In a wholly owned corporation, particularly a personal service corporation providing professional services, the corporate income arises from the personal services of the sole shareholder. In such a case, the corporation could easily pay the shareholder wages or salary of the entire net income before payment of compensation. (I refer to this as wages, as did the Court in the case I discuss below.) There would certainly be no unreasonable compensation issue. But, by paying the amount as wages, although fixing the tax issue at the corporate level, the income still is taxed at the shareholder level and the corporation has to withhold, payover and provide a W-2 for an easy IRS match at the shareholder level. By diverting that amount via either diverting the income or through falsely deductible payments to a shareholder designated entity which does not pay tax, the tax cost at both the corporate and the shareholder levels are avoided (at least until caught). When caught, of course, in order to minimum the tax avoided, the corporation and the shareholder may try to claim that the diversion payments were really wages to the sole shareholder rather than dividends thereby eliminating the corporate level tax. Sometimes, when caught, the shareholder will cause the corporation to amend its returns making that claim.
In United States v. Ellefsen, 655 F.3d 769 (8th Cir. 2011), here, Brian Ellefsen, an orthopedic surgeon, provided services through his wholly owned corporation. The surgeon entered into an illegal trust scheme (the Aegis variety) to divert the income as deductible management fees to offshore entities which he beneficially owned. He and the corporation filed tax returns accordingly -- the payments at the corporate level were deducted at the corporate level, and he omitted the payments from his form 1040. The surgeon and his brother (his office manager) were indicted for conspiracy, the surgeon for tax perjury (Section 7212), and the brother for aiding and assisting (Section 7206(2)).
In her testimony, the IRS agent characterized the amount diverted as a dividend from the corporation to the surgeon, its sole shareholder, and calculated the corporate tax avoided on that basis. On appeal, the defendants urged that, since his personal services earned the corporate income in question, the payments should be treated as wages, thus eliminating the corporate level tax. The court rejected the argument as follows:
We conclude that the district court did not abuse its discretion in allowing Vandenberg to testify that the funds flowing through the Aegis system constituted constructive dividends. "[W]here controlling shareholders divert corporate income to themselves, such diverted funds should be treated as constructive dividends." Simon v. Comm'r, 248 F.2d 869, 873 (8th Cir. 1957); see Truesdell v. Comm'r, 89 T.C. 1280, 1300 (1987) ("In concluding our discussion of the constructive dividend issue, we would emphasize that in a case such as this diverted amounts taxed to a shareholder as constructive dividends also remain fully taxable to the corporation to which attributable."). [the corporation]. paid [the surgeon] a salary for his personal services, presumably the salary that he, as sole shareholder, demanded. Although the corporation likely could have paid him more for those services and properly deducted that amount as a business expense — with [the surgeon] then paying income tax on his additional compensation — the Ellefsens did not structure Brian's income in that way. They instead decided to utilize the Aegis system and falsely deduct management fees from [the corporation's] corporate tax returns. The income was not taxed at all — despite the fact that [the surgeon] was spending the money — until after the government subpoenaed documents from [the accountant] and [the surgeon] decided to amend his personal tax returns. In these circumstances, we conclude that the so-called management fees were properly considered constructive dividends.