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.
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.
Also, whether or not the payment was an intentional attempt to avoid or evade taxes, the company faces late penalties and interest for the underpayment of the taxes. If the company purposefully tried to avoid or evade taxes, it could face criminal penalties, too.
Impact on the Shareholder
The shareholder may have tax problems, too, if the IRS treats a payment as a constructive dividend. The payment or value of the property the shareholder gets is treated as taxable income. This may mean the shareholder owes more taxes. And, just like the corporation, the shareholder may have to pay the IRS interest and penalties for underpayment of taxes.
Also, if the shareholder knew the company was trying to avoid or evade taxes and agreed to go along with the plan, the shareholder could face criminal penalties.
Examples of Constructive Dividends
Constructive dividends can take many forms, such as:
- Corporate payment of the shareholder's personal expenses that aren't related to the business, like rent or doctor's bills
- Payment of excessive rent by the company for its rental of the shareholder's property
- Shareholder purchase or lease of corporate property at a bargain price
- Excessive salaries paid to the shareholder or the shareholder's relatives
- Corporate purchases of shareholder property for more than the property's fair market value
- A loan to a shareholder where there's no expectation or demand for repayment, or with a below-market interest rate
- Loans from the corporation to finance a shareholder's purchase of personal items, such as a house, vacation or personal investments
Shareholder use of company-owned property, like cars, boats or vacation homes, without fair payment by the shareholder
Avoiding Constructive Dividends Assessment
The effects of constructive dividends can be minimized or eliminated. For instance, the IRS may not treat a payment as a dividend if the company or shareholder can show:
- The company didn't in fact have enough earnings and profits to pay any dividend
- The payment was used for necessary and ordinary business expenses, and not for personal uses
Company managers and shareholders need to be wary of constructive dividends. If there's any question about how a distribution to a shareholder might be treated by the IRS, it makes sense to talk to a professional tax preparer or a tax lawyer before the distribution is made.
Of course, if the IRS decides to treat a payment as a constructive dividend, contact your tax attorney immediately to make sure your interests are protected.
Questions for Your Attorney
- Can the IRS penalties be avoided if the shareholder pays back what the IRS thinks is a constructive dividend?
- How are penalties on constructive dividends calculated?
- Is there any way a company can let shareholders use company property for free without creating tax problems?