Final answer:
The IRS treats excessive compensation paid to shareholder-employees as constructive dividends, which are taxed as ordinary income to the shareholder, not as a deductible business expense or a capital gain for the corporation.
Step-by-step explanation:
The IRS treats constructive dividends in the form of excessive compensation paid to Shareholder-employees as taxed as ordinary income to the shareholder. This means that if the IRS determines that the compensation paid to the shareholder-employee of a corporation is excessively high, this excess portion is considered a dividend. Consequently, this amount is not deductible for the corporation as a business expense; instead, it is reclassified and taxed at the individual shareholder's level.
The correct treatment would be that these excessive payments (or constructive dividends) are not deductible for the corporation. They do not lead to a double taxation issue in this context; instead, they are considered as paid out of the taxed income of the corporation to the shareholder and then taxed again at the shareholder's level as ordinary income, not as a capital gain.
Overall, the correct option is 'B. Taxed as ordinary income to the shareholder'. The terms 'excessive compensation,' 'constructive dividends,' and the taxation of such income are relevant to understanding how such transactions are treated by the IRS in the context of corporate taxation.