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 following are examples of potential constructive dividends:
Payments made to others for the personal benefit of the shareholder: Payment by a corporation of expenses of a shareholder without expectation of repayment can result in constructive dividends (Estate of Sell, T.C. Memo. 1992-430; Gow, T.C. Memo. 2000-93, aff'd, 19 Fed. Appx. 90 (4th Cir. 2001)). Such dividends are income to the shareholder but are not deductible by the corporation. Corporate payments for shareholder expenses have also been deemed to be additional compensation to shareholders (Ghosn, T.C. Memo. 1995-192).
If the corporation is paying a shareholder's expenses, the shareholder and the corporation should determine if the corporation could treat the payments as compensation that it can deduct. However, treatment of the payments as compensation subjects them to payroll taxes. Alternatively, the shareholder could set up the payments as a valid loan. In that instance, the corporation could not deduct the payments, but the shareholder would not report them as income.
Payments to family members of shareholders: Amounts paid to a family member that were in excess of the value of services the family member provided constituted a constructive dividend (Snyder, T.C. Memo. 1983-692). Also, payments to a family member made on a lease that did not have a business purpose were constructive dividends (58th Street Plaza Theatre, 16 T.C. 469 (1951)).
Excessive compensation: Amounts paid to a shareholder in excess of what is considered reasonable may give rise to a constructive dividend. This may include not just salary but also directors' fees.
Purported loans to shareholders: An advance to a shareholder that is not a bona fide loan may be deemed to be a constructive dividend. Whether a payment is a loan or a dividend depends on the facts and circumstances.
Loans to shareholders at "below-market" interest rates.
Use by shareholders of corporate property: This can include the use of corporate-owned autos, boats, airplanes, vacation homes, and other property if the value of such usage is not repaid or is not included in a shareholder-employee's salary or wages. The amount of the constructive dividend equals the fair rental value of the property (Lang Chevrolet Co.,T.C. Memo. 1967-212; Brock, T.C. Memo. 1982-335).
No amount is included in an employee's income if the employee reimburses the employer for the fair market value (FMV) of the fringe benefit. Unless the corporation elects a special valuation rule, the FMV is based on the facts and circumstances, which generally means the amount that would be paid in an independent arm's-length transaction (Regs. Sec. 1.61-21(b)(2)). The IRS has established the automobile lease valuation rule, vehicle cents-per-mile rule, and vehicle commuting valuation rule for valuing personal use of a company car (Regs. Secs. 1.61-21(d)-(f)). It has also developed the noncommercial flight valuation rule to value personal use of a company airplane (Regs. Sec. 1.61-21(g)).
Improvements to shareholders' property: Improvements made by the corporation to property leased from a shareholder that were in excess of normal lessee improvements (based on the type and value of the property and the term of the lease) were a constructive dividend (Jaeger Motor Car Co., T.C. Memo. 1958-223, aff'd, 284 F.2d 127 (7th Cir. 1960)).
Assumption of shareholder debt by the corporation: If a corporation, without adequate consideration, assumes a debt or other legal obligation of a shareholder, or makes payments on such a debt, a constructive dividend may result. Sec. 357 provides an exception to this principle, allowing a corporation to assume the debts of a shareholder in conjunction with the transfer of assets to a corporation at the formation of the corporate entity.
An example of a corporation's payment of shareholder debt is contained in an IRS field service advice (FSA 200203061). In this case, a closely held corporation made note payments to its sole shareholder's ex-spouse for her "marital interest" in the corporation's stock. The shareholder also provided a deed of trust on property owned by the corporation as collateral for the note.
Bargain purchases of corporate property by a shareholder: The difference between the FMV and the purchase price could be a constructive dividend. For example, in IRS Letter Ruling 200215036, a corporation owned and operated a country club that charged lower dues and other fees to shareholders. The IRS ruled that the difference between the amounts paid by the shareholders and the FMV of the goods and services they received was a constructive dividend to the extent of the corporation's earnings and profits. However, in McCabe Packing Co., 809 F. Supp. 614 (C.D. Ill. 1992), the court held that a constructive dividend did not occur when a corporation allowed an officer to take advantage of a business opportunity the corporation had decided not to pursue.
In a recent Tax Court case (Welle, 140 T.C. 420 (2013)), the court found that a shareholder had not received a constructive dividend as a result of forgone profit on work his controlled corporation had performed on his personally owned property. The taxpayer had reimbursed the corporation for the cost of subcontract labor, labor, and overhead. However, he did not pay the customary profit margin that the corporation would have charged an unrelated taxpayer. The IRS held that the amount of this unpaid profit margin was a constructive dividend to the taxpayer. However, the court stated the IRS had left out an important step required by Sec. 316(a). There must be a distribution of property to the shareholder that reduced the corporation's current or accumulated earnings and profits. Without that factor, there has been no dividend payment.
Under Sec. 1(h)(11), dividends received by a noncorporate shareholder from domestic corporations generally are taxed at 0%, 15% (if taxable income does not exceed the 2017 inflation-adjusted amounts of $470,700 for married filing jointly, $418,400 for single filers, $444,550 for heads of household, and $235,350 for married filing separately), or 20% if taxable income is greater than these amounts. Some shareholder employees may prefer constructive dividend treatment because of the favorable tax rates for qualified dividends. The IRS, however, may prefer nondividend treatment (e.g., compensation) when it can collect more revenue from employment taxes and shareholder-level income taxes than it can collect from disallowing the deduction for the dividend. The IRS is likely to continue raising the constructive dividend issue when doing so will result in double taxation at the corporate and individual level.
The 3.8% net investment income tax applies to the lesser of (1) net investment income, or (2) the excess of modified adjusted gross income over $250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately. Therefore, the top tax rate on qualified dividends for higher-income individuals is 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%).
This case study has been adapted from PPC's Tax Planning Guide—Closely Held Corporations, 29th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.