On May 28, 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act. One provision was to reduce the individual income tax rates on dividends to 15% (5% if the taxpayer is in the 10% or 15% income tax bracket). To qualify for these reduced rates, the dividend must be received from a domestic corporation, a foreign corporation whose stock is traded on an established U.S. securities market, or a foreign coiporation based in a country that has signed a tax treaty with the United States. To be eligible for the reduced rates, a shareholder must have held the stock for at least 60 days in the 120-day period beginning 60 days before the ex-dividend rate. Similar to the reduced capital gains rates, the reduced rate of 15% also applies in computing the alternative minimum tax (AMT).
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 exampie, 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. …