If a corporation with earnings and profits
makes a distribution to a corporation shareholder and does not report the payment as a
taxable dividend, the IRS will often reclassify the distribution as a
"constructive dividend." The corporate distribution is then taxed as a
regular dividend, up to the earnings and profits of the corporation.
The problem of constructive dividends most
commonly affects closely-held
corporations. This is partly because shareholders in closely-held corporations tend to treat the
corporation and its cash as personal possessions. Recordkeeping is
often inadequate and leaves the corporation vulnerable in case
of a dispute with the IRS.
Note: Constructive
dividends may occur not only as the result of a direct payment, but may occur as a result
of a transaction that gives an indirect economic benefit to the corporation
shareholder.
Transactions That May Result In Constructive Dividends
• Unreasonable compensation for services
rendered by a corporation shareholder. The owner/employee should be paid wages or
commissions based on what the corporation would expect
to pay a nonowner employee for similar services.
• If a corporation pays rent to a
shareholder in excess of fair market rental value for the use of property, the
excess could be treated as a constructive dividend. If the corporation
makes excessive improvements to the rented or leased property,
especially if it is a short-term lease, constructive dividends
may result.
• Personal use of corporation property
(such as personal use of auto, airplane, entertainment facilities,
etc.) may result in constructive dividends.
• A corporation can pay a fee to a
shareholder who guarantees a loan from another person to the
corporation. The fee is tax deductible by the corporation if it is a
customary practice in the industry, the guarantee is necessary to
conduct business, and the fee is not based on the amount of corporation stock
owned by the person who guarantees the loan. However, if the fee
was in proportion to corporation stock owned, and if the shareholder had
previously guaranteed loans at no charge, the fee will likely be
considered a constructive dividend.
• Closely-held corporations often have a
problem with thin capitalization. The incentive is to obtain working capital
in the form of long-term debt rather than stockholders’ equity.
This is because interest paid on debt is a tax deduction. However, a
loan from the corporation to the shareholder will be considered a
constructive dividend if it is not a bona fide loan.
• A sale of property to a corporation may
result in constructive dividends if the sale price is more than
the FMV of the property.
• Personal expenses paid by a corporation
to or for an owner/employee may result in constructive
dividends.
• A constructive dividend may be imposed
when a stockholder purchases property below FMV from a
corporation. Book value of property should not be used in this type of
transaction.
