Revenue Ruling 83-78: Paying Shareholder Reorganization Costs

Revenue Ruling 83-78 from the Internal Revenue Service (IRS) clarifies the tax treatment of shareholder expenses paid by a corporation during a specific type of corporate restructuring. The ruling addresses a scenario where a corporation pays the costs for a shareholder exchanging stock as part of a divisive reorganization. It concludes that such payments can be treated as part of the non-taxable reorganization itself, avoiding a taxable event for the shareholder.

The Corporate Transaction at the Heart of the Ruling

The scenario in Revenue Ruling 83-78 involves a “divisive reorganization,” where a single corporation is divided into two or more separate entities. This is often done to separate distinct business lines or resolve shareholder disputes. For example, co-owners of a company with both manufacturing and retail divisions could use this structure to split the original company into two independent businesses.

This ruling focuses on a type of divisive reorganization known as a “split-off.” In a split-off, a shareholder exchanges their stock in the parent corporation for stock in a newly created or existing subsidiary. The core of the transaction is this direct exchange, which “splits off” a part of the business to be owned and operated independently by that shareholder.

Tax Implications of Corporate Payment of Shareholder Expenses

When a corporation pays a personal expense for a shareholder, the IRS treats that payment as a “constructive dividend.” This means the payment is considered income to the shareholder and is taxable, even if not formally declared as a dividend. This treatment can create a tax liability for the shareholder.

Revenue Ruling 83-78 provides an exception in the context of a split-off reorganization. It concludes that when a corporation pays for expenses directly related to the reorganization, those payments are not a constructive dividend. Instead, the payment is considered part of the tax-free stock exchange permitted under Section 355 of the Internal Revenue Code, allowing the shareholder to avoid immediate taxable income.

Qualifying Expenses Under the Ruling

The tax treatment described in Revenue Ruling 83-78 is not a blanket approval for all of a shareholder’s expenses. Its scope is narrowly defined and applies only to costs that arise directly from the divisive reorganization. Qualifying expenses are those necessary to complete the stock exchange, such as legal fees for structuring the split-off and accounting fees for preparing the required financial statements.

Conversely, expenses considered personal to the shareholder do not qualify for this tax-free treatment, even if incurred during the reorganization. Examples include fees for personal investment advice, estate planning services, or general tax planning that is separate from the reorganization’s mechanics. If the corporation pays these non-qualifying costs, that amount would be classified as a constructive dividend and become taxable income to the shareholder.

Reporting and Documentation Requirements

To secure the tax-free treatment, both the corporation and the shareholder must maintain detailed records to prove the expenses were directly related to the reorganization. This requires itemized invoices from legal and accounting firms that clearly separate qualifying reorganization services from non-qualifying personal services. A single, lump-sum bill for “professional services” is not sufficient.

The corporation’s records should include board of directors’ resolutions authorizing the payment of these specific expenses. For the shareholder, compliance may involve filing a specific form with the IRS for several years following the reorganization.