A constructive dividend is a payment made by a corporation to a shareholder that is not classified by the corporation as a dividend. For tax purposes, these payments are considered dividends, and are taxed as such. This situation most commonly arises in smaller organizations with few shareholders, where there are ongoing interactions between the entity and shareholders. For example:
- A shareholder owns the building in which a company is located, and charges rent to the company at an above-market rate. The portion of these rent payments that exceeds the market price can be construed as a constructive dividend.
- A company pays an employee/shareholder an above-market salary. The excess portion can be classified as a constructive dividend.
The corporation cannot claim a business expense deduction for the amount of these constructive dividends. This means that the taxable income of the corporation increases. The increase in taxable income for the shareholder means that the shareholder will now have a larger tax liability than had previously been the case.