What are Constructive Dividends?
What is a Constructive Dividend?
The IRS is aware of the tendency of shareholders of closely held corporations to borrow money from or lease property to their corporation. The scenario usually involves the shareholder using the cash borrowed from the corporation to purchase personal items, such as a home, or finance a vacation or even to purchase investments.
There is nothing illegal about using corporate funds for the above purposes except the shareholder needs to be aware of the possible pitfalls of doing so. Regrettably, the IRS may characterize the borrowed funds, lease payments,rental payments or personal use of corporate assets as a constructive dividend. A constructive dividend can be defined as a undeclared dividend by the Corporations Board of Directors.
A corporation cannot take a deduction for the constructive dividend, and the shareholder must report the amount of the constructive dividend on his or her tax return. The Constructive Dividend is usually an adjustment made by an IRS Revenue Agent during an audit of a C Corporation. This term used by the IRS will recharacterize an item that has been deducted on the corporate tax return to a non-deductible dividend. In other words, constructive dividends are "double-taxed,"-first at the corporate level and again at the shareholder level. This is because the item is non-deductible on the Corporation Tax return and then included on the receipent or shareholders individual tax return as taxable dividend income.
What is the Tax Impact of Constructive Dividend on the Corporation Tax Return?
The main implication here is that the IRS recharacterization will result in the denial of the deduction at corporation level. Thus, there may be additional taxable income on the Corporation Tax Return, resulting in additional Corporation Tax on the non-deductible item, along with possible late penalties and interest on underpayment of the taxes.
What is the Tax Impact of Constructive Dividend for the Shareholder/ Receipient?
The other implication is that for the receipient/shareholder, there would be additional dividend income on his/her individual tax return, resulting in additonal income tax liability along with possible late penalties and interest.
In short, there could be substantial tax liabilities along with penalties and interest for being assessed constructive dividends. Due to potential abuses by shareholders of closely held corporations, the IRS has become vigilant on related shareholder transactions of Corporations. Some of the items that have resulted in constructive dividends characterizations are as follows:
1.Unreasonably High Salaries.
2.Below Market Shareholder Loans.
3.Unreasonable Payments of Rents to Shareholder or Officers.
4.Cancellation of Debts or other Obligations from the Shareholder or Officers.
5.Transfers or Sale of Property or Other Valuable assets that appear to be below fair market value.
6.Leases of equipment and other assets to the Corporation which appear to be substantially very high.
7.Any payments or compensation paid to Officers for consulting services deemed to be unreasonably substantial.
The test here is whether an independent Board of Directors would approve these substantial salaries and payments.
Last edited by TaxGuru : 12-13-2007 at 07:23 PM.