For Corporations, It's Time for a Payout

From smSmallBiz

IT'S TIME TO convert your corporation's wealth into cash.

If you own a regular C corporation (as opposed to an S corporation), the current federal income tax regime is quite favorable. If the company pays you a taxable dividend, the maximum tax rate is only 15%. The same 15% maximum rate applies to corporate payouts that generate long-term capital gains.

But this happy scenario may not last much longer. Unless Congress takes action to extend the status quo, higher tax rates on dividends and long-term gains will kick in for 2011 and beyond. Specifically, the maximum federal rate on dividends will jump to 39.6% from 15%, and the maximum rate on long-term gains will bounce to 20% from 15%. If the Democrats (who opposed Bush's tax cuts in 2001 and 2003) sweep the November elections, it's possible these tax hikes could come as early as next year. It could soon be a lot more expensive to convert wealth from your corporation into cold hard cash.

So what can you do?

Think about making some moves before the end of this year to take advantage of the current low tax rates on dividends and long-term gains. Even if the Dems cruise to victory, they probably won’t risk the political heat that would come from retroactively imposing higher taxes on 2008 transactions. At least that's my opinion. With that assumption in mind, please consider the merits of the following two strategies.

Strategy No. 1: Take Dividends This Year

Say your profitable C corporation has built up a hefty amount of earnings and profits, or E&P, which is a tax concept similar to the accounting concept of retained earnings. While lots of E&P indicates a financially healthy corporations, it also creates two unfortunate tax problems.

First, corporate distributions to you taken from that E&P count as taxable dividends. As noted, the current federal tax rate on dividends cannot exceed 15%, but the rate could be a whole lot higher in future years. In other words, you must weigh the cost of triggering a relatively manageable tax hit on dividends received now against the possibility of taking a much bigger (but deferred) tax hit on dividends received in the future.

Second, when your C corporation retains a significant amount of earnings, there's a risk of the IRS hitting the company with the dreaded accumulated earnings tax, or AET. The tax can potentially be assessed once a corporation's accumulated earnings exceed $250,000 ($150,000 for a personal service corporation). When it's assessed, the AET rate is the same as the maximum federal rate on dividends. So the AET rate is scheduled to jump to 39.6% from 15% in 2011 (and possibly sooner, depending on election results). The good news: Dividends paid this year will be taxed at no more than 15%, and they will reduce your company's accumulated earnings. Therefore, they will also reduce or eliminate the company's exposure to the AET in future years when the rate could be 39.6% or worse.

Strategy No. 2: Do Low-Taxed Stock Redemption Deal This Year

Another way to convert C corporation wealth into cash is with a stock redemption deal — where you sell back some or all of your shares to the company. When there are several shareholders, this is a common technique to get extra cash to one or more selected shareholders (like you) while other shareholders let their bets ride. There's no need to bring in new shareholders to buy your stock — because the company does that.

Any stock redemption payment taken from E&P is generally treated as a taxable dividend to you from the corporation. However, the Internal Revenue Code happily provides several exceptions to this general rule. If one of these exceptions applies (consult your tax advisor), a redemption payment is treated as proceeds from selling the redeemed shares (i.e., garden-variety stock-sale treatment applies).

The distinction between dividend treatment and stock-sale treatment could be significant in your case. Here's why. When dividend treatment applies, you receive no offset for your tax basis (that is, your personal investment in the corporation) in the redeemed shares. In other words, the entire redemption payment counts as taxable income. In contrast, when stock-sale treatment applies, you'll have capital gain (probably long-term) to the extent the redemption payment exceeds your basis in the redeemed shares. In other words, only part of the redemption payment is taxable. In addition, you can offset capital gain from a redemption treated as a stock sale with capital losses from other sources.

However, 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 tax rules. That's because both dividends and long-term capital gains are currently taxed at the same federal rates, with a maximum rate of only 15%.

What does it all mean? Simply this: A stock redemption that's completed in 2008 could result in a much smaller federal income tax hit than a redemption that's put off until 2009 or beyond. This is especially true for a redemption that will be treated as a dividend, because there could a big hike in the applicable tax rate.

The Bottom Line

You now understand the potential advantages of taking a dividend payment or arranging a stock redemption deal under today's favorable federal income tax regime. Waiting until next year or later could prove costly. That said, don't implement the ideas explained here without consulting your tax pro and attorney. Finally, remember that the ideas explained here must be pieced together with other C corporation tax strategies, such as setting optimal salary and bonus levels for shareholder-employees and providing them with tax-favored fringe benefit packages. It's a holistic thing.

Bill Bischoff, a certified public accountant with more than 25 years of experience, has authored books and training courses for tax professionals, and frequently writes about consumer and small-business tax matters.