicate that the property interest transferred to the Cezars was a partial interest. The Cezars did not report the receipt of the lot or the improvements on their return for 2004, nor did the corporation report the distribution of the lot and the improvements on its return for 2004. On audit, IRS determined that the distribution of the lot and the improvements was a constructive dividend from the corporation. It determined that the Cezars received a qualified dividend up to the amount of the corporation's earnings and profits, and treated the balance of the distribution, less their $500 initial capital contribution, as long-term capital gain. IRS also determined that both the Cezars and their corporation were liable for the accuracy related penalty. Tax Court sides with IRS. The Cezars conceded that they received the lot as a constructive dividend from the corporation. However, they argued that the improvements were not a constructive dividend because they owned the improvements by having paid for the construction materials and having done all the work to construct the improvements. The Tax Court agreed with IRS's assessment that improvements are built on land that one owns or else there would be an agreement identifying the rights and responsibilities of the parties. The Cezars failed to show that there was an agreement between them and the corporation that would have allowed them to construct a home on the corporation's property. Their ownership argument also was directly contradicted by Mr. Cezar's statements during the audit that the lot and the improvements were both corporate assets. Moreover, there was no credible evidence to support the Cezars' claim that they owned the improvements by paying the construction costs and personally completing the labor. The only records the Cezars produced to establish that they paid the construction costs were insufficient. Furthermore, the corporation was the sole owner of the lot as well as the improvements from the start of construction until the distribution to the Cezars. The corporation received property tax bills for both the lot and the improvements and did not protest that it had been billed for improvements that it did not own. The Tax Court also find it compelling that the corporation, which was in the business of building and selling homes, offered the lot and the improvements for sale without obtaining any transfer of interest from the Cezars. No prospective buyer would buy only the improvements and not the lot or vice versa. The Tax Court also noted that no other spec home that the corporation sold before or since was owned by the Cezars individually. Rather, all the homes and lots were owned and offered for sale by the corporation. As a result, the Tax Court found that the Cezars didn't establish that they owned the improvements, and sustained IRS's determination that the Cezars must include the distribution of the lot and the improvements in gross income as a constructive dividend from the corporation. The Tax Court also found that treatment of the home as a constructive dividend to the Cezars caused the corporation to recognize taxable income to the extent that the fair market value of the lot and improvement exceeded its adjusted basis. The Tax Court also hit the Cezars with an accuracy related penalty for the underpayment of income tax attributable to negligence or disregard of rules and regulations. It also hit Cezar Corp with an accuracy related penalty for substantial understatement of its income tax.