If you're a stockholder in a successful closely-held C corporation, you know this year's federal income tax rate structure is favorable to your cause.
- If your company pays you a dividend this year, the maximum federal income tax rate will be only 15 percent.
- The same 15 percent maximum federal rate will apply to 2010 corporate payouts or stock sales that generate long-term capital gains.
But things are about to change. Here are the specifics about what's in store along with some tax-smart strategies to consider right now.
Higher Taxes on Dividends
The maximum federal rate on dividends will automatically leap from the current 15 percent to 39.6 percent on Jan. 1 as the Bush tax cuts expire. Although the president has promised more than once to limit the maximum rate on dividends to 20 percent, the little-known fact is Congress must take action for that to happen. It's no sure thing. Even if it does happen, the maximum rate on dividends will jump again to 23.8 percent in 2013, thanks to the additional 3.8 percent Medicare tax that takes effect that year. So you're facing a 59 percent increase in the maximum federal tax on dividends (at least).
Higher Taxes on Long-Term Gains
Starting Jan. 1, the maximum federal rate on long-term capital gains will automatically increase from the current 15 percent to 20 percent. Starting in 2013, it will jump again to 23.8 percent due to the additional 3.8 percent Medicare tax. So you're facing a 59 percent increase in the maximum federal tax on long-term capital gains too.
What Can You Do?
Thankfully, you still have some time to take advantage of this year's historically low tax rates on dividends and long-term gains. Here are three strategies to consider right now. Don't ponder too long, because these ideas will take some time to execute, and Jan. 1 will arrive before you know it.
- Take Low-Taxed Dividends This Year
Say your profitable C corporation has a healthy amount of earnings and profits (E&P). The concept of E&P is somewhat similar to the more-familiar financial accounting concept of retained earnings. Anyway, while lots of E&P indicates a successful company, it also creates a tax side effect. To the extent of your corporation's E&P balance, corporate distributions to shareholders (like you) count as taxable dividends. Since the 2010 federal rate on dividends can't exceed 15 percent, dividends received this year will be taxed lightly. That probably won't be true for dividends received in 2011 and beyond. Therefore, shareholders (like you) should weigh the option of triggering a manageable current tax hit by taking dividends in 2010 against the option of absorbing a potentially bigger (but deferred) tax hit on dividends taken in future years.
- Do Low-Taxed Stock Redemption Deal This Year
Another way to convert some of your C corporation wealth into cold, hard cash is with a stock redemption deal--where you sell back some or all of your shares to the company. When there are several shareholders, this is a common technique to get extra cash to one or more selected shareholders (maybe you) while other shareholders stay put.
To the extent of your corporation's E&P balance, any stock redemption payment is generally treated as a taxable dividend, which is OK if it happens this year since the maximum federal rate is only 15 percent. However, our beloved Internal Revenue Code provides several exceptions to this general rule. If one of these exceptions applies (consult your tax adviser), redemption payments are treated as proceeds from selling the redeemed shares. In that case, you can offset the resulting capital gain with capital losses from other transactions earlier this year and with capital losses carried into this year. (Lots of folks still have big capital loss carryovers left over from the 2008 stock market meltdown.) The gain left after subtracting your capital losses (if any) will probably be a long-term gain taxed at only 15 percent, as long as the redemption happens this year.
Since both dividends and long-term gains will almost certainly be taxed at higher rates in 2011 and beyond, getting a stock redemption deal done this year could result in a much smaller tax hit than if you wait until later.
- Sell Stock This Year
This last strategy is obvious. Speaking strictly from a federal income tax perspective, selling shares this year and paying no more than 15 percent on the resulting gains (assuming you've held the shares for over a year) sure beats paying 20 percent, or 23.8 percent, or maybe even more than that on gains from sales in later years.