Sunday, February 8, 2015

Dividends: It's the least tax-efficient way to withdraw money from a corporation

Peter Beach for the Union Leader writes: THE LIMITIED liability company and S corporation are generally regarded as the entities of choice for closely-held businesses, in large part because the owners can access company cash tax-efficiently. However, for a variety of good non-tax reasons many businesses still operate as corporations without electing to be treated as an S corporation. These so-called C corporations generally find it more difficult to make tax efficient distributions of cash.

From a business perspective, the simplest way to distribute cash from a C corporation is to pay a dividend. However, a dividend distribution is not very tax-efficient - it is not deductible by the corporation and is taxable to shareholders to the extent of the corporation's "earnings and profits" under both the federal income tax and the New Hampshire Interest & Dividends tax. Several alternative methods exist, however, that allow corporate shareholders, especially those that are also employed by the corporation, to withdraw cash while avoiding dividend treatment.Debt Repayment. A corporation can repay debt it owes to a shareholder without triggering tax to the shareholder except to the extent the repayment includes the payment of interest. The corporation gets no deduction for the repayment of principal, but any payment of interest is deductible. Of course, for this alternative to work the shareholder would need to have loaned money to the corporation in the first place, which may have simply resulted naturally over time from business exigencies or from good tax advice upon formation or additional capitalization of the corporation. In addition, the debt must qualify as debt for tax purposes, which generally requires that it be properly documented and made on terms (including provision for interest) that are comparable to those on which an unrelated third-party would have loaned the money.Payment of Compensation. Reasonable compensation paid to a shareholder in exchange for services actually rendered to the corporation is taxable to the shareholder but deductible to the corporation. 

The same rule applies to any compensation (e.g., rent) received from the corporation for the use of property.Borrowing from the Corporation. A shareholder can withdraw cash from a corporation without being taxed by borrowing money from the corporation. However, to avoid recharacterization of the loan as a dividend, the loan must be properly documented and be made on terms (including provision for interest) that are comparable to those on which an unrelated third-party would lend money to the shareholder.Fringe Benefits. A shareholder may withdraw cash by receiving certain fringe benefits that are deductible to the corporation and not taxable to the shareholder (most of these benefits require that the shareholder also be an employee of the corporation). These may include life insurance, certain medical benefits, disability insurance, dependent care and other benefits. 

Most of these benefits are tax-free only if provided on a nondiscriminatory basis to other employees of the corporation. A corporation can also establish a salary reduction plan that would allow shareholder/employees (as well as other employees) to take a portion of their compensation as nontaxable benefits, rather than as taxable compensation.Selling Property to the Corporation. Shareholders may withdraw cash from a corporation by selling property to the corporation. However, certain types of sales should be avoided. For instance, shareholders that own 50 percent of more of a corporation should not sell property to the corporation at a loss because the loss will be disallowed and they should not sell depreciable property to the corporation at a gain, because the gain will be treated as ordinary income, rather than capital gain.

In addition, it is generally not advisable to sell appreciating property (e.g., real estate) to a corporation. Any sale should be on terms comparable to those that would apply if an unrelated third party were purchasing the property. In this connection, it is generally advantageous to obtain an independent appraisal.
Every entity has its difficulties when it comes to taxation. S corporations are less flexible than partnerships and limited liability companies, and taking advantage of the tax benefits of partnerships and limited liability companies can be quite complicated. However, C corporations generally present the greatest tax challenges for shareholders seeking to withdraw money from the company.