Entities typically operate as limited liability companies (LLC), partnerships, Subchapter-S Corporations, or regular C Corporations. The entity type and its capital structure impact how profits may be withdrawn or distributed.
This article will focus on withdrawing from closely held C corporations. C corporation shareholders/employee owners are often interested in withdrawing cash from profits in a tax efficient manner.
Here are some withdrawal options.
Paying a dividend is typically the simplest option to withdraw cash, but note that it is usually the least tax efficient. Dividends are nondeductible and will be taxed twice. The first taxation is at the corporate level for the profit represented by the dividend. Then, the owner must also report dividends on his or her personal income tax return, just like dividends paid by publicly traded corporations.
Repayment of and Interest on Debt
In situations in which owners have capitalized the corporation with debt or additional cash advances in addition to stock, the corporation may repay the debt without it being treated as a dividend (assuming the debt amount is reasonable).
Interest paid on the debt is deductible by the corporation and must be reported as income on the owner’s income tax return. The debt must have been properly documented with certain terms that characterize it as debt instead of equity. Debt to closely held corporations usually carries a higher interest rate, which makes the interest payable option attractive.
Compensation for Services
In many instances, closely held corporation owners function as senior and middle management, which entitles them to higher compensation. While the compensation must be reasonable, an opportunity exists to award higher compensation and fringe benefits to owners and other working family members. The compensation is also deductible by the corporation.
Managing the Corporate Tax Rate
C corporations have graduated tax brackets (rates) depending on their profit level. By planning the maximum reasonable compensation deductions to owners, it’s possible to achieve the lowest corporate tax bracket of 15 percent. This results in a lower effective tax rate versus operating as an S corporation or an LLC partnership.
An owner may consider leasing real and personal property to the corporation, although rents must be reasonable. The corporation deducts the lease payments. The owner includes the income received and deducts related expenses, including depreciation. In effect, the depreciation acts as a tax shelter.
Loans from the Corporation
An owner is not taxed on loan proceeds when borrowing money from the corporation. The loan must be bona fide and reflect a proper interest rate. Timely payments are required for interest-on-demand loans, and payment of principal and interest for term loans. This technique allows the owner to borrow from the corporation and use the funds for other investments.
Fringe Benefit and Retirement Plans
Certain fringe benefits are deductible by the corporation and not taxable to the owners. These may include group life insurance, certain medical benefits, and other benefits. There is also an opportunity to design certain qualified retirement plans with benefits tilted toward higher compensated owners by using age-weight plans or plans integrated with social security benefits.
These are just a few ways closely held C corporation owners can distribute profits, cash, or benefits without incurring unnecessary taxes. Take time to review all the options before determining which will be most beneficial.
Contact us at 215.441.4600 if you have questions or would like to discuss how this topic may impact your business.