What Are Disguised Dividends and Their Tax Consequences?

A disguised dividend is a corporate payment to a shareholder that appears as a deductible business expense but is a distribution of company profits. This situation arises most frequently in closely-held corporations, where shareholders who are also employees can classify distributions of earnings for a more favorable tax outcome.

The Internal Revenue Service (IRS) examines the economic reality of these transactions to determine if a payment is a legitimate return for a service or a distribution of value based on stock ownership. The IRS seeks to prevent companies from avoiding the double taxation inherent in C corporations, where the business pays tax on its income and the shareholder pays tax again on the dividends received.

Common Forms of Disguised Dividends

Excessive compensation paid to shareholder-employees is a common form of disguised dividend. Corporations can deduct reasonable salaries as a business expense under Internal Revenue Code Section 162. When compensation exceeds what would ordinarily be paid for similar services, the excess amount may be reclassified as a non-deductible dividend. The IRS is more likely to reclassify payments that track stock ownership percentages rather than the value of the services rendered.

Loans to shareholders can be considered disguised dividends when they lack the formal characteristics of a true debtor-creditor relationship. A loan might be considered a constructive dividend if it lacks features such as:

• A signed promissory note
• A stated interest rate
• A fixed repayment schedule
• Evidence of actual repayments being made

The absence of these elements suggests the company does not have a genuine expectation of being repaid, making the “loan” a distribution of profits.

The corporate payment of a shareholder’s personal expenses can be treated as a dividend. When a company pays for a shareholder’s family vacation, home renovations, or personal vehicle costs, these are not legitimate business expenses. Since these payments lack a business purpose, the IRS will reclassify them as dividend distributions. This prevents shareholders from using the corporate entity as a personal bank account.

Bargain transactions with shareholders can also be disguised dividends. This occurs when a corporation sells or leases property to a shareholder for a price significantly below its fair market value. The difference between the fair market value and the amount the shareholder paid is considered a constructive dividend. For example, if a corporation sells a building worth $500,000 to its shareholder for $300,000, the $200,000 difference is treated as a dividend.

A shareholder’s personal use of corporate property for free or for a nominal fee is another form of disguised dividend. If a shareholder uses a company-owned vehicle, boat, or vacation home without paying fair market rent, the rental value of that use is an economic benefit. The IRS can quantify this benefit and reclassify it as a dividend distribution.

Tax Implications of Reclassification

When the IRS reclassifies a payment as a disguised dividend, there are tax consequences for both the corporation and the shareholder. For the corporation, the primary impact is the loss of a tax deduction. A payment originally recorded as a deductible expense, such as salary or rent, becomes a non-deductible dividend. This change increases the corporation’s taxable income and results in a higher corporate tax liability.

For the shareholder, the reclassified amount is treated as dividend income. The specific tax rate depends on whether the dividend is “qualified” or “non-qualified.” Qualified dividends are taxed at lower long-term capital gains rates, while non-qualified dividends are taxed at the shareholder’s higher ordinary income tax rates.

Both the corporation and the shareholder can face penalties and interest. The IRS may impose an accuracy-related penalty under Internal Revenue Code Section 6662 if the underpayment of tax was due to negligence or a substantial understatement of income tax. This penalty is 20% of the underpayment. Interest will also accrue on the unpaid tax from the original due date of the return.

Substantiating Business Transactions

To defend against a potential reclassification, corporations must substantiate the business purpose and fairness of transactions with shareholders. For compensation, this involves documenting the reasonableness of salaries and bonuses. Corporate minutes should detail the basis for compensation, linking it to the individual’s duties, qualifications, and experience. It is also helpful to gather data on what comparable companies pay for similar roles to establish a benchmark.

Formalizing loans is another important step. All loans to shareholders should be documented with a formal promissory note that specifies:

• The loan amount
• A commercially reasonable interest rate
• A clear repayment schedule
• The collateral pledged

The shareholder must also make regular, timely payments of principal and interest. This documentation provides evidence of a genuine loan.

Meticulous record-keeping is necessary to separate legitimate business expenses from personal costs. The corporation must maintain clear and contemporaneous records, including receipts and invoices, that justify every expense as having a business purpose. Using separate bank accounts and credit cards for business and personal finances is an effective practice to prevent the commingling of funds.

When dealing with property transactions, obtaining independent appraisals is a defensive measure. If the corporation sells or leases property to a shareholder, a third-party appraisal can establish the fair market value and support the transaction price. This documentation helps prove that the shareholder did not receive a “bargain” deal that could be construed as a hidden dividend.