Question

What is a constructive dividend? Under what circumstances is the IRS likely to argue that a constructive dividend has been paid? What steps can a corporation and its shareholder offset a constructive dividend? What is the tax consequences, to both the corporation and shareholder of an IRS determination that a portion of the compensation paid in a prior year is unreasonable? What steps can the corporation and shareholder take to avoid double taxation?

Answer 1

Constructive dividends result in an unintended and unfavorable recharacterization by the IRS of a corporate-shareholder transaction as a dividend. All that is required for treatment of a transaction as a constructive dividend is a finding by the IRS that a shareholder received some benefit from the corporation. Thus, a constructive dividend does not have to be declared formally or designated as a dividend. It need not be paid pro rata to all shareholders. It does not even have to be a dividend under state law.

The IRS often reclassifies corporate deductions as constructive dividends where shareholders of closely held corporations borrow money from their corporation to purchase personal items (i.e. a home, vacation, personal investments), use corporate assets for personal use, or lease their personal property to their corporation. The key inquiry is whether the expenditures were primarily for the shareholder’s benefit and whether there was an expectation of repayment.

The tax consequences, to both the corporation and shareholder of an IRS determination that a portion of the compensation paid in a prior year is unreasonable, would result in double-taxation, first at the corporate level and then at the individual shareholder level.

The corporation can reclassify the payments named as dividends into deductible wages rather than dividends, thereby allowing the corporation to avoid double-taxation.