Paying dividends as a tax planning strategy.

• Date: 01 September 2022
• Author: Hackett, Trenda B.
• Published date: 01 September 2022
• Author: Hackett, Trenda B.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's closely held C corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).

Qualified dividends are distributions of cash or property made by a domestic or qualified foreign corporation out of its earnings and profits (E&P) to a shareholder with respect to its stock (Sec. 1(h)(11)(B)). To qualify for the reduced rate on dividends, a shareholder must hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. For preferred stock dividends attributable to a period or periods aggregating more than 366 days (e.g., cumulative preferred stock with dividends in arrears), the holding period is more than 90 days during the 181-day period beginning 90 days before the stock's ex-dividend date. The holding period includes the date of disposition but not the date of acquisition (Sec. 246(c)(3)(A)).

To receive any dividend, the taxpayer must own the stock at least one day before the ex-dividend date. Because the required holding period is more than 60 days during a period beginning 60 days before the ex-dividend date, this necessarily means that the holding period must include the ex-dividend date. However, the 61-day (or 91-day) holding period does not have to be consecutive. Also, certain transactions that limit the taxpayer's risk of loss (e.g., short sales and options to sell substantially identical stock or securities) suspend the taxpayer's holding period until those transactions are closed (Sec. 246(c)(4)).

Paying compensation instead of dividends

For most closely held C corporations, avoiding the double taxation of corporate earnings has been the primary tax planning goal for many years. The traditional approach to the problem is for the corporation to zero out its annual taxable income (or nearly so) by making deductible year-end bonus payments to shareholder-employees. Legitimate corporate payments for shareholder-employee compensation can be deducted as ordinary and necessary business expenses (Sec. 162(a)(1)). Of course, shareholder-employee compensation payments (including year-end bonus amounts) are subject to Social Security tax and Medicare tax (Federal Insurance Contributions Act tax). An additional 0.9% Medicare tax applies to wages above a certain amount ($250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately).

For tax years 2018-2025, an individual's taxable income is subject to seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Furthermore, an additional tax applies to higher-income individuals, depending on whether...