Final answer:
Constructive dividends are considered personal benefits to shareholders and are taxed as ordinary income to them, without being deductible as a business expense for the corporation.
Step-by-step explanation:
The Internal Revenue Service (IRS) treats constructive dividends, which are corporate payments for a shareholder's personal expenses, as taxed as ordinary income to the shareholder. Rather than being a deductible business expense, these payments are reclassified as dividends, and the shareholder must include them in their personal income tax return. As such, the correct answer to the question is B. Taxed as ordinary income to the shareholder.
Because these payments are made for the shareholder's benefit and not as an ordinary and necessary business expense, they cannot be deducted by the corporation. The income to the shareholder is considered as being derived from the corporate earnings, and thus it mirrors the tax treatment of regular dividends. Corporate income taxes and the tax implications of constructive dividends are an important aspect of understanding the concept of 'double taxation', where the corporation is taxed on its profits, and then shareholders are taxed again on the dividends they receive.