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Tax Planning for Dividends Co-Editors: T. Chris Muirhead, CPA Author:
Editor's note: Mr. Holub is the former Chair of the AICPA Tax Divisions Tax Practice Management Committee. Mr. Muirhead is the Chair of the AICPA Tax Divisions Member Tax Practice Improvement Committee; Dr. Grooms is a former member of that Committee. For more information about this column, contact Mr. Holub at (813) 222-8555 or stevenh@apcpa.com, or Dr. Grooms at (803) 790-4400 or wmgcpa@aol.com.
Tax advisers may best serve their clients by offering tax planning advice. Any tax preparer may serve as a historian and tell a client how much tax is due as a result of past events. The true mark of the professional is to assist in planning for future events, so as to reduce the taxes to be paid in the future. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) provided tax advisers with an opportunity to advise clients on a large number of issues. This column will examine some aspects of planning for dividends and capital gains, including:
Salary Planning A basic principle of C corporation tax planning has always been that all corporate disbursements be deductible. Thus, tax advisers have sanctioned (to the extent reasonable) high salaries and rent (when stockholders have owned the rental property) and interest payments (when stockholders have been creditors). In the past, tax practitioners often sought payments to be deductible by a payer and ordinary income to a recipient. After the JGTRRA, individuals dividends are taxed at a 5% or 15% rate; thus, in many instances, it may be quite advantageous for disbursements to be nondeductible by the payer and received by a shareholder as a dividend. Indeed, if the corporations Federal income tax rate is 15% (which applies to the first $50,000 of taxable income, under Sec. 11(b)(1)(A)) and the recipient is in the highest individual marginal tax bracket (35%), a better after-tax result occurs if the corporation retains the first $50,000, pays tax on it, then pays the balance as a dividend. The shareholder receives a dividend, instead of salary, rent, interest, etc.
When a corporation retains earnings in excess of $50,000, the corporate tax will be greater and the after-tax amount to the shareholder will be lower. When a shareholders marginal tax rate is less than 35%, his or her tax bill will be less. A tax professional must work with the numbers in each situation to determine a break-even point; thus, planning should envision careful forecasting of disbursements, for the corporation to maximize its after-tax earnings and distribute them to shareholders. Some commentators have suggested reducing corporate salaries to produce higher dividends. However, under JGTRRA Section 303, the reduced tax rates on dividends will terminate after 2008. Should corporations increase compensation at that time?
If a corporation reduced
officer compensation now, then attempted to increase it later, the IRS
might well inquire as to why the amounts were reduced (were they too
high initially?) or whether the officers were underpaid. When
compensation is increased, the Service would then want to know what the
officer-shareholder had done to warrant
AE Tax A closely held corporation may have an unreasonably high level of accumulated earnings; tax practitioners have always advised such companies not to pay dividends, due to double taxation. The IRS has been very successful in assessing the Sec. 531 AE tax, which is a penalty tax. In general, the tax is calculated under Sec. 535(b), by reducing taxable income for various deductions, then deducting dividends paid (frequently, zero); there are also certain addbacks. The balance is now taxed at 15%. Because the maximum rate on dividends is now 15%, there is an excellent opportunity to bail out earnings at a very low tax rate. The corporation should record any decisions made as to dividend payments in the corporate minutes.
PHC Tax Most tax advisers have had a PHC client (as defined in Sec. 542(a)). As with the AE tax, the PHC tax is a penalty tax and can be quite severe; under Sec. 541, it is 15% of undistributed PHC income, as defined in Sec. 543 (i.e., the corporations current taxable income, reduced by the regular income tax, various deductions and certain dividends paid). There are also certain addbacks. With the low 15% rate on dividends, a common planning strategy would be to disburse an amount equal to PHC taxable income (as defined in Sec. 545).
S Corporation Fixed Assets Frequently, assets such as real estate are transferred to a corporation whose assets are appreciating in value. After the transfer, the tax adviser realizes that the asset should have remained in the transferors hands and leased to the corporation. Generally, the corporation could only return the asset to the transferor by selling it or distributing it as a dividend. If an S corporation sells the asset, the gain will flow through to the shareholders, who will generally pay a maximum 15% tax on it (25% on any unrecaptured depreciation). Further, if the corporation distributes the asset as a dividend, the S corporation (as well as a C corporation) would be deemed to have sold it and distributed the proceeds under Sec. 311(b), if the assets fair market value exceeds its basis. If the asset is left in the corporation and continues to appreciate in value, all of the appreciation will be taxed either when the corporation eventually sells or distributes it. Thus, perhaps the asset should be removed from the corporation currently.
S Corporations with E&P Problems Frequently, a C corporation with retained E&P will make an S election. A tax under Sec. 1375 will apply if the corporation makes the election and then has excess income from passive sources; further, the S election will terminate (and the corporation will revert to a C) as of the first day of the fourth year of such excess. Now that dividends are taxed at a maximum 15% rate, it is an excellent time for such corporations to bail out E&P. If an S corporation has insufficient cash to pay a dividend, Regs. Sec. 1.1368-1(f)(3) permits an election to make a deemed distribution (which requires no cash or property distribution).
Looking to 2008 Under the JGTRRA, capital gains and dividends recognized in 2008 will be tax free for taxpayers in the 5% bracket. Accordingly, any (1) installment gain, (2) S corporation E&P bailout or asset distribution or (3) Sec. 531 or 545 earnings recognized in 2008 should be Federal tax free for 5%-bracket clients. Thus, while tax advisers may plan to achieve these objectives now, they may wish to delay implementation for such clients. Of course, the law may change between now and then. If the law continues as is, tax practitioners should plan for 5%-bracket clients to sell appreciated capital assets in 2008; the gain recognized will produce no Federal tax. If a client believes the assets will continue to increase in value, he or she may sell and then repurchase them; the built-in gain will be tax free. The repurchase will establish a higher basis; when the asset is eventually disposed of, a smaller gain will be recognized and a lesser tax paid. (The Sec. 1091 wash-sale rule only applies to lossesnot to gains.) This process may be applied very easily to marketable securities. A client need only call his or her broker to establish an arms-length sale and repurchase with a new (higher) basis. The technique is more difficult with real estate. If the sale and repurchase include a related party, the IRS may successfully argue form over substance; if successful, the client would be deemed not to have sold or repurchased the asset, with no basis increase. If the sale is not to a related party, there probably could not be a repurchase. While no one knows what the future holds, tax advisers should help clients make plans today and consider the timing of implementation. Letting the client make a timing decision is always prudent.
Conclusion This column does not explore all of the planning opportunities associated with the JGTRRA, but serves as a mere departure point for the planning process. Tax professionals should constantly strive to develop programs to minimize clients tax liabilities. |
