Background: Ownership in a corporation is evidenced by the amount of stock owned. The stockholder’s cost of stock is based on the amount of cash given or the cost of property being contributed to the corporation at the time the corporation is created. Shareholders are rewarded for their investment via the payment of dividends or by the increase of the stock’s value over the time it is held.
The amount of your reward, when paid in the form of dividends, can vary depending on the type of stock you own and the privileges that comes along with the stock. For instance, corporations can issue common stock and preferred stock. Preferred stock can come with special privileges that are not given to common stockholders, like preferential dividend amounts. This makes it important to work with a CPA and a corporate attorney, as a shareholder of a closely held corporation, particularly, to ensure you can get the most reward from your corporation as possible.
What are dividends?
Dividends are great way for shareholders to get money from their corporation. They are a distribution of property (cash or other asset) from the corporation to its’ shareholders/stockholders. The IRS has special rules that requires a dividend to be issued out of either your current year’s earnings and profits or your accumulated earnings and profits. If a distribution is made to a shareholder that is not made from earnings and profits, the distribution you intended to be treated as a dividend could be treated differently for tax purposes.
How are dividends taxed?
Dividends must be added to the taxable income of the shareholder receiving them. On the flip side, the corporation can NOT deduct dividends as a write-off since it comes from previously taxed earnings and profits.
If the dividends are considered to be qualified dividends (paid from a domestic corporation, etc.) then they are taxed at a lower capital gain rate. Otherwise, ordinary income tax rates apply. Additionally, in some cases this income could be subject to the net investment income tax of 3.8%, which increases the overall tax rate the dividends are subjected to.
Since dividends are paid from earnings and profits that have been taxed on the corporate level (now a flat tax of 21%), and will be taxed on the shareholder level when distributed, this creates a double taxing of corporate income.
Disguised Dividend Practices to Steer Clear of....
Since dividends are not deductible by the corporation and to avoid double taxation of corporate earnings, there are certain practices that have been undertaken to compensate shareholders while avoiding dividend treatment.
- paying excessive compensation to shareholders and/or their relatives
- paying personal expenses of shareholders (e.g. travel, legal expenses, etc.)
- Paying interest on shareholder debt that could be excessive or unreasonable
- Paying excessive rent on use of shareholder's property
In summary, dividends are a wonderful way to reward a shareholder for their investment in the company, but comes with tax rules that may not be as rewarding, such as the non-deductibility of them by the corporation and the double taxation it creates once the shareholder receives a distribution. The unfavorable tax treatment of dividends has caused some “creative” ways that taxpayers have implemented to get around the tax rules, such as paying high salaries that are unreasonable when considering the services the shareholder may be providing to the corporation and more. Proper tax planning and the creation of various classes of stock issued under the corporation can be helpful to a shareholder seeking to increase their dividend distributions, and minimize the tax implications of this.
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If you're concerned if you've been handling your dividend payouts properly or are concerned if you are overpaying income taxes due to your dividend distribution amounts, we recommend a chat with our CPA today! We can run a tax analysis that will help you create a tax strategy that works for your corporation.
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