by George G. Jones and Mark A. Luscombe
Before this year’s tax cut, labeling a payment a “dividend” was frequently a casual exercise of no real consequence since, whether a dividend or not, the payment was usually taxed like any other item of ordinary income.
Now, with up to a 20 percentage point difference between the highest income tax rate (35 percent) and the highest dividend rate (15 percent), determining what is a qualified dividend suddenly can make a big difference in bottom-line tax liability.
Complicating matters further are issues over correctly computing the earnings and profits that determine available dividends, correctly labeling payments on preferred shares as interest or dividends, and determining the true nature of payments, which were heretofore loosely pigeonholed as “constructive dividends.”
With the advent of the lower rates on qualified dividends, it is clear that, at least in some instances, the tables have turned and labeling a payment a “dividend” is now to be coveted rather than avoided. However, especially in the case of small corporations, in which major shareholders are also key employees, an effective dividends tax strategy requires weighing a number of factors.
Rates
The Jobs and Growth Tax Relief Reconciliation Act of 2003 lowered the top federal tax rate for dividends received by an individual, estate or trust to 15 percent (5 percent for those whose incomes fall in the 10 percent or 15 percent rate brackets, and zero percent in 2008). The reduced rates, which are the same rates applicable to net capital gain, apply to eligible dividends received from Jan. 1, 2003, through Dec. 31, 2008. Dividends that are not qualified dividends, however, continue to be taxed as ordinary income.
Although qualified dividends share the 15 percent rate with net capital gains, dividends do not enter into the netting process. Instead, they are added in for purposes of the rate calculation only.
As such, capital losses offset capital gains but not dividends. If there is a net capital loss, up to $3,000 of it ($1,500 for married taxpayers filing separately) can be used to offset income other than dividend income, but any excess must reduce dividend income first before being able to be carried forward to offset ordinary income in the following year.
Qualified dividend income
Dividend income qualifies for the reduced net capital gains rates if received from either a domestic corporation or a qualified foreign corporation, and a 60/120 day holding period is satisfied.
To win qualified dividend income treatment, the stock must be held for more than 60 days during the 120-day period starting 60 days before the ex-dividend date. In contrast, dividend income received within the 120-day period is taxed as ordinary income.
To prevent short sales and other maneuvers around this rule, the act provides that dividend income is not qualified if receipt of the dividend causes the taxpayer to be obligated to make a payment with respect to positions in related property (or substantially similar property). Days are not counted on which a shareholder’s risk of loss on the shares is substantially lessened by options or a short sale.
Dividends paid on preferred shares are eligible for the reduced dividend rate. However, some of what has been marketed as preferred stock is not stock for purposes of the reduced rate. Hybrid preferred stock, for example, is really debt that allows the corporation to take an interest expense deduction. Under Code Sec. 385(c) a corporation’s characterization of the payment binds the recipient unless the recipient clearly discloses his or her contrary position on the return.
Dividends paid by a corporation that is tax exempt and payments in lieu of dividends are specifically excluded from the definition of qualified dividend income.
Dividend income that a taxpayer chooses to use in connection with the investment interest deduction is also excluded. Since investment interest may be carried over if current investment income is inadequate to cover it, however, sacrificing the 15 percent dividend rate would rarely make sense.
A foreign corporation may pay a qualified dividend if its stock is traded on an established U.S. securities market, and it is subject to an acceptable treaty or is incorporated in a U.S. possession. Foreign personal holding companies, foreign investment companies or passive foreign investment companies, however, are disqualified automatically.
Dividends
In order to be a qualified dividend, however, the payment must first and foremost be considered a dividend under the traditional Code Sec. 316(a) definition. Dividends under Code Sec. 316(a) are defined as distributions to shareholders out of current or accumulated earnings and profits. Distributions in excess of earnings and profits reduce the recipient’s basis in stock. Amounts, if any, in excess of stock basis are usually taxed as capital gain.
The determination of whether earnings and profits exist is made as of the end of the corporation’s tax year in which the distribution occurs, even if this amount cannot be determined until a later date. The presence or absence of earnings and profits when the distribution is made is irrelevant. In addition, the presence of an accumulated earnings and profits deficit will not prevent dividend treatment if current earnings and profits exist at year’s end.
Constructive distributions
A constructive dividend may occur when a corporation is found to have made a payment primarily for the benefit of a shareholder without expectation of repayment. A constructive dividend can also occur if the shareholder appropriates corporate monies, or if he or she is paid excessive compensation.
Distributions of dividends must be distinguished from payments to shareholders in other capacities, such as salary, guarantee fees and royalty payments, which would be ordinary income and deductible by the corporation.
Compensation vs. dividend
In the past, IRS agents have routinely re-characterized excessive salaries paid to shareholders as constructive dividends. This knee-jerk response may change. Under the reduced rates for dividends, employee-shareholders may actually prefer dividend treatment over salaries taxed at ordinary income rates. Dividends have the advantage of being free of employment taxes.
Payments that are characterized as compensation by the corporation and the shareholder may be dividends if they exceed a reasonable amount of compensation, or are, in fact, an attempt to distribute earnings and profits. In contrast, payments characterized as dividends may be treated as compensation if they are, in fact, paid for services rather than “with respect to stock.”
One weapon that the IRS has in its arsenal to prevent taxpayers from rushing to “convert” ordinary-income type payments into dividends is the fact that dividends paid to individual shareholders are not deductible. In addition, compensation payments cannot be deducted by a corporation if they exceed reasonable compensation for the services performed.
In developing a case for compensation or dividend income, a comparison of corporate and individual rates and benefits is important. For example, if the corporation is taxed at 35 percent and the shareholder at 33 percent, a $50,000 payment as compensation would create a $50,000 deduction for the corporation ($17,500 tax savings) and would net the shareholder $33,500 on the $50,000.
If the payment had been a dividend, however, the corporation loses the tax deduction and, therefore, would have only to pay out as a dividend to the shareholder, who would net $27,625 ($32,500 x 15 percent).
As a rule of thumb, therefore, the corporation and owner together continue to be better off, for federal income tax purposes, if the payment is characterized as compensation rather than as a dividend.
Three additional factors, however, should be considered: compensation income generates a Social Security tax obligation; the corporation may not have additional income that can be offset by a compensation deduction; and the lack of available earnings and profits can all make a dividend distribution more attractive.
Finally, there is some precedent for the IRS taking the approach that a payment that exceeds reasonable compensation can, in fact, be divided into three parts. They are:
● Reasonable compensation, which is taxable as compensation to the recipient and deductible by the corporation;
● Unreasonable compensation, which is taxable as compensation to the recipient but not deductible by the corporation; and,
● A dividend distribution, which is taxable as a dividend to the employee and not deductible by the corporation.
Conclusion
JGTRRA’03 has upset the traditional treatment of dividends and forces practitioners and clients to re-think their dividend strategy. If taking advantage of the reduced rate is beneficial, clients may want to dispose of stock that will not pay a qualified dividend and invest in stock that is eligible for the lower rate. Small, closely held businesses especially need to evaluate how they spread income to shareholder-employees.
Finally, and arching over everything, is the temporary nature of the dividend rate cut. Unless Congress extends it, the lower tax rate on qualified dividends expires in 2009.
