At trial, Palmarini, somewhat brazenly it seems, claimed $165,122 (2013) and $128,550 (2014) in additional “other” expenses paid on a VIST bank account, as well as additional large expenses of $364,261 (2013) and $467,369 (2014) paid by the company for charges on an American Express card in Benito’s personal name.
If you are confused by these expenses, you’re in good company. The court had no more patience for the mental gymnastics Palmarini was asking it to perform to reach any conclusion that these “other” deductions were legitimate since they were claimed on various amended returns, inexplicably in and out of the same year returns at different amounts, in different amendments, at trial, and eventually in post-trial briefing. The court found Benito’s testimony not credible, issuing the blistering rebuke of his “record keeping” quoted at the beginning of this article. The court added more:
The best time to tally business expenses for 2013 and 2014 was when the returns were due, in 2014 and 2015; but Mr. Palmarini now unwittingly discredits his own contemporaneous reporting by years-late allegations of substantial additional expenses.
Suffice it to say that the court sustained the Commissioner’s disallowance of other expense deductions that were not conceded elsewhere.
C. Constructive Dividends
Under sections 301(c)(1) and 316(a), dividends are any distribution of property to shareholders paid out of a corporation’s earnings and profits and must be included in gross income. A constructive dividend may arise when economic benefits are provided to shareholders or related parties “even though neither the corporation nor the shareholder intended a dividend.” The test is whether the primary purpose of the distribution is to confer such benefit. The Palmarini court provides a good primer, laying out the parameters of the test to determine whether a constructive dividend has been conferred: (1) the expense must be non-deductible to the corporation, and (2) represent some economic gain to the shareholder. The standard, however, is actually more precise for the second prong of the test: “The crucial test of the existence of a constructive dividend is whether ‘the distribution was primarily for the benefit of the shareholder.’” The Commissioner bears the burden of producing evidence of a connection between the unreported income and taxpayer.
The Commissioner’s initial determination of constructive dividends to Benito for 2013 and 2014 assumed that any non-deductible expenditure by Palmarini was a dividend to Benito: he revised the determination, but not the method of calculation, after conceding certain deductible expenses. The court found that the Commissioner’s “shorthand” method was “problematic” because it failed to satisfy the burden of connecting the taxpayer with the unreported income. Because some of the non-deductible expenses that the Commissioner included in his calculation lacked any description, the court concluded they could not be treated as constructive dividends, since there was no showing that the payments were connected to—and primarily for—Benito’s benefit, or whether they were actually made. This holding allowed Benito to benefit from his own failures, despite specifically denying the same to the company in the gross receipts analysis.
The court also found a lack of connection in analyzing the Commissioner’s case for additional constructive dividends for the benefit of other family members, including Benito’s mother. As noted, the Commissioner had used a shorthand that attributed all of the difference between disbursements and allowed expenses to Benito, but the court found that numerous payments were labeled as payments to his brothers or mother. Those payments, regardless of whether authorized by Benito, could have been made to Pacifico and/or Manuel as shareholders in Palmarini, or to their mother on the brothers’ behalf. The court held that the Commissioner did not establish a connection primarily for Benito’s benefit where other family members were shareholders of the Corp and payments to Benito’s mother could be a benefit flowing to her other sons as well as to Benito. The court appears, however, to misread Loftin for the “primarily benefits” portion of the two-part constructive dividend test. The purpose of the primary benefit test is to analyze whether the benefit was primarily for the benefit of the company or the shareholder/member, not whether the benefit is primarily or solely for the benefit of the individual shareholder/member.
A final category determined to be constructive dividends by the Commissioner were personal and rental expenses, including maintenance of Benito’s rental properties, a personal vehicle, medical bills, and a family vacation. These types of personal benefits are not deductible to a corporation and are likely to be deemed a constructive dividend. Checks written for all of these expenses on Palmarini’s bank account satisfied the Commissioner’s burden of proving a connection between the payments and Benito, shifting the burden to Benito show why these expenses should not be treated as constructive dividends. Benito argued, inter alia, that use of his rental properties was for business purposes, but no rental agreement, recurring payments, or other indicia of agreement between Palmarini and Benito were offered into evidence. Benito argued that the medical expenses were covered by the company in accordance with its bylaws, but no bylaws were produced and even had they been, “bylaws do not overrule the federal income tax consequences of a corporation’s distributions to its shareholders.” The court was unconvinced, noting Benito may be able to deduct certain of those expenses in Schedule E of his individual tax return, but they would be constructive dividends to him when paid by the corporation. Benito received constructive dividends in 2013 of $116,741 and in 2014 of $62,798.
While the Palmarini court did not make new law, it gave us a primer on a variety of issues often seen together, including taxpayer failure to keep accurate books and records; expenses that are non-deductible due to lack of substantiation; and the burden of proof on both the Commissioner and the taxpayer to connect payments to the taxpayer and provide evidence that such payments were primarily for the taxpayer’s benefit. Benito’s failure to keep accurate records in this case was ultimately to his and Palmarini’s detriment. He prepared and filed 12 original and amended returns for 2013 and 2014, reducing his credibility with the court through multiple unsubstantiated values and contradictory positions and increasing his own risk of liability. Palmarini was unable to rebut the Commissioner’s BDA because there were no credible records produced in evidence, and Palmarini was unable to prove that any of the claimed officer compensation was paid. It was only through the Commissioner’s analysis that the wages paid for labor on the garage were deductible. Palmarini’s lack of substantiation for the bad debts and Line 26 other deductions made Benito’s testimony not credible to the court and resulted in the court excoriating Benito for his role in preparing the returns and running his business.
It was the same lack of records that hurt the Commissioner in the constructive dividend context, where the Commissioner’s shorthand calculation of constructive dividends failed to meet his burden to show a connection between non-deductible expenses and Benito or a clear benefit to Benito rather than to other shareholders for payments to family members. One of the lessons for practitioners to take from Palmarini is that substantiation goes both ways. The Commissioner is bound by the same rules of substantiation under the Code and the Tax Court Rules as the taxpayer.