C corporations may distribute money or property to shareholders. The method used to make a corporate distribution will determine the tax consequences of the withdrawal. Generally, non-liquidating distributions (those that don’t dissolve the business) will take the form of dividends or a nontaxable return of capital to the shareholders. Of course, a corporation can distribute money in a number of other ways, as well, including payment of wages, fringe benefits, loans, and payment of rent. However, some of these deductible expenses can be reclassified by the IRS as taxable “constructive dividends” under certain conditions.
How Are Distributions Taxed?
The corporation itself does not recognize gain on a distribution of cash to its shareholders. Rather, the shareholders are the ones who must be concerned with taxation. Although distributions of cash or property to the shareholders will reduce the corporation’s earnings and profits (E&P), such distributions will not reduce the corporation’s taxable income. The corporation pays tax on the taxable income, and the shareholders pay tax on dividends received.
A distribution from a corporation is included in a taxpayer’s gross income to the extent that it constitutes a dividend. A taxable dividend is defined as a distribution from current or accumulated earnings and profits (E&P) of the distributing corporation (computed at the end of the year). Accumulated E&P refers to sums accumulated prior to the taxable year.
A distribution is treated as coming first from current E&P. If current E&P is sufficient to cover all distributions during the taxable year, such distributions are treated as dividends, and it is unnecessary to consider accumulated E&P. Accumulated E&P is relevant only if current E&P is insufficient to cover a corporate distribution. Distributions in excess of current E&P are dividends to the extent of accumulated E&P. The remaining balance is treated as return of capital to the extent of the shareholder’s basis in his or her stock, and any excess is treated as taxable gain.
Example: ABC Corporation has current E&P of $20,000 and accumulated E&P of $55,000. During the year, ABC distributed a total of $100,000 in dividends. Of this amount, $75,000 will be treated as taxable dividends, and the remaining $25,000 will be treated as a nontaxable return of capital (to the extent of a shareholder’s stock basis) or as a taxable gain to the shareholders.
If a corporation with E&P makes a distribution to a shareholder and does not report the payment as a taxable dividend, the IRS will sometimes reclassify this distribution as a constructive dividend, which means a de facto dividend. The distribution is then taxed the same as a regular dividend.
The following are some examples of transactions that may result in constructive dividends:
- A corporation makes payments to a shareholder’s family member without a corresponding level of services provided by the family member
- A corporation allows a shareholder the personal use of corporate property (such as an airplane, auto, or entertainment facility)
- A corporation pays personal expenses of an owner/employee and the expenses cannot be substantiated
- A stockholder purchases property from a corporation at below fair market value
Return of Capital
A distribution in excess of the corporation’s earnings and profits is generally viewed as a nontaxable return of capital to the shareholder. In other words, it is seen as merely a recovery or return of the shareholder’s investment in the corporation. The amount of this distribution first reduces the basis of the shareholder’s stock. Then, any amount in excess of the stockholder’s adjusted basis will be treated as a capital gain from the sale or exchange of property.
Wages for Services
Wages paid to a shareholder for services rendered in an employee capacity are deductible by the corporation and taxable to the shareholder. Unlike income in the form of dividend distributions, wages are not double taxed. This creates an incentive for a shareholder in a C corporation to take as high a wage as possible to minimize overall taxes on corporate earnings.
Wages paid to the shareholder must be based on services rendered and will be scrutinized by the IRS. In fact, the IRS will reclassify a portion of the wages as constructive dividends if they do not represent “reasonable compensation.” Some of the factors a court would consider to determine whether compensation is “reasonable” include the following:
- How does the amount of compensation compare with the amount of dividends paid?
- Would an unrelated outside investor consider the compensation reasonable?
- How does the compensation compare with the profit performance of the corporation?
- Was the level of compensation arranged in advance, or was it based on corporate profit?
- What is the typical level of compensation in the corporation’s industry?
Funds can also be distributed by the corporation in the form of fringe benefits. Fringe benefits, such as health insurance, medical reimbursement plans, company cars, education, and group term life insurance, are tax-deductible corporate business expenses by the corporation. Excessive fringe benefits distributed to an owner/employee may also be treated as constructive dividends.
A corporation can lend money to a shareholder. However, the IRS will reclassify the loan as a dividend distribution if the loan is not well documented. The loan must be a bona fide one, with a written promissory note signed and dated by both the lender (the corporation) and the borrower (the shareholder). The promissory note should state the time period for repayment and the interest rate to be charged.
The interest rate must be a reasonable one, based on current market conditions. However, if the principal balance of the loan does not exceed $10,000, the below market interest rate rules will not apply. In fact, the interest rate can be as low as zero percent. This exception does not apply, however, if the principal purpose of the loan is to avoid federal tax. The IRS and the courts use the following criteria to determine if corporate loans to shareholder loans are really loans or should be treated as taxable dividend distributions:
- Whether a ceiling existed on the amounts advanced
- Whether or not security was given for the loan
- Whether the stockholder was in a position to repay the loan
- Whether there existed a repayment schedule or an attempt to repay
- Whether there was a set maturity date
- Whether interest was charged
- The amount of the loan
- The extent to which the shareholder controls the corporation
- The earnings and dividends history of the corporation
- Whether a promissory note was drawn up
- Whether the corporation made systematic attempts to obtain repayment
- The corporation’s ratio of debt to equity
A corporation can pay rent to a shareholder for use of the shareholder’s personal property. The corporation gets a tax deduction for rent paid, and the shareholder reports rental income on his or her personal return. However, the IRS will reclassify rent as a dividend when payments are unreasonable. This may happen, for example, when a corporation pays rent to a shareholder in excess of the fair market rental value of the property.