Owners of closely held corporations often want or need to withdraw cash from the business. The simplest way, of course, is to distribute the money as a dividend. Distribution must be to all shareholders in proportion to their ownership. However, a dividend distribution from a C Corporation is taxable to the owner to the extent of the corporation’s earnings and profits. (Subchapter S Corporations and their distributions are treated differently.) It also isn’t deductible by the corporation. Here are four alternative strategies to consider:
Capital repayments. To the extent that you’ve capitalized the corporation with debt, including amounts that you’ve advanced to the business, the corporation can repay the debt without the repayment being treated as a dividend. Additionally, interest paid on the debt can be deducted by the corporation.
This assumes that the debt has been properly documented with terms that characterize debt and that the corporation doesn’t have an excessively high debt-to-equity ratio. If not, the “debt” may be treated as capital and the repayment taxed as a dividend. If you make future cash contributions to the corporation, consider structuring them as debt to facilitate later withdrawals on a tax-advantaged basis.
Compensation. Reasonable compensation you, or family members, receive for services rendered to the corporation is deductible by the business. However, it’s also taxable to the recipient(s). This same rule applies to any compensation (in the form of rent) that you receive from the corporation for the use of property. In both cases, the compensation amount must be reasonable in terms of the services rendered or the value of the property provided. If it’s considered excessive, the excess will be a nondeductible corporate distribution (and taxable to the recipient as a dividend).
Property sales. You can withdraw cash from the corporation by selling property to it. However, certain sales should be avoided. For example, you shouldn’t sell property to a more than 50%-owned corporation at a loss, since the loss will be disallowed. And you shouldn’t sell depreciable property to a more than 50%-owned corporation at a gain, since the gain will be treated as ordinary income, rather than capital gain and the corporation cannot claim bonus depreciation on it. A sale should be on terms that are comparable to those in which an unrelated third party would purchase the property. You may need to obtain an independent appraisal to establish the property’s value.
Loans. You can withdraw cash tax-free from the corporation by borrowing money from it. However, to prevent having the loan characterized as a corporate distribution, it should be properly documented in a loan agreement or note. It should also be made on terms that are comparable to those in which an unrelated third party would lend money to you, including a provision for interest (at least equal to the applicable federal rate) and principal. Also, consider what the corporation’s receipt of interest income will mean.
These are just a few ideas. If you’re interested in discussing these or other possible ways to withdraw cash from a closely held corporation, contact us. We can help you identify the optimal approach at the lowest tax cost.
The HoganTaylor Tax Practice
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INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.