Here are two situations when arranging for your family C corporation to pay out dividends might make sense - even if they are taxed twice:
Cash in on Low Rates and Reduce the Accumulated Earnings Threat Let's say your profitable family C corporation has built up a large earnings and profits (E&P) balance. While this is financially healthy, it could create two tax problems.
First Potential Problem: Sooner or later, your company may have to pay out most or all of that hefty E&P balance as dividends. The shareholder-level federal income tax rate on dividends paid out now would be no more than 15 percent. But if you wait, the rate could be much higher. After 2010, the maximum federal rate is scheduled to jump to the highest individual tax rate, which is currently 35 percent. This higher rate will go into effect unless Congress acts to extend the reduced dividend tax rates.
To sum up: You face only a 15 percent maximum rate on dividends taken now, while you risk paying a much higher rate if you choose to take dividends later on.
Second Potential Problem: When a C corporation accumulates lots of earnings without paying dividends, the IRS can penalize the company with the accumulated earnings tax. This tax can be assessed on accumulated earnings in excess of the corporation's reasonable business needs (subject to a $250,000 exemption; $150,000 for personal service corporations). The good news is the 2003 Tax Act reduced the accumulated earnings tax rate to only 15 percent. The bad news is the rate is currently scheduled to jump to 35 percent for 2011 and beyond. Again, Congress could act to extend the 15 percent rate but as the tax law stands now, the accumulated earnings tax will increase significantly in the future. For this reason, now may be a good time to eliminate your company's exposure to the tax by paying some low-taxed dividends that drain away excess accumulated earnings.
Lock in Today's Rock-Bottom Rate for Low-Bracket Shareholders
The 2003 Tax Act provides lots of encouragement for high-bracket taxpayers to give away stock in the family C corporation to lower-bracket family members - such as your children and grandchildren. The corporation can then start paying dividends to all shareholders. Currently, you owe no more than 15 percent to the U.S. Treasury for dividends. For 2008 through 2010, younger-generation shareholders in the 10 and 15 percent federal income tax brackets pay zero percent on dividends they receive (assuming the Kiddie Tax doesn't apply).
For example, let's say you give begin giving your young daughter up to $13,000 worth of stock in the family C corporation in 2010 (and 2009). If you're married, you and your spouse can together make annual joint gifts of stock worth up to $26,000 without any adverse estate or gift tax consequences. These gifts reduce your taxable estate in the best possible way - by removing appreciating assets from the tax collector's clutches.
Then, your daughter can receive dividends from the family C corporation and pay either the 15 percent tax, or even the zero percent tax rate to the IRS if she is in the regular 10 percent or 15 percent federal rate bracket.
However, remember that the Kiddie Tax generally applies to your children under age 19 or full-time students under age 24. Any unearned income above $1,900 received by the child in 2010 (and 2009) is taxed at the top rate of the child's parents.
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