Income and Assets · Income

Constructive dividends

A dividend does not have to be declared. Where a closely held corporation pays a shareholder’s personal costs, sells them something cheaply, or lends to them on terms no bank would offer, the tax consequences follow the substance of what moved rather than the label the books gave it. The result is the worst of both worlds for the parties: income to the shareholder with no deduction to the corporation.

The rule

The statutory route is short. A distribution of property, as defined in § 317(a), made by a corporation to a shareholder with respect to its stock is treated under § 301(c) (IRC § 301(a)) — so it is a dividend to the extent of earnings and profits (IRC § 316(a)), then a reduction of basis, then gain. “Property” means money, securities and any other property, but never stock in the distributing corporation or rights to acquire it (IRC § 317(a)). Nothing in that chain requires a declaration, a resolution, or a payment described as a dividend.

Form does not control. A distribution to shareholders with respect to their stock is within § 301 although it takes place at the same time as another transaction, if the distribution is in substance a separate transaction, whether or not connected in a formal sense (Reg. § 1.301-1(j)). That sentence is the whole doctrine: the question is what in substance moved from the corporation to the shareholder in their capacity as shareholder.

Compensation is where it usually surfaces. A deduction is allowed for a reasonable allowance for salaries or other compensation for personal services actually rendered (IRC § 162(a)(1)), and the test of deductibility is whether the payments are reasonable and are in fact payments purely for services (Reg. § 1.162-7(a)). An amount paid in the form of compensation but not in fact as the purchase price of services is not deductible, and an ostensible salary paid by a corporation may be a distribution of a dividend on stock (Reg. § 1.162-7(b)(1)).

The regulation names the fact pattern. This is likely to occur where a corporation has few shareholders, practically all of whom draw salaries; and where in such a case the salaries exceed those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings, it would seem likely that the excess is a distribution of earnings upon the stock (Reg. § 1.162-7(b)(1)). Proportionality to holdings is the evidential hinge.

Loans to shareholders are covered expressly. Any below-market loan directly or indirectly between a corporation and any shareholder of that corporation is within § 7872 (IRC § 7872(c)(1)(C)). The de minimis exception for such loans is available (IRC § 7872(c)(3)(A)) but falls away where a principal purpose of the interest arrangements is the avoidance of any federal tax (IRC § 7872(c)(3)(B)), and a loan with no repayment expectation is not a loan at all.

Ostensible salary can also be something else again. The same regulation notes that an ostensible salary may be in part payment for property — as where former partners sell a business to a corporation and continue in its service (Reg. § 1.162-7(b)(1)). Not every mischaracterised payment is a dividend.

Current figures

How it works in practice

Look for value moving to a shareholder outside an arm’s-length exchange, and then ask in what capacity they received it. The recurring sources are personal expenses paid by the company — vehicles, travel, home costs, family wages for no work — bargain purchases of company property, rent-free use of company assets, and advances recorded as loans that nobody expects to be repaid.

The asymmetry is what makes this expensive. If the payment is a dividend, the shareholder has income and the corporation gets no deduction, so a single dollar is taxed twice. That is worse than compensation, which is deductible, and worse than a genuine loan, which is neither. Clients who structure loosely because “it is all my money anyway” are choosing the most expensive of the three characterisations by default.

Proportionality is the fact the Service looks for, and it is the fact the client can most easily avoid creating. Where two shareholders own sixty and forty percent and their “bonuses” split sixty-forty regardless of what they did, Reg. § 1.162-7(b)(1) supplies the inference directly. Where compensation tracks work done, hours, and outside comparables, it does not.

For advances, the documentation is the substance. A note, a stated rate at least equal to the applicable federal rate, a repayment schedule that is actually followed, and security where the amount warrants it are what distinguish a loan from a distribution. Without them, § 7872 is the better outcome — imputed interest — and a finding that there was never a loan is the worse one.

How this has changed

Nothing in this topic has changed by legislation for a long time, and the stability is worth stating because it makes the sources unusually reliable: Reg. § 1.162-7 and Reg. § 1.301-1 read much as they did decades ago, and old material on constructive dividends is more trustworthy than old material on almost anything else in this section.

What has changed is the surrounding pressure. Because qualified dividend income is taxed at capital gain rates while compensation bears employment taxes, the incentive now often runs the other way from the one the regulation was written to police — closely held corporations may prefer distributions to salary rather than the reverse, particularly S corporations, where the recharacterisation risk is reasonable compensation being understated rather than overstated. The regulation’s two-limbed test works in both directions, and the fact pattern it names — payments proportionate to holdings — is equally probative whichever way the mischaracterisation runs.

The one moving part is the interest rate. The § 7872 thresholds are statutory and unindexed, but the applicable federal rates that determine whether a loan is below-market are published monthly, so a shareholder loan documented at a fixed rate years ago may have been at or above market when written and is unlikely to be a live issue on that account — while an undocumented advance has no rate at all and is exposed every year it remains outstanding.

Exam focus

Know that a dividend needs no declaration, and be able to point to IRC § 301(a) with Reg. § 1.301-1(j) for the proposition that substance controls.

Know the two limbs of the compensation test in Reg. § 1.162-7(a) — reasonable, and in fact purely for services — and the fact pattern in § 1.162-7(b)(1), especially that payments corresponding to stockholdings are the tell.

Know that the consequence is asymmetric: income without a deduction. Expect a question comparing the treatment of a payment as salary and as a constructive dividend.

Know that IRC § 7872(c)(1)(C) names corporation-shareholder loans, and that the worse outcome is not § 7872 but a finding that the advance was a distribution all along.

Check yourself

1. A corporation with three equal shareholders pays each a “consulting fee” of $50,000, although only one performs services. What is the treatment?

Answer: the payments to the two who perform no services are constructive dividends. Reg. § 1.162-7(a) allows a deduction only where the payments are reasonable and in fact purely for services, and § 1.162-7(b)(1) treats an ostensible salary as a distribution of a dividend on stock where the amounts bear a close relationship to the stockholdings. The corporation loses the deduction and each recipient has a dividend to the extent of earnings and profits under IRC § 301(c)(1) and § 316(a).

2. Why is a constructive dividend a worse outcome than excess compensation for the parties taken together?

Answer: because it is taxed twice. Compensation is income to the recipient but deductible by the corporation under IRC § 162(a)(1), so the amount is taxed once. A distribution with respect to stock is income to the shareholder under IRC § 301(c)(1) and carries no deduction, so corporate earnings bear tax and the same dollars are taxed again in the shareholder’s hands.

3. A sole shareholder takes $40,000 from the company recorded as a loan, with no note, no interest and no repayments. What are the two possible characterisations?

Answer: a below-market loan or a distribution. IRC § 7872(c)(1)(C) reaches any below-market loan between a corporation and a shareholder, producing imputed interest. But if there was never a genuine expectation of repayment, there is no loan and the advances are distributions with respect to stock, taxed under IRC § 301(c) when made. The evidence that separates them — a note, a stated rate, security, actual repayments — has to exist at the time.

4. A corporation distributes its own newly issued shares to its shareholders. Is that a distribution of property within IRC § 301?

Answer: no. IRC § 317(a) defines property for this part as money, securities and any other property, expressly excluding stock in the corporation making the distribution and rights to acquire that stock. A distribution of the corporation’s own shares is analysed under IRC § 305 instead, where it is generally excluded from gross income unless one of the § 305(b) exceptions applies.