Corporations: Good Time for Tax-Wise Transactions

June 21, 2010 — 1,801 views  
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If you own shares in a closely-held C corporation, you probably know the 2010 federal income tax rate structure is quite favorable for these reasons:

  • If your company pays you a taxable dividend this year, the maximum federal income tax rate is only 15 percent; and
  • That same 15 percent maximum rate applies to 2010 corporate payouts or stock sales that generate long-term capital gains.

Dividend and Capital Gains Taxes Are Almost Certain to Go Up

With the passage of the massive healthcare bill, odds are the current taxpayer-friendly picture will only last through the end of this year. Unless Congress takes action to extend the status quo, higher taxes on dividends and long-term gains will kick in on January 1, 2011, when the "Bush tax cuts" are scheduled to expire.

Even if the Republicans take back Congress in November, they might not be able to change the tax outlook anytime soon. Through 2012, the President has stated he would likely veto any tax cuts as the revenue will be needed to help pay for government healthcare.

Here are the specifics about what is likely coming down the pike:

Dividend Taxes

The maximum federal rate on dividends is scheduled to increase from the current 15 percent to 39.6 percent on January 1. Although the President has promised more than once to limit the maximum rate to 20 percent, that pledge has changed.

Beginning in 2013, the new healthcare legislation will impose an additional 3.8 percent Medicare tax on a high-income individual's net investment income, which is defined to include dividends. That raises the maximum dividend tax rate to at least 23.8 percent for 2013 and beyond. For affected individuals, that's at least a 58.7 percent increase in federal taxes on dividends (23.8 percent is 158.7 percent of 15 percent).

For this purpose, a high-income individual has an adjusted gross income of $250,000 if married and filing jointly or $200,000 for single filers.

Taxes on Long-Term Gains

Starting January 1, 2011, the maximum rate on most long-term capital gains is scheduled to increase from the current 15 percent to 20 percent. And in 2013, the new healthcare legislation will impose an additional 3.8 percent Medicare tax on a high-income individual's net investment income, which is defined to include long-term gains. As with dividends, that means a maximum federal tax rate of at least 23.8 percent for 2013 and beyond. For affected individuals, that amounts to at least a 58.7 percent increase in federal taxes on long-term gains.

Depending on where you live, your state income tax rate on dividends and long-term gains may be headed higher too.

What Can You Do?

Although next year and beyond look grim from a tax perspective, you still have some time to take advantage of this year's historically favorable rates. Here are three strategies to consider before the end of 2010:

Strategy 1: Take Dividends This Year

Let's say your profitable C corporation has a healthy amount of earnings and profits (E&P). The concept of E&P is somewhat similar to the more-familiar financial accounting concept of retained earnings. While lots of E&P indicates a financially successful company, it also creates two unfavorable tax side effects:

  1. To the extent your corporation has current or accumulated E&P, corporate distributions to shareholders (including owners and executives) count as taxable dividends. Since the 2010 federal tax rate on dividends cannot exceed 15 percent, dividends received before the end of this year will be taxed lightly compared to what is likely to happen in 2011 and beyond. Therefore, shareholders should weigh the possibility of triggering a manageable current tax bill by taking dividends in 2010 against the possibility of absorbing a much bigger (but deferred) tax hit on dividends they would otherwise plan to take in future years.
  2. 2. When your C corporation retains a significant amount of earnings, there's a risk that the IRS will assess the accumulated earnings tax (AET). This tax can potentially be assessed once a corporation's accumulated earnings exceed $250,000 (or $150,000 for a personal service corporation). When the AET is assessed, the tax rate is the same as the maximum federal rate on dividends received by individuals. Therefore, the AET rate is also scheduled to jump from the current 15 to 20 percent, starting in 2011 (assuming the President's pledge to keep it at 20 percent rather than 39.6 percent goes through).

Dividends paid in 2010 will be taxed lightly, and they will also reduce your company's accumulated earnings. So they will also reduce or eliminate the company's AET exposure in future years, when the AET rate will probably be at least 20 percent.

Strategy 2: Arrange a Low-Taxed Stock Redemption This Year

Another way to convert theoretical C corporation wealth into cash is with a stock redemption transaction in which you sell back some or all of your shares to the company. (When there are several shareholders, this is a common technique to cash out one or more selected shareholders while the others continue to hold their stakes.)

To the extent of your corporation's current or accumulated E&P, any stock redemption payment is generally treated as a taxable dividend. However, the Internal Revenue Code provides several exceptions to this rule. If one of these exceptions applies (consult with your tax adviser), the redemption payment will be treated as proceeds from selling the redeemed shares. In other words, regular stock sale treatment applies.

The distinction between dividend and stock sale treatment may or may not be important to you. That's because when dividend treatment applies, you receive no offset for your tax basis in the redeemed shares. In that case, the entire redemption payment may count as taxable dividend income.

In contrast, when stock sale treatment applies, you have capital gain (probably long-term) only to the extent the redemption payment exceeds your basis in the redeemed shares. So only part of the redemption payment is taxed. In addition, you can offset capital gain from a redemption treated as a stock sale with capital losses from other transactions (including capital loss carryovers you may have left over from the 2008 stock market meltdown).

If you don't have significant basis in the redeemed shares or significant capital losses, there's usually only a minor distinction between dividend treatment and stock sale treatment under today's federal income tax system. For 2010, both dividends and long-term capital gains are taxed at the same rates, with a maximum rate of only 15 percent.

However, as explained earlier, both dividends and long-term gains will almost certainly be taxed at higher rates in 2011 and beyond. Therefore, a stock redemption that is completed in 2010 could result in a much lower tax bill than a redemption that's put off until 2011 or later.

Strategy 3: Sell Stock This Year

Speaking strictly from a federal income tax rate perspective, selling shares this year and paying no more than 15 percent on the resulting gains (assuming you've held the shares for more than a year) sure beats paying 23.8 percent (or maybe more) on gains from sales in later years.

Exception: You might want to defer capital gains until the following year because of a reasonable expectation that you will be experiencing capital losses at that time that could offset the gains.

Consider the possible advantages of taking dividend payments, transacting stock redemptions, or selling shares in your closely-held corporation under today's favorable federal income tax structure. Waiting until next year or later could prove costly. Consult with your tax adviser before making any moves.

Rea & Associates, Inc.