Under current federal individual income tax law, both capital gains and corporate dividends are taxed at a reduced 15% rate. However, those reduced rates are scheduled to expire at the end of 2010. In addition, individual income tax rates that have been taxed at a reduced rate will increase to their normal levels: the highest rate will rise from 35% to 39.6%, with other brackets increasing similarly.
The Changed Landscape
There has been substantial political discussion of extending the reduced rates. However, if they are allowed to expire, the effect on dividends will be to increase the tax rate from 15% to as much as 39.6%. The tax rate for capital gains will increase more modestly, generally from 15% to 20% (18% for gains incurred in 2011 from property held for more than five years). Expiration of certain Alternative Minimum Tax ("AMT") rules will tend to result in more individuals being subject to AMT.
We expect to see two major effects if those changes take place:
- Corporations will have less reason to make distributions to their shareholders.
- Corporations making distributions will have an increased incentive to structure distributions as redemptions giving rise to capital gains instead of dividends.
There will probably be various collateral effects as well. For example, the Accumulated Earnings Tax (a tax on excess undistributed earnings and profits), which has been largely irrelevant for several years, may again be vigorously enforced. Also, from a planning standpoint, there may be an increased emphasis on structuring business operations using entities that are not subject to corporate taxation.
The 2010 Opportunity
A corporate taxpayer that has accumulated significant amounts of cash earnings and profits may choose to make dividends in 2010 instead of retaining those earnings. If so, its shareholders will be taxed on the distributions at the current reduced rates.
In addition, in the case of a redemption-type transaction that might qualify for capital gains treatment but only with some difficulty, it may be advantageous to carry out the transaction in 2010. Doing so will substantially reduce the tax risk if the redemption distribution is ultimately found to be a dividend.
Practical Considerations
Before rushing to plan around a potential increase in tax rates, taxpayers should consider the following practical matters:
- Whether to act now or wait and see. The current tax rates may be extended by legislation either before they expire or retroactively. If so, any action taken in 2010 in order to secure the benefit of the reduced current tax rates will have been unnecessary. It may be appropriate to defer any final decision until later in 2010 after the political picture becomes clearer, perhaps after the November election and the subsequent lame-duck legislative session.
- Whether there is any benefit to be gained from a distribution at all. A distribution is a dividend only if it is made out of current or accumulated earnings and profits. In the absence of earnings and profits, there is usually no incentive to rush a distribution, although under the right set of circumstances, a redemption transaction could still be useful.
- Whether competing cash needs and legal restrictions limit the benefits that could be obtained. Removing cash from a corporation may have important business effects. On the one hand, cash that has been removed from a corporation may be beyond the reach of its creditors. On the other hand, however, once removed it is not available for the corporation to use in its operations, except perhaps through a loan back to the corporation, which raises its own set of complications. Also, there may be state corporate law restrictions on removing the cash.
If you have questions about the expiring tax rates or their effect on you or your business, please feel free to contact us.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
|
