Legal Definitions - informal dividend

An informal dividend refers to a distribution of a company's assets or profits to its shareholders that is not formally declared or recorded as a dividend by the company's board of directors. Unlike a regular dividend, which is officially approved and documented, an informal dividend often occurs in closely held corporations where the shareholders are also often the company's officers or directors. These distributions may take various forms, such as excessive compensation, personal expenses paid by the company, or the personal use of company assets, and are treated as dividends for tax or legal purposes even without formal declaration.

Here are some examples illustrating an informal dividend:

• Example 1: Excessive Personal Expenses Paid by the Company

  Imagine "Tech Innovations Inc.," a small software company owned and operated by its founder, Sarah. Instead of formally declaring a dividend, the company regularly pays for Sarah's personal luxury car lease, her children's private school tuition, and her family's annual international vacations directly from company funds. These expenses are not legitimate business costs and are not part of her formally approved salary or benefits package.

  Explanation: In this scenario, "Tech Innovations Inc." is distributing its profits to Sarah, a shareholder, by covering her personal expenses. Because these payments are not formally declared as dividends by the board (which in a small company might just be Sarah herself, but the formality still matters) and are not justifiable business expenses or reasonable compensation for her work, they would be considered informal dividends for tax and legal purposes. They represent a transfer of company value to a shareholder without the proper corporate formalities.

• Example 2: Personal Use of Company Property

  Consider "Coastal Properties LLC," a real estate investment firm with three shareholders, all members of the same family. The company owns a beachfront vacation home intended for rental income. However, one of the shareholders, Mr. Davies, allows his extended family to use the property for several months each year, completely free of charge, effectively preventing the company from generating rental income during those periods. No rent is paid to the company, and no formal agreement exists for this personal use.

  Explanation: By allowing Mr. Davies's family to use the company's valuable asset without compensation, "Coastal Properties LLC" is effectively providing a benefit to a shareholder. This free use of a company asset, which deprives the company of potential revenue, is a distribution of company value to Mr. Davies. Since this benefit is not formally declared as a dividend or compensated at fair market value, it constitutes an informal dividend.

• Example 3: Unrecorded or Below-Market Loans to Shareholders

  A manufacturing company, "Precision Parts Co.," is owned by two partners, Emily and John. Emily frequently takes large sums of money from the company's bank account, labeling them as "shareholder loans." However, there are no formal loan agreements, no interest is charged, and there's no clear repayment schedule. These "loans" are rarely, if ever, repaid, and effectively reduce the company's available cash.

  Explanation: When a company provides funds to a shareholder without the proper documentation, reasonable interest rates, and a clear expectation of repayment, these "loans" can be reclassified as informal dividends. The company is distributing its assets to Emily without the formal declaration process, effectively transferring company profits to her benefit. The lack of formal loan terms and repayment makes it clear that this is not a true loan but rather a disguised distribution of company earnings.