Constructive dividend is a taxable benefit derived by a shareholder from the corporation even though the benefit was not designated a dividend. It is a division of profits of a corporation among the stockholders without a formal declaration of a dividend or intent by the directors to declare a dividend.
Transactions that can produce constructive dividends include the payment of unreasonable compensation, making of loans to shareholders or bargain purchases of corporate property.
Constructive dividend is characterized by the Internal Revenue Service (“IRS”) as a dividend distribution even though the corporation calls it something else. For example, a small firm may pay an employee who is also a stockholder an excessive salary so that the payment can be used as a tax-deductible expense rather than as an after tax dividend payment. The IRS may determine that part of the payment is a constructive dividend and then disallow it as a tax-deductible expense.