A constructive dividend is an undeclared dividend by the Corporations Board of Directors. It can be defined as any payment to a shareholder which is not classified as a dividend by the company. These payments are considered dividend and are taxable. For instance, when a company rents its offices from a shareholder and pays in excess of the office’s fair market value, the company’ s rent is considered a constructive dividend. As a result, rent becomes a taxable expense and the company cannot write off the rent. Borrowed funds, lease payments, rental payments, or the personal use of corporate assets of a shareholder is characterized as a constructive dividend.
It is well established that when a corporation uses its funds to pay personal expenses of its shareholders or members of shareholder’s families, which bear no relation to the economic interests of the corporation, such payments constitute constructive dividends to the shareholders to the extent of earnings and profits. To constitute a constructive dividend, a corporate distribution to a shareholder must be both nondeductible to the corporation and must confer some economic benefit or gain to the shareholder. Each corporate expenditure conferring an economic benefit to the shareholder is not a constructive dividend. The deciding factor is if the expenditure was primarily for the shareholder’s benefit and there was no expectation of repayment[i].
When a corporation confers an economic benefit upon a shareholder, in his or her capacity as such, without an expectation of reimbursement, that economic benefit becomes a constructive dividend, taxable to the respective shareholder. This benefit is taxable to the shareholder whether or not the corporation intended to confer a benefit upon him[ii].
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 re-characterize 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 recipient or shareholder’s individual tax return as taxable dividend income.
[i] NOBLE v. COMMISSIONER, T.C. Summary Opinion 2002-68 (T.C. 2002)
[ii] Loftin & Woodard, Inc. v. United States, 577 F.2d 1206 (5th Cir. La. 1978)