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This article will discuss the options available to shareholder owners, other than borrowing, to realize cash from a corporation that is expected to continue.
Stockholder owners can sell shares to another shareholder or back to the company if the company has the cash and wants to regain shares. As with any other stock transaction, the taxpayer’s profit may be subject to taxation depending on the fair market value (FMV) of the shares. Similarly, if the taxpayer sees a loss, they may be able to claim a deduction.
How do you determine the fair market value of your shares and, therefore, the tax implications? Loosely defined, the FMV is simply the price a willing buyer and seller can agree upon. The FMV is much harder to determine for shares in a closely held company, which has a small number of concentrated shareholders, as opposed to a publicly traded company.
As long as the shares have been held for over a year, any gain will be taxed as long-term capital gain. The tax rate varies by income but is capped at 20%. Even better, if the stock is small business stock and has been held for more than five years, it may qualify for special treatment under IRC Section 2012. This rule allows portions of the gain to be excluded from income, up to 100% in certain cases.
If the stocks are sold at a loss, this will typically be considered a capital loss, which is not realized until an asset is sold for a price lower than the original purchase price. Capital losses can be used to offset other capital gains, but the deduction for capital losses is capped at $3,000 per year. Any additional losses are carried forward by the taxpayer indefinitely and cannot be passed on to the taxpayer’s beneficiaries after death.
Shareholder owners are typically more than passive investors: they usually hold one or more jobs within their corporation. If the company is profitable and the board agrees, executive compensation can be increased to give shareholder owners additional cash.
In this approach, the wages and associated payroll taxes are deductible expenses to the corporation. For C corporations, this reduces corporate income tax and the double taxation that occurs when profits are distributed to shareholders as dividends.
With executive raises, additional payroll taxes will be required, and the company may be subject to scrutiny from the IRS if they perceive the increase as excessive compensation. From a tax perspective, C corporations typically want to maximize compensation for employee owners to minimize double taxation when the company is profitable. However, this payroll strategy can backfire when shareholder owners are not fully aware of tax rules. If the IRS decides C corporation compensation is excessive, they can reclassify wages as a constructive dividend, which is then taxable by the IRS.
EXPLAINER:
The IRS has closed certain distribution loopholes by getting court cases ruled in their favor. The courts have consistently defined constructive dividends as expenditures that “do not give rise to a deduction on behalf of the corporation” (or do not qualify as an ordinary and necessary business expense). Therefore, these dividends create “economic gain, benefit, or income to the owner-taxpayer” and are considered taxable.
Common examples of transactions that have been ruled as constructive dividends include:
Of course, a final example would be excessive compensation, which makes the option of giving shareholder owners a raise a possible tax risk.
If available, shareholders are entitled to simply take cash from a company. However, the tax implications surrounding this option can complicate matters. If a shareholder takes non-liquidating distributions of cash (payments that do not result in the dissolution of the business), the distributions with the highest tax consequences must unfortunately be taken first. Tax rules state that distributions must occur in this order:
Let’s break each of these distributions down separately to understand the tax consequences:
Public corporations typically announce a quarterly dividend and then pay those out to shareholders. Similarly, many non-public corporations, like small C corporations, will regularly distribute most or all of their annual earnings and profits to their shareholders. Each shareholder’s dividends are based on their pro rata (proportional) ownership share.
The disadvantage of E&P distributions is that they are subject to double taxation. E&P are subject to income tax (21%) at the corporate level, and any dividend distributions are also taxed at the shareholder’s marginal any dividend distributions are also taxed at the shareholder’s marginal tax rate. This is why closely held corporations often prefer to increase shareholder owners’ compensation. The employer’s share of the payroll taxes (around 8%) is substantially less than the income tax rates. These payroll taxes and wages are also deductible to the corporation. Even when the employee’s share of the payroll taxes is considered, this still results in roughly 5% in tax savings over corporate income tax alone.
However, as mentioned above, the IRS may reclassify compensation it deems excessive as a constructive dividend.
On the other hand, if a corporation does not distribute their entire annual E&P to shareholders, the E&P is subject to accumulated earnings tax. Of course, leaving some cash in a corporation can provide a buffer in case there are lean years, the company wants to expand, or other capital-intensive projects arise. However, the formation of a corporation implies the distribution of dividends, so attempting to avoid tax by leaving E&P in the corporation will result in negative tax consequences.
Is there any way to take money out of a corporation without it being subject to tax? Yes. Any cash distributions that exceed a shareholder’s pro rata share of E&P dividends are not taxable to the shareholder. These distributions are considered a tax-free return of capital,
which can total up to the amount of the shareholder’s adjusted basis (the change to the stock compared to its initial cost).
With this option, the taxpayer keeps their shares, but the basis is adjusted down by the amount of the distribution. Let’s look at an example:
That adjusted basis will be used to determine gain or loss when the That adjusted basis will be used to determine gain or loss when the shares are sold. So, this option may help you to avoid taxation now, but there may be taxes to pay later. The only way to increase basis is to make capital contributions of cash or property to the corporation that are not given in exchange for additional shares.
Let’s say a shareholder takes a non-liquidating cash distribution that exceeds both their annual share of E&P and their adjusted basis in their stock. The excess distribution will be taxed as long-term capital gains. Long-term capital gains rates are much more favorable than ordinary income rates. However, the size of the distribution and the ordering rules may mean that only a small part of the distribution will receive long-term capital gains treatment.
Remember, the corporation does not recognize gain or loss on cash distributions. However, if the corporation receives non-liquidating distributions of appreciated property, such as investment property like stock or real estate, these gains may be taxable. The gain to the corporation is the difference between the FMV and the corporation’s adjusted basis in the distributed property.
Shareholder owners should carefully consider the tax implications of distributing appreciated property for a shareholder to sell rather than simply distributing cash.
To take a timely example, let’s say it is late fall of 2020. A taxpayer wants to take a cash dividend of $50,000 from their corporation, and they are trying to decide whether to take the cash this year or wait until next year.
In 2020, the company was closed due to COVID-19, so the taxpayer owner reduced their own salary in order to continue paying employees. Though annual income and E&P were greatly reduced due to closure, the annual income and E&P were greatly reduced due to closure, the company does have cash available.
What’s more, in late 2020, the company was able to pivot, and its contact-free sales became more profitable than their previous in-person model. As a result, their 2021 revenue is expected to see a large increase over 2020 and possibly over prior years.
Now let’s take a look at the numbers:
Given the above, the taxpayer will end up paying:
If the taxpayer takes the cash in 2020, the $50,000 distribution will result in $5,700 in taxes.
Based on late 2020 projections, the company could double its E&P in 2021. The company is expected to do well enough to return the shareholder owner’s salary back to its original level. This example will assume that the taxpayer had no other additional income in 2021 that might push them into the 20% capital gains tax bracket.
Here are the projected numbers for 2021:
In this case, the taxpayer would pay:
So, if the taxpayer takes the distribution in 2021, the resulting taxes would be $6,950-that’s a $1,250 tax increase. By understanding the tax consequences, the taxpayer can elect to take the cash distribution earlier and increase their tax savings.
Timing and planning can make a significant difference in tax consequences. If you want to reduce tax when taking cash out of a C corporation, you will likely want to take it in a year with low E&P. This assumes that the corporation still has a good cash flow, though its earnings may not be high. This could be the case if large capital expenditures cause a lot of depreciation on the books, for example.
If a shareholder owner is a highly compensated corporate employee in the year of the distribution but plans on becoming just an investor in the future, the best option may be to get a distribution that results in a tax-free return of capital. The reduced basis that will result may not matter as much if the shareholder sells their shares strategically in the future, say when they are retired or in a lower tax bracket.
Determining when and how to take cash can be a complex process. This is where the assistance of a qualified tax professional will prove valuable. Consult a tax advisor if you are considering taking cash out of your C Determining when and how to take cash can be a complex process. This is where the assistance of a qualified tax professional will prove valuable.
If you are considering taking cash out of your C corporation Prep Tax Smart is here to help ensure you are fully aware of the possible short- and long-term tax consequences.
If you require assistance with avoiding double taxation for a C-corporation, please contact us, and we will help you find the best solution
Posted: 12/11/2023
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