Revenue Ruling 82-37 and Constructive Dividends

Closely held corporations often make payments that benefit their shareholders directly. The IRS provides specific guidance on how payments made by a corporation on behalf of its shareholders are to be handled, which can result in tax consequences for both the company and the individual shareholder.

The Constructive Dividend Determination

When a corporation pays the personal income tax liability of one of its shareholders, the IRS has determined that such a payment is not a loan or compensation but rather a distribution of corporate earnings. This type of distribution is classified as a “constructive dividend.” A constructive dividend occurs when a corporation confers an economic benefit on a shareholder without formally declaring a dividend.

The determination rests on the fact that the payment satisfies a personal obligation of the shareholder, not a business obligation of the corporation. Even if the corporation and shareholder did not intend for the payment to be a dividend, the tax law recharacterizes it based on the economic substance of the transaction. This classification prevents the distribution of corporate profits from avoiding taxation at the shareholder level.

Tax Treatment for the Shareholder

When a corporation pays a shareholder’s personal income tax, the amount of that payment must be included in the shareholder’s gross income for the tax year in which the payment was made. This amount is treated as dividend income. The shareholder is responsible for reporting this income on their personal tax return, typically on Form 1040.

The dividend income is subject to the same tax rates as qualified or ordinary dividends, depending on the shareholder’s circumstances and the nature of the corporate earnings. This inclusion in gross income ensures that the economic benefit received from the corporation is properly taxed at the individual level.

Tax Treatment for the Corporation

From the corporation’s perspective, the payment of a shareholder’s personal income tax is not a deductible business expense. Instead, the corporation must treat the payment as a distribution of its profits and earnings.

This means the amount reduces the corporation’s retained earnings, similar to how a formally declared cash dividend would. The corporation will report this distribution to the shareholder and the IRS, typically using Form 1099-DIV. The inability to deduct the payment prevents the corporation from lowering its taxable income through what is, in substance, a distribution of profits to its owner.