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Indeed, if the corporation's Federal income tax rate is 15% (which applies to the first $50,000 of taxable income, under Sec. 11(b)(1)(A)) and the recipient is in the highest individual marginal tax bracket (35%), a better after-tax result occurs if the corporation retains the first $50,000, pays tax on it, then pays the balance as a dividend. The shareholder receives a dividend, instead of salary, rent, interest, etc.
Example: In 2004, Corp. X has $50,000 in taxable earnings (all of which will be paid as a dividend) and a 15% Federal tax rate. After Federal taxes, X will have $42,500. Y, an individual X shareholder, is in the 35% Federal tax bracket and will net $36,125 ($42,500 x 0.85).
If, instead, X had paid Y a $50,000 bonus (in addition to a salary that exceeded the 2004 Social Security withholding threshold), there would be no corporate level tax, but a 1.45% Medicare tax would have applied (deductible by X), leaving $49,275 for Y. The bonus would be subject to a 35'% tax rate ($17,500), plus the $725 Medicare tax, leaving g $31,775 ($50,000-$18,225). Y thus nets $4,350 more with a dividend ($36,125-$31,775).
AE Tax - Accumulated Earnings
A closely held corporation may have an unreasonably high level of accumulated earnings; tax practitioners have always advised such companies not to pay dividends, due to double taxation. The IRS has been very successful in assessing the Sec. 531 AE tax, which is a penalty tax. In general, the tax is calculated under Sec. 535(b), by reducing taxable income for various deductions, then deducting dividends paid (frequently, zero); there are also certain addbacks. The balance is now taxed at 15%.
Because the maximum rate on dividends is now 15%, there is an excellent opportunity to "bail out" earnings at a very low tax rate. The corporation should record any decisions made as to dividend payments in the corporate minutes.
PHC Tax
Most tax advisers have had a PHC client (as defined in See. 542(a)). As with the AE tax, the PHC tax is a penalty tax and can be quite severe; under Sec. 541, it is 15% of undistributed PHC income, as defined in Sec. 543 (i.e., the corporation's current taxable income, reduced by the regular income tax, various deductions and certain dividends paid). There are also certain addbacks.
With the low 15% rate on dividends, a common planning strategy would be to disburse an amount equal to PHC taxable income (as defined in Sec. 545).