 Hello and welcome to the session in which we will discuss constructive dividend. What is the big idea here? Well, when you think of constructive dividend, it occurs in a small, closely held corporation. Think of manager slash owner situation. What does that mean? Think of small businesses where the people who work there, the owners are also the manager. So you are the owner of the company and you are basically slash the CEO, the manager of this company. What these individuals they'll try to do, they'll try to benefit themselves from the company with no tax consequences. And if they try to do that, if they try to get a benefit, the IRS might reclassify this benefit as dividend. And as a result, they cannot have a tax deduction and they will be taxed on that dividend. So once again, this is usually happens in closely held corporations. Simply put, that does not happen in publicly traded companies. And those closely held corporation, I dealt with them a lot when I was in practice. They are not well structured or well documented. They will try to get some money out of the corporation via expenses by charging expenses, what in reality, they might have to classify those as dividend. What are we talking about here? Just give you a few examples. We're going to look at more, for example, rental transaction between the company and the owners. So for example, if this couple owns a restaurant, what they do is they own the restaurant, but they own the business building separately and they rent, the, they rent themselves the building to run the restaurant. So there's rental transaction between the two. Are they charging fair market value or not? We'll talk about that. Borrowing cost. Well, this and these two couples own a restaurant. They can lend money to that restaurant or they can borrow money. Are they charging fair interest rate? Excessive salaries, they might pay themselves excessive salaries. You might be saying, OK, what if they rented themselves this building and they paid and they made the business pay too much in rental? Well, they're going to have rental income. Yes, they might have excessive rental income, but what they might do, they might also have rental losses from other property and they might offset each other. The point is this happens in the real world. The the IRS might reclassify things as constructive dividend. And this is what we're going to be discussing in this session. Before we proceed any further, I have a public announcement about my company, Farhat Lectures dot com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true, false questions, as well as exercises. Go ahead, start your free trial today. So technically, what is constructive dividend? Is any financial advantage granted to a shareholder can be considered a dividend for tax purposes. So of something, if any tax advantage given to the shareholder that potentially could be reclassified as dividend, that's constructive dividend. If it's reclassified, then it's technically dividend. Now, it can only be considered dividend if the company has current earnings and profit or accumulated earnings and profit. So the dividend rules still apply. You have to have CEP and AEP. Simply put, constructive dividend. It's when a payment might substitute an actual dividend and it's considered a form of evading taxes. So when you make a payment, when there's a transaction between the company and the owners, whether it's a salary, rental, borrowing, use of property asset, sale between the two, between the two parties or purchase between the two parties. If it could be considered a dividend, it will be reclassified. So the benefit conveyed will be reclassified, recharacterized as dividend and as a corporation. If you're dealing between two corporations, the corporation would receive a dividend, receive deduction. They would have to consider the income, but they will get a deduction. If it's a shareholder, they will be taxed most likely on a preferential tax treatment like 0, 15 or 20 percent. But nevertheless, many they would rather have they would rather have an expense to the corporation rather than an income to them. Examples of constructive dividends, just to give you some examples. The use of corporate asset at a lower or no cost to the shareholder, such as using the company vehicle planes or react for non-employee shareholders. Simply put, what you do is you want to take your family on vacation. You would use the company's planes to fly there. Well, it might cost you five thousand dollars to fly there, but now you're using the company plane for free. Well, that's constructive dividend. OK, the dividend equal to the fair market value of the usage. For example, you might sell property to a shareholder at a discounted price. For example, selling a property worth 100,000 for 10,000. Well, that's there's a 90,000 dollar difference that's considered basically a dividend. Renting corporate property to a shareholder at a reduced cost. You're letting them rent something and it's at a reduced cost, whether it's a vehicle, a boat, a plane, whatever it is. Lending to shareholders at interest rate below market level. So you are giving them a loan for zero or two percent. Well, in reality, if they go to the bank, they have to be charged 10 percent. So they're getting a benefit. The benefit could be recharacterized as dividend charging high interest rate on loans from shareholders to company. Now it's the other way around. The owners are lending money and they're lending the money at a high rate to the company and charging the company interest. Yes, the company will have a deduction, but the owner will have income. Again, the owner might have a way to reduce their income. Some other ways, some other expense that they can offset that's income. So they offset the income, the company get a deduction, they're both happy. And this is where the IRS might intervene. Payment made for the benefit of the shareholder, including personal expenses or obligation. So you have a personal expenses and you don't pay it. Well, the corporation pays it. They get a deduction, you get a benefit. Overpaying shareholders through rental agreement. And I used to, when I was in practice, we had many medical doctors and dentists. And they had rental agreement between themselves and their business because they would buy property and they would open different practices or they would rent the practices to other doctors and they will have a rental business on the side beside their practice. So that's normal because the doctors, they make money. They want to invest that money, but you have to be very careful paying the fair value of the rental property. Let's take a look at an example that's kind of considered excessive compensation. Let's take a look at an example that might be considered amount to excessive compensation or compensation being paid indirectly. Madison, the CEO and a single shareholder of Harrison Enterprises, she paid herself half a million dollar from the company. Okay. And she's always looking for ways to gain more advantage from the corporation. But she wants to evade dividend because she doesn't want to take the dividend out because the profit was already taxed and if she takes the dividend out, you have to pay taxes again. And has no wish to raise her salary. Why? Because if she raised her salary, the IRS might argue the compensation is excessive. Now, how would the corporate, how would the IRS argue this? I'm going to show you on the next slide, on the following slide, you know, what are some of the factors they look at. So Madison would like to donate $60,000 to her former college to create a scholarship for financially strapped students. She would like to make a donation. Well, here's what's going to happen. Harrison Enterprises would pay the donation in place of Madison. So the corporation will pay the donation rather than Madison from her personal account. Well, the donation is really benefiting Madison because she's the only shareholder, but she is not taxed on the donation amount because she didn't took the money out, then she paid it. Okay. So and Harrison would declare a charitable contribution deduction assuming that they can do what? They can deduct it assuming there's no limitation. You know, it's less than 10% of taxable income. So that's what she did. Simply put, she took $60,000 to benefit herself, but indirectly, indirectly. Now, avoiding unreasonable compensation. Now, Madison is making half a million. Is this amount fair or not? Well, how do we know whether the amount is fair or not? Well, you have to document how, why are you getting paid that much? Why are you paying someone that much? Well, what are some of the things you should look at or the IRS would look at? So you need to be aware of the qualification of the employee. What are the qualification of the employee? Do they deserve this amount of money? Analysis of past salary versus dividend distribution. If we notice that suddenly the company is no longer paying dividend or they reduce their dividend and they increase their salary. Well, it could be that's what they're trying to do. Reduce their dividend because it's not tax deductible and increase their salaries. We have to look at similar compensation structure for equivalent roles in the same sector. We look at other positions, similar positions. Are they being paid the same in other companies? What is the extent of the employee tax? Is the employee tasks, are they making strategic decision? Are they taking risk? Or are they, the role is manual mind numbing. They don't have to, they don't have to have a special skill. What's the task? How large is the business? The scale of business operation, is it small? Is it local? Is it regional? Is it international? Well, the larger, the more you have to compensate that employee. Is there a compensation policy for other employees? So how do you pay other employees? And let's take a look at that and compare how you are paying this individual. If everyone is fair, is treated fairly, then it's fair. Also, we have to look at whether a shareholder with the corporation best interests in mind would have consented to the paid compensation. What the IRS says is this, we are going to be in the shoes of the shareholder. As an owner of this company, we're going to look from the outside, from the shareholder. As a shareholder, what I think this individual is compensated well, or not well, or compensated too much. If the individual is compensated too much, then what they're trying to do, they're trying to get that individual, is trying to get money out of the corporation through salaries rather than dividend. Again, what's the point? The point is to reclassify the payment as dividend for the IRS. The individual, the company, wants to classify it as an expense, so they have a tax deductible. That's what we're trying to do here. What should you do now? To look at additional exercises, through false, multiple choice questions, go to Farhad Lectures and practice this topic. Constructive dividends is an important topic because it's a dividend that's packaged and directly through an expense. You have to understand how it works, examples of it. Good luck, study hard, and of course, stay safe.