Page 479 - TaxAdviser_2022

If B pays out all taxable income as Doing so may make it seem more
Paying out dividends deductible compensation, it would owe reasonable for the corporation to start
nothing in tax ([$100,000 income −
paying meaningful dividends when
each year after $100,000 deductible compensation] × little or none have been paid in the
paying nothing in the 21%). If J is in the 24% marginal tax past.
past may bracket, she would owe $24,000 in tax ■ The dividend strategy will not work
($100,000 × 24%). Out of the $100,000
when there are multiple shareholders,
look suspicious of corporate earnings, $24,000 would be some of whom are employed by the
to the IRS. paid in tax. corporation and some of whom are
If J is in the 32% marginal tax
not, because switching to a policy
bracket, she would owe $32,000 in tax of paying dividends could alter the
($100,000 × 32%). Out of the $100,000 bottom-line cash flow reaped by the
net investment income tax will cause of corporate earnings, $32,000 would be various shareholders. However, when
the maximum rate on qualified paid in tax. there is just one shareholder, this is
dividends to be 18.8% (15% + 3.8%) If J is in the top 37% marginal tax not a concern.
or 23.8% (20% + 3.8%). The 3.8% net bracket, she would owe $37,000 in ■ State income tax implications at the
investment income tax applies to taxpay- tax ($100,000 × 37%). She would also corporate and shareholder levels must
ers with modified adjusted gross income owe the additional 0.9% Medicare tax, be evaluated.
above a certain amount ($250,000 for which applies to wages of $200,000 or
married filing jointly, $125,000 for more for single filers. (In fact, the 0.9% Considering other factors
separate filers, and $200,000 in all other Medicare tax would apply if she is in the in paying dividends or
cases). 35% marginal tax bracket, since both compensation
kick in near the same $200,000 taxable The federal income tax treatment of
Example 1. Paying corporate profits income threshold.) Out of the $100,000 a nonliquidating corporate distribu-
as taxable dividends or deductible of corporate earnings, $37,900 would be tion paid to an individual shareholder
compensation: J is a single filer who paid in tax. generally depends on the amount of the
owns 100% of the outstanding stock This example indicates that pay- distributing corporation’s E&P. Distri-
of B Inc., an incorporated book shop. ing double-taxed dividends begins to butions up to the amount of a domestic
If B has $100,000 in earnings for the be beneficial when the shareholder- corporation’s E&P generally count as
current year, it would owe $21,000 employee’s marginal income tax rate is qualified dividends eligible for the 15%
in tax ($100,000 income × 21%). 32% or higher. But as a practical matter, or 20% maximum federal dividend rate.
determining the preferable way to ex- Distributions in excess of E&P reduce
If the after-tax earnings are distrib- tract cash from a corporation depends the recipient shareholder’s tax basis in
uted and J is subject to a 15% quali- on many factors and assumptions. To his or her stock (i.e., they are tax-free
fied dividend tax rate, she would owe give meaningful advice, the practitioner recoveries of capital). Distributions in
$11,850 in tax ([$100,000 − $21,000] × needs to work with reasonably accurate excess of stock basis are treated as capital
15%). Out of the $100,000 of corporate dollar amounts and the actual tax rates gain and generally qualify for the 15%
earnings, $32,850 would be paid in tax that the shareholder-employees expect or 20% maximum rate on long-term
($21,000 + $11,850). to pay. capital gains.
If J is subject to a 20% qualified
dividend tax rate, she would owe Weighing the negative Paying dividends to low-bracket
$15,800 in tax ([$100,000 − $21,000] aspects of paying dividends shareholders
× 20%). Together, B and J would owe When considering the dividend strat- In the context of family-owned C cor-
$36,800 in tax ($21,000 + $15,800). egy, the following points must be kept porations, existing high-bracket share-
If J is subject to a 20% qualified in mind: holders should consider giving away
dividend tax rate and the 3.8% net ■ Paying out dividends each year after some stock to low-bracket family mem-
investment income tax, she would owe paying nothing in the past may look bers. Recipient shareholders (who are
$18,802 in tax ([$100,000 − $21,000] × suspicious to the IRS. One way to often the shareholder’s child(ren)) with
23.8%). Out of the $100,000 of corpo- justify the corporation’s new practice taxable income below a certain threshold
rate earnings, $39,802 would be paid is to add a group of new shareholders may pay no federal income tax on their
in tax ($21,000 + $18,802). who are not corporate employees. dividend income (0%). Assuming that

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