What Is a Constructive Dividend?

A constructive dividend is a payment or allowance to a participant or shareholder in a company that is not intended or classified as a distribution to the participant, but which is classified later as a dividend by the Internal Revenue Service (IRS) and thus becomes taxable.

Key Takeaways

  • A constructive dividend is a payment or allowance to a participant or shareholder in a company whereby it's not intended or classified as a distribution.
  • However, a constructive dividend is classified later as a dividend by the IRS and thus becomes taxable for the recipient.
  • Constructive dividends can include below-market loans, use of company resources, compensation for a shareholder that's an above-market salary.

How Constructive Dividends Work

A dividend is typically a distribution, payment, or reward to a shareholder for investing in a corporation. Dividends are often cash payments or issuance of stock to shareholders by the company. However, there are other non-cash dividends that shareholders could receive from a company.

A constructive dividend is not the typical cash dividend one would receive as a shareholder. Constructive dividends are classified by the IRS as dividends if they meet certain criteria. Essentially a constructive dividend is when a shareholder benefits somehow financially from the corporation, it's influence or assets.

The classification could be seen–from a tax standpoint–as unfavorable by the recipient of a constructive dividend because it is taxable even if the recipient did not receive cash as compensation. Also, the classification can occur retroactively at any time making the recipient of the constructive dividend liable for taxes on the dividend at that time. Constructive dividends are not classified as dividends for corporations. In other words, the corporation cannot expense the dividend, which would typically reduce its taxable income.

Types of Constructive Dividends

A constructive dividend often occurs in smaller companies where there are only a few shareholders and those shareholders either do business or interact with the company. The types of constructive dividends can vary depending on the size of the company and the relationship with the shareholders, but some common types of constructive dividends include:

Expenses Paid

Constructive dividends can include any reimbursements for expenses paid out to a shareholder or if a corporation is paying the expenses of a shareholder, and it's not intended to be paid back.

Corporate Property

Use of a corporate property such as vehicles, residences, airplanes, and boats whereby no payment to the corporation has been made by the shareholder nor is any money deducted from the employee's wages would be a constructive dividend.

Debt Payments

Paying off or forgiveness of loans or debt by the corporation to the shareholder, including the assumption of shareholder debt by the corporation would be a constructive dividend.

Below-market Loans

Loans made to shareholders at below-market interest rates are considered constructive dividends and would be taxable for the recipient.

Property Improvements

If a corporation engages in improvements or purchase of property on behalf of the shareholder, the value determined by the IRS would be taxable.

Family Compensation

Payments to family members of shareholders by the corporation that are in excess to the amounts that would typically be paid for those services are considered constructive dividends.

Typically with constructive dividends, the shareholder has not received any liquid financial compensation with which to pay the taxes that are determined to be due by the IRS. However, if the shareholder reimburses the corporation for the fair market value of the benefit, the IRS will not count the benefit as a received dividend.

Taxes and Constructive Dividends

For a service or payment to be considered a constructive dividend, the IRS must classify the benefit received as a constructive dividend and determine that it has not been reimbursed by the shareholder to the corporation. The IRS also calculates the value of the constructive dividend, and the taxes due based on the marginal income tax bracket of the shareholder.

The taxes due can vary depending on the tax rate applied by the IRS and total income of the shareholder or the shareholder and spouse if filing jointly. The IRS has three tax rates for dividends (0%, 15%, or 20%), depending on the income of the shareholder. The IRS also reserves the right to count a constructive dividend as compensation, and tax it as part of the shareholder's total compensation.

A constructive dividend's tax can vary depending on the various IRS dividend income thresholds, the total income of the taxpayer or shareholder, and whether the tax return is a single-filer or joint-filer. As a result, those who have received a constructive dividend should contact a tax professional for assistance.

Examples of a Constructive Dividend

Let's say, as an example, a shareholder of a company owns a building that the company rents from the shareholder. If the shareholder charges a rental amount that's at an above-market rate, the net difference between the market rent versus the rental amount that exceeds the market rent will be considered a constructive dividend by the IRS.

As another example, let's say the same shareholder is paid a salary that is above the typical salary for that specific job or role. The IRS will likely consider the above-market salary amount as excess income and classify that portion of income as a constructive dividend.