C corporation owners often need to withdraw cash from the business, whether to cover personal expenses or protect excess cash from creditors. While paying dividends is one way to take money out, it has some significant downsides. Fortunately, there are other tax-efficient methods available. Here’s what you need to know:
The primary issue with dividends is double taxation: the corporation pays tax on its earnings, and the shareholder pays taxes on the dividends received. Shareholders typically pay capital gains tax on dividends, which ranges from 15% to 20% depending on taxable income and filing status. Additionally, dividends might be subject to the 3.8% net investment income tax (NIIT) if modified adjusted gross income exceeds certain thresholds ($250,000 for married couples filing jointly, $125,000 for married couples filing separately, and $200,000 for all other filers).
State statutes intended to prevent fraudulent distributions to owners may also limit the amount of dividends that can be paid. Moreover, dividends exceeding the corporation’s current-year or accumulated earnings and profits are considered a return of capital, which reduces the basis in your shares and could lead to additional capital gains when the business is sold.
Here are five alternative methods to withdraw cash from your corporation and potentially avoid double taxation:
1. Compensation: The IRS allows corporations to deduct reasonable compensation as a business expense. This means that these payments are taxed only once. However, excessive compensation is not deductible and will be treated as dividends. If you underpaid yourself in the early years of your business, you might be able to compensate with higher pay in subsequent years. Your tax advisor can help determine reasonable compensation, including both salary and bonuses, and recommend any necessary adjustments.
2. Fringe Benefits: Certain fringe benefits are deductible for the corporation and tax-free for recipients. These include health insurance, life and disability insurance, and nondiscriminatory contributions to qualified retirement plans. A salary reduction plan, where the corporation makes pretax contributions to retirement plans, can also be immediately deductible for the business while deferring your tax liability.
3. Loans: If you need cash urgently, your corporation can extend a loan to you. However, the IRS may reclassify it as a dividend if it’s not a “bona fide loan.” To qualify, you need a written promissory note with signed and dated repayment terms, including an interest rate no lower than the applicable federal rate. It’s crucial to eventually repay the loan to maintain its status as a loan.
4. Lease Arrangements: Shareholders can lease personal property to the corporation in exchange for rent. The business can deduct the rent, while the shareholder reports the rental income on their individual tax return. Ensure that the rent does not exceed market rates, as the IRS might reclassify excessive lease payments as dividends. Be aware that state and local governments may require sales tax collection on leases of tangible personal property.
5. Return of Capital: If you previously advanced capital to the corporation, the business can make nontaxable repayments. These repayments won’t be treated as dividends, and the corporation can deduct any interest paid if the capitalization is properly structured as debt. However, if repayments exceed your stock basis, the excess will be a taxable capital gain.
Withdrawing cash from your corporation can be complex and fraught with potential pitfalls. This overview highlights some key issues and requirements, but it’s crucial to document the details and follow relevant corporate formalities. Ensure decisions are recorded in shareholder meeting minutes and adopt formal written policies or plans.
Need assistance navigating the complexities of withdrawing cash from your C corporation? Reach out to Patten and Company LLC for expert guidance and support. Our experienced team can help you explore tax-efficient strategies and ensure compliance with all relevant regulations.
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