IF YOU’RE A SHAREHOLDER in a successful closely-held C corporation, you know this year’s federal income tax rate structure is favorable to your cause.
* If your company pays you a dividend this year, the maximum federal income tax rate will be only 15%.
* The same 15% maximum federal rate will apply to 2010 corporate payouts or stock sales that generate long-term capital gains.
But things are about to change. Here are the specifics about what’s in store along with some tax-smart strategies to consider right now.
Higher Taxes on Dividends
The maximum federal rate on dividends will automatically leap from the current 15% to 39.6% on Jan. 1 as the Bush tax cuts expire. Although the president has promised more than once to limit the maximum rate on dividends to 20%, the little-known fact is Congress must take action for that to happen. It’s no sure thing. Even if it does happen, the maximum rate on dividends will jump again to 23.8% in 2013, thanks to the additional 3.8% Medicare tax that takes effect that year. So you’re facing a 59% increase in the maximum federal tax on dividends (at least).
Higher Taxes on Long-Term Gains
Starting Jan. 1, the maximum federal rate on long-term capital gains will automatically increase from the current 15% to 20%. Starting in 2013, it will jump again to 23.8% due to the additional 3.8% Medicare tax. So you’re facing a 59% increase in the maximum federal tax on long-term capital gains too.
What Can You Do?
Thankfully, you still have some time to take advantage of this year’s historically low tax rates on dividends and long-term gains. Here are three strategies to consider right now. Don’t ponder too long, because these ideas will take some time to execute, and Jan. 1 will arrive before you know it.
Strategy No. 1: Take Low-Taxed Dividends This Year
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. Anyway, while lots of E&P indicates a successful company, it also creates a tax side effect. To the extent of your corporation’s E&P balance, corporate distributions to shareholders (like you) count as taxable dividends. Since the 2010 federal rate on dividends can’t exceed 15%, dividends received this year will be taxed lightly. That probably won’t be true for dividends received in 2011 and beyond. Therefore, shareholders (like you) should weigh the option of triggering a manageable current tax hit by taking dividends in 2010 against the option of absorbing a potentially bigger (but deferred) tax hit on dividends taken in future years.
Strategy No. 2: Do Low-Taxed Stock Redemption Deal This Year
Another way to convert some of your C corporation wealth into cold, hard 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 (maybe you) while other shareholders stay put.