Dividend Tax Rate Cuts Benefit Closely Held Corporations

By Phillip J. Korb, John N. Sigler, and Thomas E. Vermeer

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As with many recent tax law changes, the reduced tax rates on dividends are scheduled to sunset after a limited period of time (December 31, 2008). Political factors could also lead to the repeal of these changes before the sunset date. Taxpayers that can benefit from these changes now should take advantage of them while they are still law.

Closely Held C Corporations

One kind of taxpayer that can benefit from the reduced tax rates on dividends is an owner/employee of a closely held C corporation. Four situations where an owner/employee of a closely held C corporation can benefit from the reduced tax rates on dividends are described below.

Bonuses and dividends. Typically, a closely held C corporation has avoided double taxation either through reducing a majority of its profits by granting a bonus to its owners/employees or through deferring the second tax by leaving the profits in the corporation as accumulated earnings. In fact, many recent tax court cases related to closely held C corporations involve either the recharacterization of a bonus as a nondeductible dividend or the nonpayment of sufficient dividends relative to profits, which subjects the C corporation to the accumulated earnings tax.

With the reduction in tax rates on dividends, a closely held non–personal service C corporation should consider distributing a greater portion of its profits as a dividend rather than as a bonus. By distributing a larger portion of its profits as a dividend, a closely held C corporation can take advantage of the lower corporate income tax rates for taxable income under $75,000 and can reduce its payroll taxes. For example, if a closely held C corporation normally reduces its taxable income to zero by providing the sole owner/employee an annual bonus of $150,000, the taxes paid by the C corporation and the owner/
employee total $72,000. However, if this same C corporation decides to pay the sole owner/employee a bonus of $75,000 and distribute the remaining $75,000 as a dividend, the total taxes paid by the C corporation and the owner/employee are $61,000, a total tax savings of $11,000 (see the Exhibit).

A closely held C corporation should consider certain issues before adopting this strategy. First, tax courts have scrutinized year-end bonuses to an owner/employee because of the possibility of a disguised dividend. With the reduction in the tax rates on dividends, tax courts will probably scrutinize closely held C corporations that have traditionally paid a large bonus and no dividend but have switched to the payment of a large dividend and no bonus since the dividend tax rates were reduced. Thus, it is important that a corporation develop an incentive plan that includes a predetermined formula for bonuses. This plan should be logical and should be approved by the board of directors. An arbitrary payment of a dividend based on cash available will likely draw scrutiny from the courts.

Second, a reduction in a bonus could significantly impact the retirement plan contribution of the C corporation on behalf of its owners/employees. Third, the reduced tax rates on dividends are expected to expire in 2008; it will be difficult to dramatically increase salaries when the tax rates on dividends increase again in 2009. Finally, regardless of the advantages or disadvantages of a bonus versus a dividend, the payment of both a bonus and a dividend with a clear indication of why each payment was made will significantly increase a taxpayer’s chance of a favorable outcome in Tax Court. The determination of compensation and the declaration of dividends should also be included in the minutes of the board of directors’ meetings.

Accumulated earnings. Prior to the reduction of the tax rates on dividends, many closely held C corporations would accumulate earnings in the corporation until liquidation in order to take advantage of lower capital gains tax rates. Closely held C corporations would also buy back stock from their owners/employees to create capital gains with no real change in the ownership. The new parity between most capital gains rates and dividend rates also reduces or eliminates the need to pursue strategies to structure transactions as sales of capital assets instead of dividend distributions (e.g., stock redemptions or certain types of liquidations).

With the same income tax rates applying to both dividends and capital gains, it is unnecessary for a C corporation with a large amount of accumulated earnings to devise strategies to convert ordinary income into capital gains for its owners/employees. A closely held C corporation with large accumulated earnings should distribute, as dividends, as much as possible before the reduced rate expires in 2008. Substantially reduced accumulated earnings will allow the corporation to “rebuild” its accumulated earnings after the tax rates on dividends revert to their prior levels. If the corporation adopts this strategy, it should ensure that the reduction in accumulated earnings does not violate any existing debt covenants, which could cause problems that outweigh the tax savings.

Debt forgiveness. If a C corporation forgives a note receivable from a shareholder, the shareholder will have cancellation-of-indebtedness income that would be subject to ordinary income tax rates. If the shareholder receives a dividend from the corporation and uses a portion of the funds to satisfy the debt, the shareholder would have dividend income that would be subject to the reduced income tax rates on dividends.

Form of business. Finally, with the reduction in tax rates on dividends, an owner/employee of an S corporation, a partnership, or a limited liability company (LLC) should consider whether the reduction in the income tax rates on dividends makes a C corporation more attractive than the current form of business. Although the uncertain duration of these rates mitigates against changing to a C corporation, nonetheless certain organizations should consider whether a C corporation is more attractive than the current form of business if these low rates become permanent.

The Wealth-Enhancement Factor

Many large companies, including Goldman Sachs Group, Viacom, Citigroup, Microsoft, and Limited Brands, have significantly raised their dividends. Although these companies have commented that raising their dividends is not intended to enrich senior executives, many are skeptical of the reasons offered by these companies. Skeptics believe that this is another example of senior executives making decisions based on enhancing their own personal wealth. Closely held corporations should be careful to ensure that any dividend changes motivated by the reduced tax rates make sound business sense. They should not be structured as to suggest that the sole reason for the change was the avoidance of taxes.