Question

Contrast constructive dividends and stock dividends. Explain the taxation of each. Give some examples. Also respond to another student's post. Write two to three large paragraphs

Answer 1

Most businesses are taxpayers, too. And just like any other taxpayer, they want to pay as little taxes as possible. Sometimes, however, companies take deductions or other tax benefits when they're not supposed to. For example, a company may pay some personal expenses for a shareholder and take a business expense deduction.

The IRS can call the payment a constructive dividend. If it does, the company may lose the tax benefit, and both the company and shareholder may face penalties.

Constructive Dividends

A dividend is any distribution of money or property made by a corporation to its shareholders. Typically, dividends are declared or announced by the company in advance and are paid out to all shareholders in proportion to the amount of stock each of them owns.

A constructive dividend is an undeclared dividend by the corporation, usually paid to one or only a few shareholders. It can be a direct payment of money, like a salary, or some other indirect economic benefit to the shareholder, like paying a shareholder's rent.

If a corporation makes a distribution or payment from profits to a shareholder and doesn't report the payment as a taxable dividend, the IRS may - and often does - reclassify the distribution as a constructive dividend.

Generally, problems with constructive dividends pop up with small, closely-held corporations. Shareholders of these companies often treat the corporation and its cash as personal property and use both as they see fit. However, big, publicly traded companies can run into the problem, too.

Tax Problems with Constructive Dividends

As a practical matter, constructive dividends and ordinary dividends get about the same tax treatment. Both dividends are taxable income to the shareholder and can't be deducted by the corporation.

This is where the trick lies. If a corporation can pass off payments to a shareholder as compensation, wages or some work-related expense, the corporation can take a tax deduction for the payment.

Impact on the Company

When the IRS treats a payment as a constructive dividend, the deduction taken by the company is denied or disallowed. The payment is then taxed as a regular dividend, up to the earnings and profits of the corporation. As a result, the company's taxable income goes up, and so does its tax bill.