Corporate Distributions

There are several ways to extract cash from a closely held C corporation. The purpose of this article is to alert you to the tax planning opportunities that exist if you intend to tap into that hard-earned business cash.

Historically, dividend treatment has been something to avoid because of the double taxation issue. In effect, dividends are subject to double taxation because your corporation pays income taxes on the earnings that generate the dividends, on which you also pay income taxes when the earnings are paid out to you. This harsh effect has been softened somewhat by the lowering of the maximum qualified dividend tax rate to 15%. However, in 2013 (barring any intervening tax legislation) this favorable tax rate will expire.

A planning strategy for a closely held C corporation is to calibrate shareholder-employee salary and bonus payments to reduce the corporation’s annual taxable income to the $50,000 level and minimize the combined shareholder-owner/corporate tax liability. Sometimes, however, intentionally arranging for you to receive double-taxed dividends can be beneficial. For example, a dividend paid by your corporation begins to become tax-efficient compared to a deductible payment when your income tax rate is 28% or higher, and your corporation’s tax rate does not exceed 15%. As long as the corporation’s top rate is 15%, dividends become relatively more tax-efficient as your personal tax rate increases to 33% and 35%. Note that the top individual rate is currently scheduled to increase to 39.6% in 2013.

Your corporation may have built up substantial earnings and profits over the years. A profitable corporation becomes exposed to the accumulated earnings penalty tax when it accumulates earnings in excess of reasonable business needs and does not pay dividends. Right now, the accumulated earnings tax rate is only 15%. However, after 2012, the accumulated earnings tax rate will return to the maximum individual federal rate on ordinary income. Therefore, now is a good time to pay out dividends and reduce your corporation’s exposure to this penalty tax.

Another way for you to tap the earnings that have built up in your corporation is to arrange to distribute cash and or property for your stock. This is called a stock redemption. A stock redemption may be treated as a sale in some cases, which qualifies for capital gain or loss treatment. Sale treatment would be preferred if you have a substantial basis in your stock. Sale treatment is a good thing because the maximum tax rate on long-term capital gains is currently only 15%, but is scheduled to increase to 20% in 2013.