What Is a Constructive Dividend and How Does It Work?

Corporations sometimes distribute benefits to shareholders in ways that aren’t labeled as dividends, but the IRS may still treat them as such. These are known as constructive dividends, and they carry significant tax implications. Unlike formal dividends declared by a board of directors, constructive dividends arise from transactions that provide an economic benefit to shareholders without proper documentation or justification.

Because these payments are not explicitly categorized as dividends, companies and shareholders might overlook their tax consequences. Understanding how they work is essential to avoid unexpected liabilities and ensure compliance with tax regulations.

Criteria for Classification

For a payment or benefit to be considered a constructive dividend, it must provide an economic benefit to a shareholder without a corresponding corporate purpose. If a company distributes funds, assets, or services to an owner without receiving fair market value in return, the IRS may reclassify the transaction as a dividend, making it taxable to the recipient.

Intent does not matter. Even if a corporation did not intend to issue a dividend, the IRS focuses on the substance of the transaction rather than its label. If a shareholder receives a financial advantage—such as the use of company property at below-market rates or the forgiveness of a debt—the IRS can still treat it as a dividend. Courts have consistently upheld this principle, emphasizing that the economic reality of a transaction takes precedence over corporate records.

The corporation’s earnings and profits (E&P) also play a role. A constructive dividend can only be recognized if the company has sufficient E&P to support it. If a corporation lacks E&P, the distribution may instead be classified as a return of capital or a capital gain, which carries different tax consequences. The IRS examines financial statements, tax filings, and corporate records to determine whether the company had the capacity to issue a dividend at the time of the transaction.

Common Types

Constructive dividends often arise from transactions that provide financial benefits to shareholders without proper corporate justification. The IRS scrutinizes these transactions to determine whether they should be reclassified as dividends.

Excessive Compensation

When a corporation pays a shareholder-employee a salary that significantly exceeds reasonable compensation for their role, the IRS may treat the excess amount as a constructive dividend. Determining what constitutes “reasonable” pay depends on factors such as industry standards, the individual’s responsibilities, company profitability, and historical compensation trends.

For example, if a small business owner pays themselves a $1 million salary while the company generates only $2 million in revenue, the IRS may argue that a portion of this salary is not justified by the work performed. If the IRS reclassifies part of the salary as a dividend, the company loses the ability to deduct that portion as a business expense, increasing its taxable income. Meanwhile, the shareholder must report the reclassified amount as dividend income, which is typically taxed at a lower rate than ordinary wages but does not allow for deductions like payroll taxes or retirement contributions.

Shareholder Loans

Loans from a corporation to a shareholder can be legitimate, but if they lack proper documentation, repayment terms, or a reasonable interest rate, the IRS may treat them as constructive dividends. A valid loan should include a written promissory note, a fixed repayment schedule, and an interest rate at least equal to the Applicable Federal Rate (AFR) set by the IRS.

For instance, if a company lends $200,000 to a shareholder without requiring repayment or charging interest, the IRS may argue that the loan is actually a disguised dividend. In such cases, the shareholder must report the amount as taxable income, and the corporation cannot deduct it as a business expense. Additionally, if the loan is later forgiven, the IRS may treat the entire forgiven amount as a dividend at that time. To avoid reclassification, businesses should ensure that loans are properly structured, recorded in financial statements, and repaid according to the agreed terms.

Personal Expenses

When a corporation pays for a shareholder’s personal expenses without requiring reimbursement, the IRS may classify these payments as constructive dividends. This often occurs when business funds are used for non-business-related travel, housing, vehicles, or entertainment.

For example, if a company pays $50,000 annually for a shareholder’s personal mortgage or luxury vacations, and these expenses are not recorded as compensation or reimbursed, the IRS may determine that the payments are disguised dividends. Unlike legitimate business expenses, which reduce taxable income, these payments do not provide a corporate benefit and therefore cannot be deducted. The shareholder must report the amount as dividend income, which is subject to taxation. To prevent this issue, businesses should maintain clear records distinguishing personal and business expenses, require reimbursement for non-business costs, and ensure that any personal benefits provided to shareholders are properly documented and reported.

Tax Ramifications

When the IRS reclassifies a transaction as a constructive dividend, the tax treatment changes for both the corporation and the shareholder. Constructive dividends are not deductible by the corporation, increasing its taxable income. This often results in higher corporate tax liabilities, particularly for C corporations subject to the federal corporate tax rate of 21% under the Tax Cuts and Jobs Act (TCJA). For shareholders, these reclassified amounts are treated as ordinary or qualified dividends, with tax rates ranging from 0% to 20% based on individual income levels.

If a shareholder-employee receives excessive compensation reclassified as a dividend, the amount is no longer subject to payroll taxes such as Social Security and Medicare. While this might seem like a benefit, the IRS often imposes penalties and interest on unpaid employment taxes. Additionally, S corporations—whose shareholders avoid self-employment tax on distributions—face heightened scrutiny when the IRS suspects that payments disguised as dividends should have been classified as wages, triggering employment tax liabilities.

Beyond immediate tax liabilities, constructive dividend reclassifications can trigger penalties for underpayment and noncompliance. The IRS may assess accuracy-related penalties under IRC 6662, which imposes a 20% penalty on the portion of underpaid tax due to negligence or substantial understatement. If the IRS determines that a taxpayer knowingly misrepresented transactions to avoid taxes, fraud penalties under IRC 6663 can apply, carrying a penalty of 75% of the underpayment. These financial consequences can be severe, especially when compounded with interest charges that accrue from the original due date of the tax return.

Recordkeeping Requirements

Maintaining thorough and accurate records is fundamental to preventing transactions from being misclassified as constructive dividends. Proper documentation not only supports the legitimacy of business expenses and shareholder transactions but also provides a strong defense in the event of an IRS audit. Companies should ensure that financial records clearly distinguish between corporate expenditures and shareholder benefits, adhering to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), depending on jurisdiction.

Corporate minutes and shareholder agreements play an essential role in recordkeeping, particularly when documenting board-approved compensation structures, expense reimbursements, and loan arrangements. If a company issues a loan to a shareholder, maintaining a signed promissory note with stated repayment terms and market-rate interest is necessary to differentiate the transaction from a disguised dividend. Similarly, expense reimbursement policies should be formalized in writing, requiring employees and shareholders to submit receipts and justification for business-related costs. Failure to maintain these records can make it difficult to prove the legitimacy of transactions, increasing the risk of IRS scrutiny.

Consequences of Noncompliance

Failing to properly identify and report constructive dividends can lead to significant financial and legal consequences for both corporations and shareholders. The IRS actively audits businesses with closely held ownership structures, as these entities have a higher risk of improperly distributing corporate benefits without proper tax treatment. If an audit uncovers unreported constructive dividends, the resulting tax liabilities, penalties, and interest can be substantial.

Beyond monetary penalties, corporations may face reputational damage and increased scrutiny in future tax years. A history of noncompliance can lead to more frequent audits, additional reporting requirements, and potential legal action if the IRS determines that tax avoidance was intentional. Shareholders who receive improperly classified distributions may also encounter issues with their personal tax filings, including amended returns and potential fraud investigations. Publicly traded companies face even greater risks, as improper dividend classification can lead to financial restatements, shareholder lawsuits, and regulatory enforcement actions from the Securities and Exchange Commission (SEC).