Sunset provisions make corporate distributions before 2011 worth considering The maximum 15% rates on qualified dividends and long-term capital gains now in effect are scheduled to expire at the end of this year under the sunset provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA, P.L. 108-27 ). Barring congressional and presidential action, maximum rates of 39.6% and 20% will go into effect for dividends and long-term capital gains, respectively, for 2011 transactions. (For 2011, a maximum rate of 18% on long-term capital gains rate would apply in the case of assets held more than five years.) As this Practice Alert explains, taxpayers with cash sitting idle in their corporations should consider pulling some of it out before the end of 2010 to avoid the higher rates that may go into effect next year. Taking money out of the corporation. A lot of complicated rules make it very difficult to take money out of a corporation by means of a stock redemption and have the transaction produce capital gains. However, the good news here is that a maximum 15% rate will apply in 2010 whether the distribution in redemption is treated as a dividend or as a payment for stock entitled to long-term capital gains treatment, or indeed if a pro rata distribution is made to all the shareholders without regard to any redemption. (Even though the maximum rate is the same for both dividends and long-term capital gains, there is an extra benefit in getting capital gain treatment in that basis in the stock redeemed will reduce the amount subject to tax. This is not so if the redemption distribution is treated as a dividend.) When a corporation buys stock from a shareholder, he may be treated as exchanging the stock for the redemption proceeds (capital gain) or the redemption proceeds may be treated as a dividend to the extent it does not exceed earnings and profits (E&P). A redemption payment is a distribution taxable as a dividend unless it is (1) a complete termination of a shareholder's interest in the corporation, (2) a distribution that is substantially disproportionate in its effect on the shareholder, or (3) a distribution that is not substantially equivalent to a dividend. Other provisions provide non-dividend treatment of certain partial liquidation payments to noncorporate shareholders, and payments to pay the estate tax of a deceased taxpayer. These rules are complicated and difficult to negotiate, and often make it hard to take money out of a corporation at anything other than ordinary dividend rates. On the other hand, as pointed out above, it doesn't matter as much for 2010 transactions since the 15% maximum rate will apply in any case. RIA illustration 1: Taxpayer, an individual, is in a maximum tax bracket of 35% in 2010, and, barring action to extend the current tax rates, will be in a 39.6% bracket in 2011. Taxpayer has shares in Corporation in which he has a basis of $100,000, and which he has owned for more than five years. Assume his shares are redeemed before the end of 2010 for $1 million, in a transaction that qualifies as a complete termination of his interest and thus produces long-term capital gain of $900,000. Under the 2010 tax rates, he pays $135,000 in taxes (15% of $900,000). If he receives the same gain in 2011 (and Congress takes no action on the JGTRRA sunsets), his tax will be $162,000 (18% capital gains rate for assets held more than five years applied to $900,000), or $27,000 more than he would pay if the distribution were made in 2010. If he didn't own the shares for more than five years, his tax will be $180,000 (20% of $900,000). RIA illustration 2: Same facts as in illustration (1) except that the distribution in redemption is treated as an ordinary income dividend. If the distribution is made in 2010, Taxpayer would pay a tax of $150,000 (15% of total distribution of $1 million since there is no reduction in the taxable amount for his basis in the stock). On the other hand, if the distribution is delayed until 2011 (and Congress takes no action on the JGTRRA sunsets), he will pay a tax of $396,000 (39.6% of $1 million), or $246,000 more than he would pay if the distribution were made in 2010. Thus, if dividend treatment is expected, it is even more urgent that the transaction be carried out in 2010 than it would be if the distribution were eligible for long-term capital gain treatment RIA observation: As noted above, the 15% maximum rate is available this year whether the redemption route is followed or if outright distributions are made. However, in addition to applying basis to reduce the taxable amount of the distribution, using a redemption that qualifies for capital gain treatment also has the advantages of (1) accomplishing a shift in relative ownership percentages (e.g., where the object is to shift control to younger family members), and (2) not having to make a distribution to all shareholders. RIA caution: The downside of a pre-2011 distribution is that it is impossible to know at present whether the 15% rates will simply expire and be replaced by higher rates in 2011, or be extended, or be replaced by another set of rates somewhere inbetween. As a result, if the 15% rates are extended for all taxpayers, the taxpayer who pulls money out of his corporation in 2010 will just have paid his taxes a year earlier. 9/9/10