A constructive dividend is any payment to a shareholder which is not classified as a dividend by the corporation. These payments are considered dividends and must be reported as income by the shareholder and are not deductible by the corporation. In other words, constructive dividends are double-taxed, first at the corporate level and then at the individual shareholder level.
The IRS often reclassifies corporate deductions as constructive dividends where shareholders of closely held corporations borrow money from their corporation to purchase personal items (i.e. a home, vacation, personal investments), use corporate assets for personal use, or lease their personal property to their corporation. The key inquiry is whether the expenditures were primarily for the shareholder’s benefit and whether there was an expectation of repayment.
When the IRS audits a corporation’s tax return and recharacterizes a corporate deduction as a constructive dividend, the corporate distribution is then taxed as a regular dividend, up to the earnings and profits of the corporation. With the additional taxable income, the corporation will incur more tax liability. Additionally, the corporation may be subjected to late penalties and interest on the underpayment of tax. The shareholder’s tax return is also impacted. The shareholder will have additional income to report on his or her individual tax return resulting in additional income tax liability. The shareholder may also be charged late penalties and interest on the underpayment of tax.