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.