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This fast-paced, information-packed program showcases state-of-the-art planning ideas and tax-saving devices to show you how to keep more profits in the pockets of corporate clients and business owners. And, all with an emphasis on the current year’s returns. This course helps you offer clients quality service.
Objectives:Prerequisite: Basic knowledge of corporate income taxation.
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Chapter 1 - Corporate Tax Trends
Learning Objectives
• Provide small business clients with up-to-date planning tips.
• Get up to speed on business tax changes included in recent legislation.
Introduction
Because this is an update chapter, it does not have a case study. Instead, it focuses on planning issues.
Taking Advantage of Planning Strategies Under the Current Tax Rate Structure (Before It Ends)
A few years ago, Congress significantly reduced individual federal income tax rates on ordinary income from salary, interest, alimony, and the like. As the law currently reads, these reduced individual rates will last through the end of 2010. Fingers crossed!
Even better, qualified dividends received through 2010 are taxed at a maximum individual rate of only 15%. Individuals whose dividends fall within the 10% and 15% ordinary income rate brackets will pay 0% for 2008-2010. These historically low rates apply equally to qualified dividends received by individual shareholders from their closely held corporations.
The same 15%/0% rates apply to most long-term capital gains from capital asset sales in 2008- 2010.
Sunset Rules. After 2010, dividends will again be taxed at ordinary income rates unless Congress takes further action and capital gains will be taxed at higher rates than under the current system. After 2010, ordinary income rates will return to 15%, 28%, 31%, 36%, and 39.6%.
The current 15%/0% rates apply only to qualified dividends paid on shares of corporate stock [IRC Sec. 1(h)(11)]. However lots of payments that are commonly called "dividends" are not qualified dividends under the tax law. For example,
• Dividends paid on credit union accounts are really interest payments. As such, they are considered ordinary income and are therefore taxed at regular rates – which can be as high as 35%.
• The same is true for dividends paid on some publicly traded preferred issues that are actually trust units wrapped around underlying bundles of corporate bonds. In other words, these issues are not really shares of stock in a corporation. Therefore, the dividends paid on these issues are taxed as interest at ordinary rates. Moral: clients should not buy preferred issues without knowing exactly what they are buying.
• Mutual fund dividend distributions that are paid out of the fund's short-term capital gains, interest income, and other types of ordinary income are taxed at regular rates. So, mutual funds that engage in rapid-fire trading will generate payouts that are taxed at ordinary income rates of up to 35% rather then at the optimal 15%/0% rates your clients might be hoping for.
• Bond fund dividends are also taxed at ordinary income rates, except to the extent the fund is able to reap long-term capital gains from selling appreciated assets.
• Here is some good news: mutual fund dividends paid out of (1) qualified dividends from the fund's corporate stock holdings and (2) long-term capital gains from selling appreciated securities positions are eligible for the 15%/0% rates. This means mutual funds' annual tax information statements must separately identify dividends eligible for the 15%/0% rates as well as ordinary income dividends that are taxed at regular rates.
• Most REIT dividends are not eligible for the 15%/0% rates. The main sources of cash for REIT payouts are usually not qualified dividends from corporate stock held by the REIT or long-term capital gains from asset sales. Instead most payouts are derived from positive cash flow generated by the REIT's real estate properties. So, most REIT dividends are taxed at ordinary income regular rates. Clients should not buy REIT shares with the expectation of benefiting from the 15%/0% rates.
• Dividends paid on stock in qualified foreign corporations are theoretically eligible for the 15%/0% rates. Here is the rub, these dividends are often subject to foreign tax withholding. Under the U.S. foreign tax credit rules, individual shareholders may not receive credit for the full amount of withheld foreign taxes. So they can wind up paying more than the advertised 15%/0% rates. [See IRC Secs. 1(h)(11)(C)(iv) and 904.]
Warning. To be eligible for the 15%/0% rates on qualified dividends, the stock on which the dividends are paid must be held for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date (the day following the last day on which shares trade with the right to receive the upcoming dividend payment). Bottom line, when shares are owned only for a short time around the ex-dividend date, the dividend payout will be taxed at ordinary income rates [IRC Sec. 1(h)(11)(B)(iii)].
Congress has not changed the corporate federal income tax rate schedule. As has been the case for many years, a C corporation's income is taxed like this:
• 15% on the first $50,000 of income;
• 25% on income between $50,001 and $75,000;
• 34% on income between $75,001 and $100,000;
• 39% on income between $100,001 and $335,000;
• 34% on income between $335,001 and $10 million;
• 35% on income between $10,000,001 and $15 million;
• 38% on income between $15,000,001 and $18,333,333;
• 35% on income above $18,333,333.
Current Strategies for Closely Held C Corps
Taken together, the favorable federal income tax rate changes for individuals and the unchanged corporate rate schedule have important implications for clients who operate their businesses as C corporations. Here are five tax-saving strategies opened up by the currently low tax rates on qualified dividends.
Strategy 1: Pay Dividends Intentionally
Say your client is employed by his own C corporation. Avoiding the double taxation of corporate earnings has probably been this client's number one tax planning goal for years. Before the current era of low tax rates on dividends, the standard strategy was to "zero out" the corporation's taxable income each year (or nearly so) via compensation payments (salary and year-end bonus) to the shareholder-employee. As you know, legitimate payments for shareholder-employee compensation can be deducted by the corporation as ordinary and necessary business expenses [IRC Sec. 162(a)(1)].
Of course the shareholder-employee is then taxed on the compensation payments he receives. In addition, federal employment taxes must be paid (half by the corporation; the other half withheld from the shareholder-employee's salary and bonus checks). This is not a perfect situation, but it avoids double taxation.
Thanks to reduced tax rates on dividends, the cost of double taxation is now a lot less than before, because qualified dividends – including those from one's own closely held C corporation – are now taxed at no more than 15%. Still, double taxation is something that should always be avoided. Or is it?
What if the shareholder-employee's salary and bonus payments are fine-tuned to reduce the corporation's taxable income to $50,000 annually (or thereabouts)? Under the graduated federal income tax rate schedule for corporations, annual taxable income between zero and $50,000 is taxed at only 15%. So the tax bill on an even $50,000 of corporate taxable income is a mere $7,500 (15% × $50,000). Let us assume the corporation retains $50,000 of taxable income and pays the resulting tax bill.
Next, the corporation distributes $42,500 of after-tax cash to the shareholder-employee ($50,000 – $7,500). In most cases, that $42,500 will be a qualified dividend. So the shareholder-employee is taxed at only 15%, which means he owes $6,375 to the U.S. Treasury (15% × $42,500).
Under this intentional dividend strategy the shareholder-employee nets $36,125 after all federal taxes ($50,000 – $7,500 – $6,375).
What happens if the corporation instead follows the traditional strategy of zeroing out the last $50,000 of taxable income by paying the shareholder-employee a $50,000 year-end bonus? Assuming the shareholder-employee pays the maximum 35% federal rate, he owes $17,500 to the U.S. Treasury (35% × $50,000). Of course, he will also have federal employment taxes
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