Taking Advantage of the Preferential Tax Rate on Dividends

Unless action is taken to extend them, the Bush tax cuts will expire at the end of 2010. One of the more beneficial provisions that will expire relates to the taxing of qualified dividends at a 15 percent rate. Obviously, if you are holding 100 shares of stock in a public company, there is no possibility that your voice will be heard by them when it comes to paying a [larger] dividend before the end of this year. This is not the case, however, if you are a substantial or majority shareholder of a closely held corporation.

A dividend is a distribution of previously taxed profits that accumulate during the life of a "regular" [C] corporation. Although there are other issues that could arise if a company does not distribute its accumulated earnings, the one addressed in this blog addresses what people generically refer to as the double tax on corporate earnings. A C corporation pays a tax on its earnings each year; an additional tax is due when those earnings are distributed to the shareholders.

Prior to the Bush tax cuts, dividend payments had always been taxed as ordinary income; after 2010, that rate could again be almost 40 percent, before considering state taxes. If the payment of these earnings by a qualified corporation (read "domestic") is made prior to the end of this year, they will be taxed at a maximum federal rate of 15 percent.

Although this provision generally applies to C corporations, it can also benefit the shreholders of an "S" corporation that had been a regular corporation at some point.  Earnings of an S corporation are taxed at ordinary rates as the income passes through to the shareholders annually. This pass through income is taxed regardless of whether any actual cash distribution is made to the shareholders. A distribution of the earnings realized during the entity's S period will generally not be subject to a second level of tax. If the entity had previously been a regular corporation prior to the S election, however, it could have C corporation earnings that are "trapped" in the entity.

So where is the tax saving opportunity here? If they desire, the shareholders of the S corporation can elect to be taxed on any distribution made in 2010 at the 15 percent rate.  Although this would result in a current tax payment, this distribution would cause a reduction or elimination of the C corporation accumulated earnings, it would have no impact on the shareholder's basis in the entity, they could distribute the accumulated S corporation earnings tax-free in 2011, and they would eliminate a number of other adverse outcomes that could arise if the entity maintained a C corporation accumulated earnings balance.

This provision has been in place for a number of years. Only now when the window is closing on this opportunity, however, are taxpayers seriously entertaining this tack. The only way to determine whether this is the right thing to do is to prepare projections of the cost of making such a distribution.

If you need more information on this, please contact a member of the Commercial Enterprise team at BBD.