Court Rules Against Contractor for Underreporting Taxes

When it comes to tax reporting, a contractor can't be too careful. This is especially true if the contractor does business as a regular C corporation. A recent Tax Court decision illustrates this point.

Building Houses on Spec

Contractor Corp. built spec houses that it sold to the public. Joe, a general contractor, was the company's sole employee, and he and his wife were listed as the business's sole shareholders. They paid $500 for their stock in Contractor Corp.

The company paid $150,000 for a lot, partially financed by a mortgage. It spent an additional $502,000 building a top-of-the-line home on the lot, a home that was almost twice the size of its typical spec home. Contractor Corp. was listed as the sole owner of the home on blueprints, the permit and the notice of completion.

A Transfer of the House's Ownership

After failing to sell the home, Contractor Corp. transferred the spec home to Joe and his wife. They then assumed a $57,227 outstanding mortgage on the property. The lot and improvements had a fair market value of $920,000 at the time of the transfer. Neither Joe nor his wife reported the receipt of the lot or the improvements on their tax returns for that year. The company also failed to report the distribution of the lot and the improvements on its return for that year.

The IRS went after Contractor Corp. and Joe and his wife after determining that the distribution of the spec home to Joe and his wife was a "constructive dividend" from Contractor Corp. The IRS claimed both the company and the couple underpaid their taxes for the year of the transfer. The IRS determined that Joe and his wife received dividend income up to the amount of the corporation's earnings and profits. The balance of the distribution, less the couple's $500 initial investment in the company, was treated by the IRS as long-term capital gain. Recently, the Tax Court agreed with the IRS.

Talk to us if you have any concerns about the tax consequences of any of your business transactions.