‘Dividend’ – No Longer a Dirty Word
By SG Business & Taxation Practice Group
SAALFELD GRIGGS PC
Previously, much of the tax planning for closely-held corporations involved efforts to avoid dividend tax treatment on amounts distributed by the corporation to its shareholders. Prior to recent legislation, individuals were taxed on ordinary income, including dividend income, at federal rates of up to 38.6%. Now, under new rules adopted as part of the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividends are now taxed at a rate of 15%, which is the same preferential tax rate given to capital gains income. This drastic reduction in rates for dividend income creates some unique planning opportunities which should cause us to rethink the tax planning strategies that we previously applied for our corporate clients and shareholders.
First, what is a dividend? Dividends are distributions of a corporation’s earnings and profits. Distributions in excess of a corporation’s earnings and profits are treated as a return of basis, and any amount distributed in excess of a particular shareholder’s basis will be treated as capital gains income. With this definition in mind, let’s examine a couple of planning alternatives that the new dividend rates make available to us.
Year end tax planning often involves some consideration of whether or not compensation paid to shareholders might be reclassified by the Internal Revenue Service as excessive compensation. This would result in double taxation on the excessive amount, since the corporation would loose its deduction. Now, some consideration should be given to actually lowering salaries and weighing the benefits at the lower dividend income rate and no payroll expenses, e.g., FICA, unemployment, etc., against the disadvantage of losing a corporate deduction for the amounts treated like dividend income. With the lower dividend rates, this may be a good opportunity to distribute cash to a shareholder at a 15% rate, which the shareholder can use to repay an outstanding indebtedness owed to the company. If a corporation simply cancels the debt, the shareholder would realize cancellation of indebtedness income at typically higher ordinary income rates.
Another area for planning relates to corporate redemptions. Previously, a selling shareholder would often make every effort to make sure their sale of stock to the corporation would qualify for capital gains treatment under IRC Section 302(b). Although this could often be accomplished, the constructive ownership rules usually created hurdles for family owned businesses. For instance, a father owning 60% of a corporation could not be assured of capital gains treatment on the sale of his stock back to the company if his son or daughter owned the remaining 40%, unless the father could qualify for waiver of the family attribution rules.
Under the family attribution rules, favorable capital gains rates would be lost if the father were to continue as an officer, director, or employee. Now, with the lower dividend income rates, who cares? If the father’s sale is reclassified as a dividend, assuming the father has a low basis in his stock, the redemption proceeds would be treated as a dividend. To the extent of any earnings and profits, the dividend will be taxed at the 15% rate, which is the same as capital gains rates. To the extent that the distribution exceeds the earnings and profits of the company, the distribution will next be treated as a return of the shareholder’s basis in his or her shares. Any distribution in excess of basis will simply be treated as gain on the sale of a capital asset.
In some cases, dividend treatment will actually be preferable to a qualified stock redemption. If, for instance, it would be preferable to remove or eliminate more earnings and profits from the company, a dividend distribution will eliminate $1.00 of earnings and profits for each $1.00 distributed. In a stock redemption, earnings and profits are removed on a pro rata basis, so only a percentage of each dollar distributed will constitute earnings and profits.
Another planning opportunity is made available with the new dividend rates for S corporations. Many S corporations have some accumulated C corporation earnings and profits. The existence of the C corporation earnings and profits can result in the imposition of a corporate level tax on passive investment income and may ultimately result in the termination of the S election if the company receives more than 25% of its gross receipts from passive investment income for three consecutive years. New lower dividend rates give us a chance to cure this risk by simply distributing an amount that will eliminate the C corporation earnings and profits at the low 15% tax rate.
For example, let us assume that we have an S corporation with $50 of C corporation earnings and profits. Also assume that we have a AAA account of $100 and a shareholder basis of $120. Generally, S distributions in this context would first be attributed to the AAA account. Only after that account is exhausted would the distribution be treated as coming from the old C corporation earnings and profits. However, the corporation can make an election which will treat the first dollars distributed as if they come from the old C corporation earnings and profits. Accordingly, if such an election were in effect, a distribution of $75 in this example would completely eliminate the old C corporation earnings and profits. The balance of the distribution, $25, would be treated as a reduction of the AAA account and the shareholder’s basis. By making this distribution, the corporation could eliminate the passive investment income limitations which might otherwise threaten the existence of its S corporation status.
In conclusion, the new dividend rates should cause all of us to rethink our prior planning strategies for many of our clients. Keep in mind that these reduced rates are scheduled to expire in 2008, unless Congress chooses to continue the current, favorable treatment for dividends.
However, please keep in mind that if a dividend is to be paid in anything but cash, the distribution of appreciated property will still result in taxable gain to the corporation or its shareholders (in the case of an S corporation).