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If you're a C-corporation owner, there's a short window of opportunity under the Jobs and Growth Tax Relief Reconciliation Act of 2003 you won't want to miss. Here's why: This tax law brightens your dividend picture.
Under the new law, the top rate on dividends is now 15 percent, while the top rate on compensation can run as high as 35 percent. As a result, you may want to shift your compensation strategy and increase dividend payouts while reducing your compensation. While any dividends you receive are free of employment taxes, keep in mind that they are not deductible as a business expense. In the past, given a choice, it made sense to pay compensation rather than dividends. Compensation was deductible by the corporation, thus avoiding one level of tax. Dividends, on the other hand, can generally be paid only out of income that has already been taxed at the corporate level, and are then taxed again when received by the shareholder.
Not only were dividends taxed at ordinary income tax rates, as high as 38.6 percent in 2002, but they were also taxed as corporate income, with rates up to 35 percent. "If you consider shareholder-owners the ultimate bearers of the total taxes on corporate earnings, the double layer of tax can be viewed as a 45 percent tax on their income," says Paul Gada, a tax analyst with CCH Business Owner's Toolkit, a division of Riverwoods, Illinois-based tax and business law information and software provider CCH Inc.
One downside of the new tax on dividends is that it won't be attractive to family-owned businesses, says Thomas Ochsenschlager of accounting firm Grant-Thornton in Washington, DC. That's because family-owned companies are usually reluctant to pay dividends, no matter how attractive the tax rates, because they need to keep the cash in the company for growth. "Paying out dividends reduces the value of the company, making it more difficult for the company to borrow," Ochsenschlager adds.
Even so, he predicts rising pressure from minority shareholders to pay more dividends because of the tax benefits. Moreover, owners may also want to use this tax change as a way to hire and retain valuable employees. A company can offer restricted stock with the promise of dividend payouts rather than bonuses, which will enable employees to keep more of their "compensation" after tax. This might be an especially good strategy if your company can't meet a competitor's salary offer.
Bear in mind that this special tax treatment of dividends is temporary, lasting only from 2003 until the end of 2008. So if you're going to act, do it soon.
Great Falls, Virginia, writer Joan Szabo has reported on tax issues for 16 years.