A corporate distribution to a stockholder that is viewed by the tax authorities (such as the IRS) as a dividend payment even though the company doesn’t recognize it as such. For example, a company may pay a manager who is also a stockholder a higher-than-usual salary so that it can use the payment as a tax-deductible expense rather than as an after-tax dividend payment. The tax authorities may decide that part of the payment is a constructive dividend and cannot be treated as a tax-deductible expense.
A constructive dividend may also occur when a company sells or leases property to its stockholders for less than fair market value. If a company sells property to a stockholder for an amount below its fair market value, the stockholder will be deemed as having received a dividend virtually out of the company’s accumulated earnings and profits. The amount of the dividend is generally equal to the amount paid for the property minus its fair market value if the amount paid exceeds the company’s basis for the property. The same applies to the case when property is sold to a shareholder for a price less than the fair market value and also less than the company’s basis. However, if the property is sold to a shareholder for an amount less than the property’s fair market value and less than the selling company’s basis, the distribution is calculated as follows:
(1) If the fair market value equals or exceeds the basis, the distribution equals:
Distribution = adjusted basis – selling price
The adjusted basis takes into account any gain recognized on the sale.
(2) If the fair market value is less than the basis, the amount of the distribution is:
Distribution = fair market value – amount paid for property
A constructive dividend can also occur when a shareholder uses corporate property and pays less than the fair market value of the use. The dividend is equal to the excess of the property’s fair rental value over the amount the shareholder pays.
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