When a corporation turns a profit, portions will often be distributed to shareholders in amounts based on the total number of shares each individual holds—in addition to reinvesting some of the funds in the business itself. These distributions are called dividends (this classification applies to any payment of money or property to shareholders) and are supposed to be reported to the Internal Revenue Service for tax purposes.
Unfortunately, it’s somewhat common for corporations to try to avoid paying taxes when they can help it, and one way they try to do so is by disguising dividends as business expenses and deducting them from their taxes. When the IRS catches a dividend misclassified and declared as a business expense, the federal agency will reclassify the amount as a constructive dividend. A constructive dividend is a payment to a shareholder on which taxes have not been paid—and thus presents a situation the IRS will look to remedy.
The most common example of constructive dividends involves personal expenses unrelated to the company being classified as business expenses to avoid taxation for the business and the shareholder. For example, a company that pays a shareholder’s rent and writes it off as a business expense is likely to incur the wrath of the IRS once the agency digs deeper and discovers what has happened.
Be aware of the consequences
In general, regular dividends and constructive dividends are taxed in much the same way, but because regular dividends have been properly taxed and constructive dividends have not, it leads to tax trouble for both the corporation and the shareholder.
In addition to forcing adjustments to both their tax bills—that the amount owed will increase is basically a foregone conclusion—constructive dividends generally lead to the imposition of various fines and penalties, causing further financial headache to both parties. Finally, if the misclassification of constructive dividends was intentional, the company (and even the shareholders, if they knew about it) could even face criminal penalties.
Corporate tax law is complex, and opportunities for unintended mistakes—as well as intentional attempts to flout the law—present themselves seemingly at every turn. If your company has questions about the particulars of tax law, including what counts as a taxable dividend and what counts as a legitimate business expense, seek the counsel of a skilled and knowledgeable tax attorney. This will allow your business to abide by the law law and avoid harsh, unnecessary penalties from the IRS and other agencies.
BoltNagi is a well-established and widely respected business law firm serving corporations and partnerships throughout the U.S. Virgin Islands.