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Should a Corporation Pay Dividends in 2010 To Take Advantage of Low Dividend Tax Rates?

November 10, 2010

by Steven B. Gorin

Whether a corporation should pay dividends in 2010 to take advantage of low rates depends, of course, on whether paying dividends will ever be beneficial. As you know, under current law dividends are taxed at long-term capital gain rates in 2010 and would be taxed at ordinary income rates in 2011 and future years.

For a C corporation, the answer depends on whether the corporation needs to pay the dividend to save accumulated earnings or personal holding company tax and whether the shareholders need the cash.

For an S corporation that had been a C corporation that retained earnings and profits (E&P), the questions are whether the shareholders need a distribution in excess of AAA or have excess passive income issues.

C Corporation
If a corporation appears headed for an accumulated earnings tax problem, then one should consider accelerating dividends to take advantage of low rates; making an S election would be a better solution, because S corporations are not subject to that tax, but the corporate structure or exposure to built-in gain tax might preclude that strategy. Personal holding tax is a year-by-year calculation, so only short-term planning would be available for that. Details about accumulated earnings and personal holding company taxes are beyond the scope of these materials.

Whether the shareholder needs the cash is more of a matter of when. If the shareholder plans to hold the stock for a long time, then the shareholder can get capital gains rates on the sale of stock or liquidation of the corporation, although the latter risks double taxation on any growth in reinvestments of accumulated dividends.

S Corporation With E&P
S corporations with E&P that earn excess passive income risk imposition of a tax. If the situation lasts too long, then the S election will be terminated.

One solution is to distribute E&P. An election can be made to have all distributions be first from E&P and then, when E&P are exhausted, from AAA. The corporation can even declare a deemed dividend of E&P and practically guarantee that no E&P remain. If such a strategy is pursued, 2010 might be one’s last chance to get rates this low.

Another solution is to generate sufficient non-passive gross receipts. Such receipts would include an active business or active rental real estate (“passive” has a different definition here than it does for the Code § 469 passive loss rules). Some people stop here, because clients say that they have sold their business and do not want to run another one. However, gross receipts attributable to an active business run by someone else would also work. The most common example is oil and gas partnerships. This author’s experience is that, when an S corporation just has marketable securities, investing only 2-3% of the portfolio in oil and gas partnerships often will do the trick.

Therefore, although distributing the corporation’s E&P is technically sound, as a practical matter investing in oil and gas partnerships often is much less expensive than paying tax – even at 2010’s low rates – on a dividend that cleanses a corporation that has substantial E&P.

Paying dividends now to take advantage of low dividend tax rates has its merits, but one should consider alternatives to see whether that strategy truly measures up.

Steven B. Gorin