Avoiding Constructive Dividends Under Rev. Rul. 79-10

Revenue Ruling 59-184, issued by the Internal Revenue Service, provides guidance on the tax implications when a closely held corporation pays the premiums on a life insurance policy for a shareholder. This situation is common in business planning but can lead to unintended tax consequences if not structured correctly. The ruling clarifies when these premium payments are considered a taxable distribution of corporate profits to the shareholder, affecting how both the individual and the corporation must handle financial reporting.

The Core Principle of Constructive Dividends

A constructive dividend is a tax concept where a corporation provides an economic benefit to a shareholder that is not formally declared as a dividend. The IRS can recharacterize these transactions, treating the value of the benefit as dividend income to the shareholder. This doctrine prevents shareholders from extracting corporate earnings tax-free under the guise of other payment types.

For instance, if a corporation pays for landscaping at a shareholder’s personal home, the cost of that service confers a direct economic benefit. The IRS would view this payment as a constructive dividend, requiring the shareholder to report the value as taxable income. Other examples include a corporation paying for a shareholder’s family vacation, making below-market-rate loans, or allowing personal use of corporate property without fair compensation.

The underlying logic is that the corporation used its assets to satisfy a personal obligation of the shareholder. This principle applies regardless of the corporation’s intent or how the payment is labeled on the company’s books. The focus is on the economic reality: if the shareholder receives a benefit they would otherwise have to pay for with their own funds, it can be treated as a dividend.

Application of Revenue Ruling 59-184

Revenue Ruling 59-184 presents specific scenarios where corporate-paid life insurance premiums result in taxable income to shareholders. The ruling’s analysis centers on who possesses the “incidents of ownership” in the policy, which are the rights and benefits associated with it. When these rights belong to the shareholder, the premium payments are treated as a constructive dividend.

One situation involves a corporation paying premiums on a policy owned directly by a shareholder. In this arrangement, the shareholder holds all rights, such as the ability to change the beneficiary, surrender the policy for its cash value, or borrow against it. Because the shareholder is the owner, the corporation’s payment of the premium is a direct economic benefit, and the amount is included in the shareholder’s gross income.

A more nuanced scenario arises when the corporation is the legal owner of the policy, but the shareholder retains the right to designate the beneficiary. Even though the corporation holds the policy title, the power to control the ultimate recipient of the death benefit is a valuable economic right. The IRS reasons that this allows the shareholder to use corporate assets for personal estate planning, and the cost of this protection is treated as a constructive dividend.

Structuring Corporate-Owned Life Insurance

To avoid the constructive dividend outcomes in Revenue Ruling 59-184, the life insurance arrangement must be structured so that all economic benefits accrue to the corporation. The most direct way to achieve this is for the corporation to be both the legal owner and the sole, irrevocable beneficiary of the policy. This structure ensures that the shareholder does not receive any personal economic benefit from the premium payments.

When the corporation is the exclusive owner and beneficiary, it controls all aspects of the policy. The corporation holds the right to the cash surrender value and is the only entity entitled to receive the death benefit upon the insured shareholder’s passing. Since the policy’s value and proceeds are corporate assets, the premium payments are not considered a distribution to the shareholder but an expenditure to acquire and maintain a corporate asset.

This arrangement is common for legitimate business purposes. For example, corporations often purchase “key person” insurance to protect against the financial loss that would result from the death of a valuable executive or shareholder. The death benefit provides the company with funds to manage the transition, hire a replacement, or offset lost profits.

Another valid use is to fund a corporate buy-sell agreement. In an entity-purchase agreement, the corporation is obligated to redeem a deceased shareholder’s stock. The life insurance proceeds provide the corporation with the necessary liquidity to purchase the shares from the deceased shareholder’s estate, ensuring a smooth ownership transition without depleting the company’s working capital.

Tax Reporting and Compliance

When a constructive dividend occurs, specific tax reporting obligations are triggered. The corporation must report the premium payment as a distribution by issuing Form 1099-DIV, “Dividends and Distributions,” to the shareholder who received the benefit. The value of the premiums paid on their behalf is reported in Box 1 of the form.

Upon receiving Form 1099-DIV, the shareholder must report this amount as dividend income on their personal income tax return, such as a Form 1040. This income is subject to the same tax rates as other dividends. Failure to report this income can lead to audits, back taxes, and penalties.

The taxability of the distribution depends on the corporation’s “Earnings and Profits” (E&P). A distribution is only taxable as a dividend to the extent the corporation has sufficient current or accumulated E&P, which is a tax measure of its ability to pay dividends.

If the constructive dividend exceeds the corporation’s E&P, the excess portion is first treated as a non-taxable return of capital that reduces the shareholder’s stock basis. Once the stock basis is reduced to zero, any further distributions are taxed as a capital gain and reported on Schedule D.