## Facts

- James V. Truesdell controlled two closely held corporations, including one he solely owned and another he effectively controlled through his minor son’s stock ownership.
- During 1977–1979, Truesdell diverted corporate receipts for personal use, including depositing corporate funds into personal accounts and paying personal expenses with corporate funds.
- Neither Truesdell’s individual returns nor the corporations’ returns reported the diverted amounts.
- Corporate records were poorly maintained, and supporting paperwork was often discarded, leaving accountants unaware of some receipts and omissions from corporate books and returns.
- The IRS issued notices of deficiency for 1977–1979 and asserted civil fraud additions under I.R.C. § 6653(b); the amounts were later increased in the Commissioner’s amended answer.
- Truesdell petitioned the Tax Court, disputing the deficiencies and fraud additions and arguing the diversions should be treated as corporate distributions taxable only to the extent of corporate earnings and profits.

## Issues

1. Whether amounts diverted by a controlling shareholder from closely held corporations are taxable in full as gross income under § 61(a) or instead are constructive dividends governed by §§ 301(c) and 316(a).
2. If treated as constructive dividends, whether the amounts are taxable as dividends only to the extent of the corporations’ earnings and profits, with any excess treated under § 301(c) as return of capital and then gain.
3. Whether the Commissioner proved, by clear and convincing evidence, that underpayments for 1977–1979 were due to fraud warranting additions to tax under § 6653(b).

## Decision

- The Tax Court held the diverted funds were constructive dividends and were taxable under §§ 301(c) and 316(a), rather than fully taxable as uncharacterized § 61 income.
- The court required application of the dividend distribution ordering rules: dividend income to the extent of corporate earnings and profits, then return of capital to the extent of stock basis, then capital gain for any remaining excess.
- The court sustained the § 6653(b) fraud additions for each year, finding a consistent pattern of diversion, concealment, nonreporting, and destruction or non-preservation of records.
- The court indicated that, to the extent prior Tax Court authority suggested a different approach on similar facts, it would no longer be followed.
- The case was set for recomputation consistent with the constructive dividend characterization.

## Legal Principles

- When a controlling shareholder takes corporate funds for personal use and the taking is not treated as an unlawful misappropriation, the amounts are properly characterized as constructive dividends (corporate distributions to the shareholder).
- Constructive dividends are taxed under §§ 301(c) and 316(a): ordinary dividend income is limited to corporate earnings and profits; amounts exceeding earnings and profits are applied against stock basis as a non-taxable return of capital, and any remaining amount is treated as gain.
- In cases involving shareholder diversions, the Commissioner must respect the shareholder-corporation distribution framework when the facts support a distribution characterization rather than an illegal taking.
- Civil fraud under § 6653(b) must be proven by clear and convincing evidence and may be inferred from conduct such as intentional diversion of income, consistent failure to report on both corporate and individual returns, concealment, and destruction or non-retention of records.

## Conclusion

The Tax Court treated a controlling shareholder’s unreported diversions of corporate receipts as constructive dividends subject to the §§ 301 and 316 earnings-and-profits limitations and upheld civil fraud additions under § 6653(b) based on intentional diversion, nonreporting, and record destruction.


Truesdell v. Comm’r, 89 T.C. 1280 (1987)