Tax
Jun. 25, 2002
Minimizing Taxes on Distributions to Shareholders of C Corporations
Focus Colum - By Stephen M. Loeb - Federal tax law classifies corporations as C corporations or S corporations. C corporations are separate taxable entities. Transactions between a C corporation and its owners are taxable events, governed by subchapter C. Internal Revenue Code Sections 301-385. S corporations are pass-through entities, governed by subchapter S. Internal Revenue Code Sections 1361-1379.
By Stephen M. Loeb
Federal tax law classifies corporations as C corporations or S corporations. C corporations are separate taxable entities. Transactions between a C corporation and its owners are taxable events, governed by subchapter C. Internal Revenue Code Sections 301-385. S corporations are pass-through entities, governed by subchapter S. Internal Revenue Code Sections 1361-1379. This article discusses transactions between a shareholder owner and a closely held C corporation.
There are various methods for an owner of a corporation to withdraw funds from the corporation. Each method has its own tax rules and costs, which are delineated in the Internal Revenue Code, Internal Revenue regulations and case law. Counsel should take care to make sure that any transaction meets all of the applicable requirements.
Additionally, since the state tax implications of a transaction are usually, but not always, similar to the federal tax implications, counsel should review separately every transaction based on state tax law for the state or states in which the corporation does business.
The methods of transferring money from a corporation to shareholders generally fall into four categories: stock transactions, debt transactions, employee compensation and other transactions between the shareholder and the corporation. By selecting the proper mix of the different types of distributions, shareholders can receive distributions from their closely held corporations while minimizing the tax cost of making those distributions.
Counsel should develop the mix of methods used with the owner's needs in mind. Ideally, attorneys should give consideration to desired future distributions when the corporation is first formed and, thereafter, as the owner's goals are refined. This allows the owner to receive distributions in the optimal manner under the circumstances.
Generally, distributions relating to stock are treated as dividends and are paid from after-tax earnings and profits. Internal Revenue Code Sections 301, 316. Dividends are fully taxable to the individual shareholder. Thus, dividends are subjected to two layers of taxation, first on the corporate level, because dividends are paid from the after-tax funds of the corporation, and then on the shareholder level because dividends are taxable to the individual recipient.
There are special rules that may allow a distribution to a shareholder to be treated as being made in exchange for stock owned by the shareholder. They include rules relating to substantially disproportionate redemptions and partial liquidations. Internal Revenue Code Section 302. Should the transaction be treated as a distribution in exchange for stock owned by the shareholder, then the shareholder is only taxed on the gains from the sale, not on the entire distribution. Additionally, the tax will usually be at capital gains tax rates. Internal Revenue Code Section 301. This tax treatment, if available, greatly reduces the tax on the shareholder level, but does not reduce the tax on the corporate level.
If a shareholder lends money to a corporation, there are various tests for whether the loan will be treated as a valid debt obligation or as a contribution to capital. The tests include such things as whether the loan bears market interest and whether there is proper documentation of the loan, as well as other factors. Internal Revenue Code Section 385; see also Rev. Rul. 83-98; R.A. Hardman v. United States, 827 F.2d 1409 (9th Cir. 1987).
If the loan is treated as a valid debt obligation, then interest payments from the corporation to the shareholder are deductible for the corporation and taxable to the shareholder, while the repayment of principal is neither deductible by the corporation nor taxable to the shareholder. Thus, loan payments are only taxable on one level: the shareholder level for interest payments and the corporate level for principal repayments.
Reasonable employee compensation is another way of transferring funds from a corporation to its employee shareholders. Both the shareholder and members of the shareholder's family may be employees of the corporation, which can compensate them reasonably for their services.
Employee compensation can include both salaries and a wide range of benefits. Some of the benefits available are health insurance, life insurance, savings and retirement plans and various fringe benefits.
Reasonable salaries are deductible for the corporation and taxable to the shareholder. Thus, the payment of a reasonable salary to shareholder employees is only taxable on the shareholder level.
The taxability of benefits depends on the circumstances. Premiums paid directly by the corporation for group health insurance and contributions made directly by the corporation to medical savings accounts are generally deductible by the corporation and not taxable to the employees provided they do not discriminate in favor of highly compensated employees and participants. Internal Revenue Code Section 106. Thus, the provision of nondiscriminatory group health insurance to shareholder employees will, in most cases, not be taxable on either the corporate or the shareholder level.
Premiums paid directly by the corporation for up to $50,000 of nondiscriminatory group term life insurance generally are deductible by the corporation and not taxable to the employees. Internal Revenue Code Section 79. Thus, the provision of nondiscriminatory life insurance to shareholder employees will, in most cases, not be taxable on either the corporate or the shareholder level.
Contributions to nondiscriminatory profit-sharing, pension and stock-bonus plans can be deductible by the corporation and not currently taxable to the employees. Internal Revenue Code Sections 401-417. Thus, contributions to nondiscriminatory profit-sharing, pension and stock-bonus plans for shareholder employees will, in most cases, not be taxable on the corporate level and be tax-deferred on the shareholder level.
Various other fringe benefits also may be available to shareholder employees. Internal Revenue Code Section 125. Depending on the circumstances, these may or may not be taxable on the corporate or shareholder level. Counsel should review each option separately.
Additionally, a shareholder may enter into reasonable arrangements in which the corporation compensates the shareholder for the business use of the shareholder's property. The property can be real, personal or intangible property. The payments can be in the form of reasonable sales proceeds, rents, royalties, etc. The tax treatment depends on the facts of the transaction.
Depending on the circumstances, the payments made by the corporation may be deductible, depreciable or amortizable by the corporation and may result in the shareholder being taxed on all, a portion or none of the distribution. The taxability of these other types of transactions on the corporate and shareholder levels will vary from transaction to transaction, and each must be separately evaluated.
Thus, with proper planning, the owner of a closely held corporation can have distributions made in the manner that best meets the owner's needs and can minimize the taxability of those distributions by properly structuring corporate-shareholder transactions.
Stephen M. Loeb is an attorney with offices in Los Angeles who practices in the areas of tax planning, estate planning and planning for the preservation and transmission of wealth.
Columnist
For reprint rights or to order a copy of your photo:
Email
Jeremy_Ellis@dailyjournal.com
for prices.
Direct dial: 213-229-5424
Send a letter to the editor:
Email: letters@dailyjournal.com