Editor: Trenda B. Hackett, CPA
Qualified dividends are distributions of cash or property made by a domestic or qualified foreign corporation out of its earnings and profits (E&P) to a shareholder with respect to its stock (Sec. 1(h)(11)(B)). To qualify for the reduced rate on dividends, a shareholder must hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. For preferred stock dividends attributable to a period or periods aggregating more than 366 days (e.g., cumulative preferred stock with dividends in arrears), the holding period is more than 90 days during the 181-day period beginning 90 days before the stock’s ex-dividend date. The holding period includes the date of disposition but not the date of acquisition (Sec. 246(c)(3)(A)).
To receive any dividend, the taxpayer must own the stock at least one day before the ex-dividend date. Because the required holding period is more than 60 days during a period beginning 60 days before the ex-dividend date, this necessarily means that the holding period must include the ex-dividend date. However, the 61-day (or 91-day) holding period does not have to be consecutive. Also, certain transactions that limit the taxpayer’s risk of loss (e.g., short sales and options to sell substantially identical stock or securities) suspend the taxpayer’s holding period until those transactions are closed (Sec. 246(c)(4)).
Paying compensation instead of dividends
For most closely held C corporations, avoiding the double taxation of corporate earnings has been the primary tax planning goal for many years. The traditional approach to the problem is for the corporation to zero out its annual taxable income (or nearly so) by making deductible year-end bonus payments to shareholder-employees. Legitimate corporate payments for shareholder-employee compensation can be deducted as ordinary and necessary business expenses (Sec. 162(a)(1)). Of course, shareholder-employee compensation payments (including year-end bonus amounts) are subject to Social Security tax and Medicare tax (Federal Insurance Contributions Act tax). An additional 0.9% Medicare tax applies to wages above a certain amount ($250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately).
For tax years 2018–2025, an individual’s taxable income is subject to seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Furthermore, an additional tax applies to higher-income individuals, depending on whether the payment is characterized as compensation or qualified dividends. The additional 0.9% Medicare tax applies to compensation above a certain amount ($250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately). The 3.8% net investment income tax will cause the maximum rate on qualified dividends to be 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%). The 3.8% net investment income tax applies to taxpayers with modified adjusted gross income above a certain amount ($250,000 for married filing jointly, $125,000 for separate filers, and $200,000 in all other cases).
Example 1. Paying corporate profits as taxable dividends or deductible compensation:Jis a single filer who owns 100% of the outstanding stock ofBInc., an incorporated book shop. IfBhas $100,000 in earnings for the current year, it would owe $21,000 in tax ($100,000 income × 21%). If the after-tax earnings are distributed andJis subject to a 15% qualified dividend tax rate, she would owe $11,850 in tax ([$100,000 − $21,000] × 15%). Out of the $100,000 of corporate earnings, $32,850 would be paid in tax ($21,000 + $11,850).
IfJis subject to a 20% qualified dividend tax rate, she would owe $15,800 in tax ([$100,000 − $21,000] × 20%). Together,BandJwould owe $36,800 in tax ($21,000 + $15,800).
IfJis subject to a 20% qualified dividend tax rate and the 3.8% net investment income tax, she would owe $18,802 in tax ([$100,000 − $21,000] × 23.8%). Out of the $100,000 of corporate earnings, $39,802 would be paid in tax ($21,000 + $18,802).
IfBpays out all taxable income as deductible compensation, it would owe nothing in tax ([$100,000 income − $100,000 deductible compensation] × 21%). IfJis in the 24% marginal tax bracket, she would owe $24,000 in tax ($100,000 × 24%). Out of the $100,000 of corporate earnings, $24,000 would be paid in tax.
IfJis in the 32% marginal tax bracket, she would owe $32,000 in tax ($100,000 × 32%). Out of the $100,000 of corporate earnings, $32,000 would be paid in tax.
IfJis in the top 37% marginal tax bracket, she would owe $37,000 in tax ($100,000 × 37%). She would also owe the additional 0.9% Medicare tax, which applies to wages of $200,000 or more for single filers. (In fact, the 0.9% Medicare tax would apply if she is in the 35% marginal tax bracket, since both kick in near the same $200,000 taxable income threshold.) Out of the $100,000 of corporate earnings, $37,900 would be paid in tax.
This example indicates that paying double-taxed dividends begins to be beneficial when the shareholderemployee’s marginal income tax rate is 32% or higher. But as a practical matter, determining the preferable way to extract cash from a corporation depends on many factors and assumptions. To give meaningful advice, the practitioner needs to work with reasonably accurate dollar amounts and the actual tax rates that the shareholder-employees expect to pay.
Weighing the negative aspects of paying dividends
When considering the dividend strategy, the following points must be kept in mind:
- Paying out dividends each year after paying nothing in the past may look suspicious to the IRS. One way to justify the corporation’s new practice is to add a group of new shareholders who are not corporate employees. Doing so may make it seem more reasonable for the corporation to start paying meaningful dividends when little or none have been paid in the past.
- The dividend strategy will not work when there are multiple shareholders, some of whom are employed by the corporation and some of whom are not, because switching to a policy of paying dividends could alter the bottom-line cash flow reaped by the various shareholders. However, when there is just one shareholder, this is not a concern.
- State income tax implications at the corporate and shareholder levels must be evaluated.
Considering other factors in paying dividends or compensation
The federal income tax treatment of a nonliquidating corporate distribution paid to an individual shareholder generally depends on the amount of the distributing corporation’s E&P. Distributions up to the amount of a domestic corporation’s E&P generally count as qualified dividends eligible for the 15% or 20% maximum federal dividend rate. Distributions in excess of E&P reduce the recipient shareholder’s tax basis in his or her stock (i.e., they are tax-free recoveries of capital). Distributions in excess of stock basis are treated as capital gain and generally qualify for the 15% or 20% maximum rate on long-term capital gains.
Paying dividends to low-bracket shareholders
In the context of family-owned C corporations, existing high-bracket shareholders should consider giving away some stock to low-bracket family members. Recipient shareholders (who are often the shareholder’s child(ren)) with taxable income below a certain threshold may pay no federal income tax on their dividend income (0%). Assuming that the children are not subject to the kiddie tax rules of Sec. 1(g) (under age 18, or age 18–23 if certain requirements are met), any dividends they receive will completely escape tax. In addition, having a group of new shareholders who are not employees makes it seem more reasonable to pay meaningful dividends when little or none have been paid before.
Distributing appreciating assets to shareholders
A C corporation’s distribution of appreciated corporate assets to its shareholders can trigger double taxation. However, the double-tax consequences are less severe under the 15% or 20% maximum individual federal income tax rate on qualified dividends (including dividends paid in the form of appreciated corporate assets). Therefore, corporations should consider distributing appreciated corporate assets, especially when the corporation has losses to offset some or all of the corporate-level gains triggered by the distribution. Another idea is to distribute corporate assets that have not appreciated substantially but that are likely to do so.
Reducing earnings and profits
Many closely held C corporations have built up substantial accumulated E&P balances over the years, mainly because paying dividends would have resulted in double-taxation consequences. These corporations should now consider draining away E&P balances by paying qualified dividends that will be taxed at no more than 15% or 20%, while also keeping in mind the impact of the 3.8% tax on net investment income.
Avoiding corporate-level penalty taxes
The accumulated earnings tax (AET) penalizes the unnecessary accumulation of income within a corporation. The application of the AET is subjective, as it is based on the accumulation of income at the corporate level with an intent to avoid tax at the shareholder level (Sec. 531). The personal holding company (PHC) tax penalizes the use of a corporation to hold an individual’s investments. The calculation of the PHC tax is objective, requiring the use of specific quantitative tests (Sec. 541).
A corporation classified as a PHC can reduce the penalty tax by paying dividends. Several types of dividends can be deducted, including dividends paid during the year or within 3½ months of year end, consent dividends, and liquidating dividends. The dividends-paid deduction for AET purposes generally follows the same rules that apply to the PHC dividends-paid deduction.
Treating qualified dividends as investment income
Investment interest expense is deductible generally only to the extent of net investment income (Sec. 163(d)(1)). Qualified dividend income is not treated as investment income for purposes of Sec. 163 (Sec. 1(h)(11)(D)(i)). However, taxpayers can elect to treat qualified dividend income as investment income (Sec. 163(d)(4)(B)). If the election is made, the dividends treated as investment income will not qualify for taxation at the reduced rates. This gives taxpayers the choice of applying the favorable tax rates to qualified dividend income or using qualified dividend income to offset investment interest expense. It may be possible to save taxes by electing to treat qualified dividends as investment income in lieu of using the reduced net capital gain tax rate, because there may be a better tax benefit to having a larger investment interest deduction than having a lower qualified dividend tax rate. The election should be considered if the taxpayer’s investment interest deduction is limited because the interest exceeds the amount of the net investment income. However, if the taxpayer’s investment interest would be deductible without the election, the election should not be made.
Paying a constructive dividend
A payment made by the corporation primarily for the benefit of a shareholder, as opposed to the business interests of the corporation, will often be treated by the IRS as a constructive dividend. Constructive dividends are generally found in closely held corporations where dealings with shareholders may be informal. The issue of constructive dividends is governed mostly by case law. For example, many cases have held that shareholder expenses paid by the corporation without an expectation of repayment are constructive dividends in an amount equal to the fair market value of the benefit received. A constructive dividend has the same general tax consequences as a true dividend. It is income to the shareholder and is not deductible by the corporation.
Example 2. Paying a constructive dividend:Jis president and sole shareholder ofJJIInc. In addition to payingJa reasonable salary,JJImakes the mortgage payments onJ’s residence as well as paying for the utilities.JJIalso pays other personal living expenses ofJand his family. These payments constitute constructive dividends that will be taxable toJand are not deductible by the corporation.
Contributor
Trenda B. Hackett,CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contactthetaxadviser@aicpa.org. This case study has been adapted fromCheckpoint Tax Planning and Advisory Guide’sclosely held C corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025);tax.thomsonreuters.com).
