Identifying constructive dividends to shareholders.

• Author: Ellentuck, Albert B.

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).

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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...