Consider Paying Corporate Dividends Before 2011

Dividends paid by C corporations are taxable to shareholders and are not deductible to corporations.  This is the classic "double tax" treatment of C corporation profits.  For this reason most privately-owned C corporations do not pay dividends.  Dividends are ordinary taxable income, but since the Bush tax cuts of 2003, the maximum qualified dividend tax rate has been 15%, equal to that of long-term capital gains.  The Bush tax cuts expire at the end of 2010.  If Congressional action is not taken, the maximum dividend tax rate would increase to 39.6% for dividends received after 2010.  Pres. Obama has proposed that the maximum dividend tax rate not exceed 20%.  The post-2010 tax rate is hard to predict given the dysfunction of our national leaders.  Furthermore, the so-called health care reform law will add an additional 3.8% Medicare tax to dividend income beginning in 2013, for individuals having modified adjusted gross income of $200,000 or more ($250,000 for joint filers).  Given the higher, possibly dramatically higher, dividend tax rates in the near future, should your corporation pay dividends before 2011?

There are several specific circumstances where paying a dividend could make sense.  Additional financial and tax analysis is necessary to determine whether the ideas below are proper for your circumstances.

1. The C corporation has accumulated excess funds that are not needed for business purposes.  An accumulated earnings penalty tax of could be imposed by the IRS on the corporation.  The penalty tax rate is equal to the maximum dividend tax rate.  Paying a dividend of the excess accumulation avoids the risk of the penalty tax.
2. The C corporation has sold assets and has retained the after-tax sale proceeds to invest.  If the investments produce interest, dividends, royalties, rents, and annuity income, and such income equals 60% or more of the adjusted ordinary gross income of the corporation, then the corporation must pay the personal holding company penalty tax.  The penalty tax rate is equal to the maximum dividend tax rate.  Distributing the investments in liquidation of the corporation eliminates the annual problem of the personal holding company tax.  Note, however, that the corporation could recognize a taxable gain on the dividend distribution if the investments have appreciated in value.
3. The S corporation was previously a C corporation having accumulated earnings and profits.  If the S corporation earns passive investment income in excess of 25% of gross receipts, then a penalty tax applies.  Furthermore, the S election is lost after three consecutive years of excess passive income.  Passive investment income includes interest, dividends, royalties, rents, and annuity income.  The penalty tax is equal to the maximum C corporation tax rate, currently 35%.  A special election is available to distribute the accumulated C corporation earnings as profits as a taxable dividend.  The election and distribution will purge the S corporation of the problem of accumulated C corporation earnings and profits and enable the S corporation to avoid the penalty tax and potential loss of the S election.
4. The C corporation has strong cash flow, low debt, and currently pays dividends.  A special dividend that is financed with debt could be paid in 2010 in order to capture the lower tax rates.  The special dividend is in essence a prepayment of future dividends.