The Effect of Tax Minimization Strategies on the Financial Statements of Closely Held Corporations

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U.S. tax law provides for a tax on corporate income and a personal income tax. Included in the personal income tax is a tax on dividends received by shareholders. Hence, on a combined basis, the corporation and shareholders incur a "double tax" on corporate profits. This double tax is a considerable concern to shareholders of all profitable regular corporations.

As an example, consider the Splendid Corporation. Splendid is a closely held business with pretax income of $1 million. The combined federal and state corporate income tax rate is 40%, and a 45% tax rate applies to the shareholders. This setup leads to the situation shown in Figure 1.

Figure 1. Income and Taxes for Splendid Corp.

Corporate income                              $1,000,000
Corporate tax at 40%                             400,000
Available for dividends                         $600,000
Shareholder tax on dividends at 45%              270,000
Amount shareholders keep after tax              $330,000

Splendid's shareholders keep only one-third of corporate earnings ($330,000 of $1 million). The remaining two-thirds is consumed by income taxes. Thus, the actual tax rate is 67% of the corporation's pretax income. Why don't lawmakers modify the system? The answer is that the double tax has been an integral part of the tax legislation for generations and is an important source of government revenue.

Strategies to Reduce Corporate Taxes

Corporations and shareholders routinely minimize the impact of double taxation. A number of options are commonly used. One is to provide for cash distributions to owners in forms other than dividends. (Dividends are taxable to investors but cannot be deducted by corporations.) Alternative forms of distribution, however, can provide cash to owners and tax deductions to their corporations. Key alternatives to dividends include the following:

* Compensation to shareholders who are also managers.

* Loans to the corporation by shareholders.

* Rentals to the corporation by shareholders.

Any of these options should provide returns to investors while simultaneously providing tax deductions for the corporation.

Shareholder Compensation

High compensation to shareholder-managers is a favorite tax minimization technique for the closely held corporation. This strategy provides a corporate tax deduction for payments to the owners. As an example, assume that the Splendid Corporation is owned by a single family and that this family actively manages the business. Splendid expects its income to be $1 million. In this case, a tax advisor might suggest increasing shareholder-manager salaries by …