Treatment of Distributions and Constructive Dividends

Corporate cash or property transfers to shareholders trigger downstream tax consequences that turn on earnings-and-profits availability, distribution form, and whether the payment disguises itself as something else—salary, rent, or loan—rather than a formal dividend.

Distributions become dividends when earnings-and-profits support them.

Section 316 ties dividend status to current and accumulated E&P, forcing corporations to track both buckets.

If current E&P covers the distribution, shareholders receive dividend income; once exhausted, payments reduce stock basis, and only after basis hits zero does capital gain emerge. Year-end projections help boards size distributions so basis reduction or gain timing aligns with shareholder preferences.

Earnings-and-profits accounting diverges from GAAP retained earnings.

E&P starts with taxable income, adjusts for tax-free income, nondeductible expenses, depreciation timing, and federal taxes, creating a parallel ledger.

Corporations maintain running schedules of current E&P, accumulated E&P, and previously taxed earnings from Subpart F or GILTI to determine dividend capacity for each period.

Journal entry — cash dividend within E&P capacity.

Corporation declares $8 million dividend; E&P balance $12 million.

Dr Retained Earnings (E&P) $8 000 000

Cr Cash $8 000 000

No corporate deduction arises; shareholders include $8 million in dividend income. Backup withholding applies if Form W-9 is missing, and Form 1099-DIV reports the payment.

Constructive dividends surface when value shifts without formal declaration.

Excessive compensation, personal-use corporate jets, below-market loans, or rent-free property use all represent hidden distributions.

The IRS recharacterizes the benefit as a dividend, denying corporate deductions (or depreciation), yet taxing the shareholder. Boards document wage studies and fair-market rent schedules to shield ordinary deductions from dividend reclassification.

Loan versus dividend hinges on contemporaneous documentation and repayment.

Bona fide loans feature written notes, fixed maturity, stated interest, collateral, and actual collections. Absence of these attributes converts advances into constructive dividends.

Illustrative recharacterization

• Advance to shareholder $2 million

• No note, no repayments after 18 months

Upon audit:

Dr Retained Earnings $2 000 000

Cr Due from Shareholder $2 000 000

Shareholder dividend income equals $2 million; corporation loses interest income and potential bad-debt deduction.

Stock dividends and § 305 exclusions turn on proportionality.

Pro rata stock dividends generally nontaxable; however, selective stock distributions, convertible-preferred issuances, or rights offerings favoring some classes become taxable dividends equal to fair-market value on distribution date.

Public companies monitor anti-dilution clauses and shelf registrations to avoid inadvertent taxable stock dividends.

Redemptions may escape dividend treatment when they reduce ownership sufficiently.

Section 302 tests—complete termination, substantially disproportionate, and not essentially equivalent to a dividend—let qualifying redemptions follow sale treatment with basis recovery and capital-gain rates.

Family-attribution waivers, corporate options, and constructive ownership through trusts complicate the analysis; advance ruling requests can pre-clear large redemptions.

Payroll and withholding consequences follow constructive dividend findings.

When excessive salary morphs into dividend, the corporation loses wage deduction yet payroll taxes remain unrecovered. Audit settlements often recast only a portion, so careful allocation mitigates double pain.

Reporting demands Form 1099-DIV, Form 1099-MISC, or Schedule K-1 accuracy.

S-corporations classify distributions under § 1368, splitting pockets of AAA, previously taxed income, and shareholder basis. Failure to issue correct forms triggers per-form penalties, escalating when constructive dividends appear years later.

Tracking earnings-and-profits, documenting related-party transactions at arm’s-length, and reviewing shareholder advances each quarter remain the surest defenses against dividend recharacterization and unexpected tax liabilities.

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