The Effect of Tax Minimization Strategies on the Financial Statements of Closely Held Corporations
Ruland, William, The Journal of Lending & Credit Risk Management
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.
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 $900,000. This reduces corporate income to only $100,000. The effects of this tax planning strategy are shown in Figure 2.
Looking only at the corporation, the advantage of the salary increase is not apparent because the increased salary reduces both the corporation's income and the amount available for dividends. However, the advantage of high shareholder-manager compensation becomes dear when considering both the family's dividends and the additional salary or bonuses received. With the base situation in Figure 1, shareholders receive $600,000 in dividends and keep $330,000 after tax. With the salary increase, shareholders keep $528,000 after taxes ([ILLUSTRATION FOR FIGURE 3 OMITTED]).
[TABULAR DATA FOR FIGURE 2 OMITTED]
The net benefit to the shareholders after taxes is $198,000 ($528,000 minus $330,000). Alternatively, the $198,000 savings can be viewed as a $360,000 corporate tax reduction offset by $162,000 of additional tax to the shareholder.
Since the U.S. Internal Revenue Service (IRS) is aware of the tax reduction potential of high shareholder compensation, the taxpayer must be able to show that the shareholder compensation is reasonable. Otherwise, the IRS considers the compensation to be a nondeductible dividend. …