Tax planning for dividends and capital gains.

• Author: Holub, Steven F.

Tax advisers may best serve their clients by offering tax planning advice. Any "tax preparer" may serve as a historian and tell a client how much tax is due as a result of past events. The true mark of the professional is to assist in planning for future events, so as to reduce the taxes to be paid in the future.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) provided tax advisers with an opportunity to advise clients on a large number of issues. This column will examine some aspects of planning for dividends and capital gains, including:

* Salaries (and other deductible items) of C corporations.

* Corporations facing possible accumulated earnings (AE) tax problems.

* Personal holding companies (PHCs).

* S corporations that should transfer some fixed assets.

* S corporation with C earnings and profits (E&P) issues.

* Planning for 2008 and beyond.

Salary Planning

A basic principle of C corporation tax planning has always been that all corporate disbursements be deductible. Thus, tax advisers have sanctioned (to the extent reasonable) high salaries and rent (when stock holders have owned the rental property) and interest payments (when stockholders have been creditors).

In the past, tax practitioners often sought payments to be deductible by a payer and ordinary income to a recipient. After the JGTRRA, individuals' dividends are taxed at a 5% or 15% rate; thus, in many instances, it may be quite advantageous for disbursements to be nondeductible by the payer and received by a shareholder as a dividend.

Indeed, if the corporation's Federal income tax rate is 15% (which applies to the first $50,000 of taxable income, under Sec. 11(b)(1)(A)) and the recipient is in the highest individual marginal tax bracket (35%), a better after-tax result occurs if the corporation retains the first $50,000, pays tax on it, then pays the balance as a dividend. The shareholder receives a dividend, instead of salary, rent, interest, etc.

Example: In 2004, Corp. X has $50,000 in taxable earnings (all of which will be paid as a dividend) and a 15% Federal tax rate. After Federal taxes, X will have $42,500. Y, an individual X shareholder, is in the 35% Federal tax bracket and will net $36,125 ($42,500 x 0.85).

If, instead, X had paid Y a $50,000 bonus (in addition to a salary that exceeded the 2004 Social Security withholding threshold), there would be no corporate level tax, but a 1.45% Medicare tax would have applied (deductible by X), leaving...