What are Constructive Dividends by IRS (Definition and Example)

What are Constructive Dividends by IRS (Definition and Example)

What are Constructive Dividends

Sometimes, when a corporation wants to distribute to the shareholders, it will issue dividends. From a tax perspective, dividends are taxable – and the tax rate will vary based on which tax bracket the person is in and whether it is considered a qualified dividend or not. To circumvent taxes on dividends, some shareholders will take distributions from a company but not classify them as a dividend – instead, they will try to classify distribution as a loan since a loan is not taxable to the shareholder. As you may imagine, the IRS is not a big fan of this practice and can take the position that the distribution or loan was actually a dividend, which is referred to as a constructive dividend and can have tax implications to both parties. Let’s explore the basics of constructive dividends using an example.

Dividends Defined (26 U.S.C. 316)

      • (a)General rule

        • For purposes of this subtitle, the term “dividend” means any distribution of property made by a corporation to its shareholders—

            • (1) out of its earnings and profits accumulated after February 28, 1913, or

            • (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. To the extent that any distribution is, under any provision of this subchapter, treated as a distribution of property to which section 301 applies, such distribution shall be treated as a distribution of property for purposes of this subsection.

Common Constructive Dividends Example

David is a shareholder of a corporation. After a very successful year, the corporation makes a $200,000 distribution to David as a loan. Since David has been a shareholder for many years, the company issues a loan with little to no interest and a very long payback period, with the first several years interest-free. In addition, David’s son performed consulting services for the company for which he is paid a handsome sum — far beyond what another consultant may be paid in the same industry for the same type of work. Clearly, in this situation, the goal is to get David and his family distributions from the company without classifying it as a dividend — so that David does not have to pay tax on the income. Since David is in the highest tax bracket, even a qualified dividend would be taxed at 20%. And, since David’s son just graduated from school and is interning for David, even paying him above market consulting fees would not result in a significant tax liability for him, as this is his only income.

IRS Examination Leads to Constructive Dividends Reclassification

The business is audited and during the examination, the payment to David and his son comes to light. The IRS agent does not believe that the payment to David is a true loan or that the payment to David’s son represents the services performed. Therefore, the IRS agent reclassifies the distributions as dividends to David. The $200,000 loan is reclassified as a Dividend and the difference between the value of the services performed by the son and the value of the payments made to him are also attributed to David as dividend income. 

Civil or Criminal

Oftentimes, issues involving constructive dividends will remain a civil issue although there may be possible penalties for accuracy-related and even fraud. If for any reason the IRS believes there was something criminal, then the matter may be referred to the special agents — but that is not common.

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