Consider the following five alternative means of withdrawing cash from your corporation to potentially avoid double taxation:
1. Compensation. The IRS allows your corporation to claim a business expense deduction for reasonable compensation, so these payments are taxed only once. Excess amounts aren’t deductible, though, and the IRS will treat them as dividends. However, if you underpay yourself in the early years of operating your business, when cash is tight, you might be able to pay yourself a little extra in subsequent years to make up the difference. Your tax advisor can help determine what’s reasonable, including both salary and bonuses, and recommend adjustments to prior years, if applicable.
2. Fringe benefits. Examples of fringe benefits that are generally deductible for the corporation and tax-free for recipients, include:
- Health insurance,
- Life and disability insurance, and
- Nondiscriminatory contributions to qualified retirement plans.
With a salary reduction plan, the corporation makes pretax contributions to certain retirement plans that are immediately deductible for the business, while deferring your tax liability. Additional rules and restrictions may apply. For example, if an employer provides life insurance to employees, up to $50,000 is tax free. But if the policy provides a death benefit of more than $50,000, the imputed cost of the coverage in excess of $50,000 must be included in an employee’s income.
3. Loans. If cash is required more urgently, a corporation can extend a loan to a shareholder. However, the IRS may reclassify the arrangement as a dividend if it isn’t deemed a “bona fide loan.” Several factors are used to determine whether a loan is bona fide. Among other things, you must have a written promissory note that’s signed and dated by the lender and the borrower. The note should spell out the repayment terms, including an interest rate no lower than the applicable federal rate.
The existence of a note alone isn’t decisive, though, if the substance of the arrangement indicates it wasn’t truly a loan. It’s also important to eventually repay the loan.
4. Lease arrangements. Shareholders can lease personal property to a corporation in exchange for rent. The business can deduct the rent, while the shareholder receives rental income that’s reported on the individual income tax return. These transactions also run the risk of IRS reclassification. For example, if the rent exceeds market rates, lease payments could be treated as dividend payments.
Beware: State and local governments may require the collection and remittance of sales taxes on leases of tangible personal property, such as vehicles and equipment.
5. Return of capital. If you previously advanced capital to the corporation, the business could make nontaxable repayments. A repayment of capital won’t be treated as a dividend, and the corporation can deduct any interest paid, assuming you’ve properly structured the capitalization as debt. But, if repayments exceed your stock basis, the excess will represent a taxable capital gain.
Important: In general, shareholders should be cautious about contributing additional capital to the business. In most cases, you’d be better off obtaining financing in the corporation’s name.