Time to Distribute Corporate Earnings?

Taking advantage of the lower tax rate on dividends received.

he Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) reduced the individual tax rate on corporate dividends received to 15% for individuals in the 25%, 28%, 33% and 35% tax brackets (5% (0% in 2008) for individuals in the 15% and 10% income tax brackets); this affords some planning strategies for closely held corporations that want to reduce their accumulated earnings and profits (E&P). CPAs should become aware of some of these opportunities.

The bane of corporate taxation always has been the double taxation of corporate earnings. So, this may be a good time for some corporate taxpayers to minimize (“bail out”) E&P by distributing dividends that will be taxed at the post-JGTRRA rate.

The goal of the planning techniques below is to distribute earnings as dividends during the period of lower tax.

Excess compensation issues. Closely held C corporations traditionally have maximized salaries to officer-shareholders to reduce corporate taxable income. Under IRC section 162(a)(1), the IRS often seeks to treat a portion of a shareholder’s salary as a nondeductible constructive dividend if it is excessive or unreasonable. With the lower rates on dividends, corporations might want to pay compensation as dividends, not salary, to avoid this issue. Even excess salary reclassified by the IRS as a dividend will be taxed to the shareholder at a lower rate.

AE tax. Section 531 of the tax code provides an additional tax on a C corporation’s accumulated taxable income; the pre-JGTRRA rate was the highest individual income tax rate. The accumulated earnings (AE) tax is a penalty for accumulating E&P beyond a business’s reasonable needs.

The JGTRRA lowered the AE tax rate. Corporations with potential AE tax exposure will find it advisable to pay some dividends to avoid this issue.

Family transfers of stock. Another strategy is to transfer stock to family members in the 10% or 15% brackets, followed by dividend distributions to take advantage of the 5% rate (0% in 2008). The stock must meet a 60-day (120-day for preferred stock) holding period provided in sections 1(h)(11)(B)(iii) and 246(c). The lowering of the long-term capital gain rate to 15% (5% for taxpayers in the 10% and 15% brackets (0% for 2008)), in certain circumstances, may make a sale of stock preferable to a gift.

PHC tax. Section 541 imposes an additional corporate-level tax on undistributed personal holding company income (UPHCI)—for example, passive income such as interest, dividends, royalties and sometimes rent income. The personal holding company (PHC) tax was imposed at the highest individual tax rate, but the JGTRRA reduced it to 15% (in addition to the corporate income tax). Corporations may now want to pay dividends from UPHCI.

CPA tax advisers should examine closely held corporate clients for E&P bailout opportunities at the temporarily reduced dividend rates. For more information see “Post-JGTRRA Dividend Planning” by Danny Pannese and Paul Iannone in the June 2004 issue of The Tax Adviser.

—Lesli Laffie, editor
The Tax Adviser

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