Final answer:
The IRS treats excessive compensation for the use of shareholder property as ordinary income to the shareholder, and it may disallow the deduction on the corporate side. These payments are deemed constructive dividends and taxed accordingly, reflecting the IRS's efforts to prevent earnings distribution disguised as deductible expenses.
Step-by-step explanation:
The IRS treats constructive dividends such as excessive compensation for the use of shareholder property as ordinary income to the shareholder. From a corporate perspective, it may also disallow part of the deduction for the compensation paid, considering it excessive and non-deductible. In this case, the payment is deemed a constructive dividend, which is taxed as ordinary income to the shareholder, not as a deductible business expense, capital gain, or an item to be ignored for tax purposes.
The rationale behind this is to prevent companies from disguising distributions of earnings to shareholders under the guise of deductions such as excessive salaries, rents, or interest. When a corporation makes payments to shareholders that exceed what is considered reasonable compensation for services rendered or use of property, the IRS may recharacterize these payments as dividends. Consequently, these payments do not reduce the corporation's taxable income because they are not regarded as legitimate business expenses.
Shareholders in corporations face a double taxation scenario: the business itself is taxed on its profits, and then shareholders are taxed again on the dividends they receive. Although the shareholders own a portion of the business and have a voice in how it is operated, they must be mindful of IRS regulations to ensure compliance with tax laws and avoid corrective action such as reclassification of payments.