Post-JGTRRA dividend planning.

• Author: Pannese, Danny A.
• Position: Jobs and Growth Tax Relief Reconciliation Act of 2003

EXECUTIVE SUMMARY

* E&P can be distributed as dividends during the JGTRRA period of lower tax to avoid higher tax in a future year.

* Corporations with accumulated E&P and PHCI should consider paying dividends to shareholders in the 10% and 15% brackets.

* The lower dividend rates also affect traditional planning strategies, such as compensation, shareholder advances, Sec. 302 redemptions and sec. 306 preferred stock transactions.

The JGTRRA reduced the tax rate on dividends for individuals and lowered the accumulated earnings and personal holding company taxes for corporations until 2008.

This article reviews some of the planning techniques corporations and shareholders can use to take advantage of the temporarily lower rates.

One of the key provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), if not the prime emphasis of the legislation, is Section 302's reduction in the individual tax rate on corporate dividends received to 15% (5% for individuals in the 15% and 10% brackets). In an emerging trend, the lower tax rates on dividends will sunset in 2008. This six-year window affords some interesting planning opportunities for both C and S closely held corporations that want to reduce their accumulated earnings and profits (E&P). This article discusses some of the dividend planning opportunities under the JGTRRA for closely held corporations and their shareholders.

Background

The bane of corporate taxation has always been the double taxation of corporate earnings. Because of this, most closely held corporations (usually C corporations) have beers loathe to distribute dividends, and have also planned to avoid constructive dividends. Consequently, many C corporations (and some S corporations that were previously C corporations) have locked-up E&P that, in post-2008 years, can generate a second level of tax to shareholders at pre-2003 tax rates.

Example: X, a C corporation (not a personal service corporation), has $1 million taxable income and distributes its entire after-tax earnings as a dividend to its sole shareholder Y, whose marginal tax bracket is 35%.

Pre-JGTRRA Post-JGTRRA X Taxable income $1,000,000 $1,000,000 Corporate tax rate 34% 34% Corporate tax $340,000 $340,000 After-tax earnings $660,000 $660,000 Y Dividend distribution $660,000 $660,000 Individual tax rate 35% 15% Individual tax $231,000 $99,000 Combined X and Y tax $571,000 $439,000 Combined effective tax rate 57.1% 43.9% Combined tax savings $132,000 Combined rate change 13.2% For some taxpayers, this may be an opportune time to "bail out" E&P at this lower tax rate. Of course, it is unknown whether the law will become permanent.

New Dividend Tax Rate

JGTRRA Section 302 reduces the individual tax rate for qualified dividends received to 15% and to 5% for individuals in the 15% and 10% brackets, for dividends received in tax years beginning after 2002 and before 2009. (1) For 2008 only, the tax rate on qualifying dividends for individuals in the 15% or 10% bracket is reduced to zero. The change in the dividend tax rate applies only to individuals, not corporations. (2) Sec. 1(h) shows how to calculate the tax on dividends, which are included with adjusted net capital gains under Sec. 1(h)(3) and taxed at the 15% capital gain rate. However, under Sec. 1(h)(3)(B), capital losses cannot offset dividend income.

Only qualified dividends are eligible for the reduced rates. Under Sec. 1(h)(11)(B)(i), qualified dividends are "dividends received" from domestic corporations (3) and qualified foreign corporations. Unfortunately, the JGTRRA and the Committee Reports do not provide a definition of a "dividend" and do not expound on "received." However, dividends are defined generally in Sec. 316(a) as property distributions that a corporation makes to its shareholders out of E&P. Presumably, constructive dividends will be qualified dividends subject to the lower tax rate; however, this is not certain until regulations are promulgated. Qualified foreign corporations include corporations incorporated in a U.S. possession, foreign corporations eligible for benefits under a tax treaty with the U.S. and foreign corporations whose stock is readily tradable on an established U.S. securities market. (4)

Special rules under Sec. 1(h)(11)(D)(i) exclude otherwise qualified dividends to the extent a taxpayer takes the dividend into account as investment income for purposes of the Sec. 163(d) investment income limit. Other special rules deal with extraordinary dividends under Sec. 1059 and dividends received from regulated investment companies and real estate investment trusts under Sec. 1(h)(11)(D)(ii) and (iii). (5))

Dividend Planning--Bailing Out E&P

The goal in most of the planning techniques discussed below is to distribute earnings in certain cases as dividends during the period of lower tax, to avoid (1) a higher rate in a future year or (2) future dividend potential, by reducing (or even eliminating) E&P. This is not an all-inclusive list; hopefully, it will help spark other ideas. It should also encourage tax advisers to reexamine their C or S clients with accumulated E&P for possible dividend distribution opportunities.

Compensation Issues for C Corporations

Closely held C corporations have traditionally maximized salaries to officer shareholders to reduce corporate taxable income. Under Sec. 162(a)(1), (6) the Service often seeks to treat a portion of a shareholder's salary as a nondeductible constructive dividend if there is evidence that it is excessive or unreasonable. Prior to the JGTRRA, because salary and dividend income were taxed at the same rates, a successful unreasonable compensation issue would garner corporate level tax, with no meaningful mitigating effect on the individual shareholder. (7) If the disallowed compensation is accorded constructive-dividend treatment (and constructive dividends are considered qualifying dividends eligible for the lower tax rate), the reduced JGTRRA dividend tax rate should lessen the effect of the unreasonable salary disallowance.

In certain cases, closely held C corporations that want to reduce E&P should consider paying dividends, rather than salaries. From the shareholder's perspective, a dividend might be...