Under current federal law, most corporate dividends are taxed no higher than 15%, through 2010. Press coverage of this tax law usually features publicly-traded stock and the impact on investors. For example, if you receive $1,000 in dividend income this year from the stocks and stock funds you own, you generally will owe $150 (15% of $1,000) to the IRS. That’s true if you’re in the 25%, 28%, 33% or 35% federal tax brackets.

Private corporations, too

The law regarding taxes on dividends is not limited to publicly-traded shares. If you own shares in a closely-held corporation and receive dividends, the bargain tax rates also apply. As a result, this tax break may be valuable to owners of private companies, too.

Opportunity for C corporations

Among those who stand to gain are the owner-employees of C corporations. Under previous law, such owner-employees often were reluctant to pay out dividends.

That’s because dividends are not deductible from corporate income. In effect, such dividends are double-taxed: they’re subject to the corporate income, and also to personal income, tax on the return of the shareholder receiving the dividend.

Double taxation of corporate dividends is still effective. However, this double taxation is not as painful now, with the top personal tax rates on dividends capped at 15%. Under prior law, dividends were taxed as ordinary income, at rates that now go up to 35%.

What’s more, tax rates on dividends might be lower than 15%. In 2006 and 2007, taxpayers in the lowest two federal tax brackets pay only 5% on corporate dividends. This year, that 5% rate will be effective for single taxpayers with taxable income up to $30,650. For married couples filing jointly, the 5% rate on dividends applies to $61,300 of taxable income.

Thus, if shares of your corporation are owned by retirees of by children, it may be possible to pay them dividends that will be taxed at only 5%. In 2008 to 2010, moreover, those low-bracket taxpayers will owe no tax at all on qualified dividends.

Savvy planning

One tactic C corporation owners might consider is to pay themselves just enough compensation (salary and bonus) to leave $50,000 as corporate earnings this year. That $50,000 will be taxed at only 15%, under the corporate income tax rates. (Keep in mind that any compensation paid must be justified as reasonable, considering corporate performance, the employee’s experience, and so on.)

After paying 15% ($7,500) tax on the $50,000 in corporate income, the remaining $42,500 can be passed through to shareholders as a dividend, taxed at only 15%, or even 5%. The total tax on that $50,000 may be less than if the entire amount had been paid out as compensation, subject to ordinary income tax and Medicare tax.

This differs from past tax strategies for closely-held corporations. Previously, many small businesses tried to minimize distributions to avoid double taxation. The corporation would defer taxes and retain capital for growth which would ultimately be taxed at capital gains rates. The maximum capital gains tax rate also stays at 15% through 2010.

Exit strategies

At least through 2010, the low tax rate on dividends will provide C corporation owners with an opportunity to pull cash from their companies. Suppose, for example, Bob Brown is the sole owner of Bob Brown Corp (BBC). Over the years, BBC has accumulated a substantial amount of cash rather than pay him double-taxed dividends.

Now, Bob can distribute BBC’s cash to himself as a dividend. In all likelihood, some of these earnings and profits (E&P) will be taxed at 15%, as a dividend, while some of that payout may be a tax-free return of capital. There might be some long-term capital gains, too, which also will be taxed at only 15%, under current law.

Thus, if you have been building up cash inside your C corporation, you should ask your CPA to determine the tax you’d owe on a withdrawal. The time between now and the end of 2010 might be a window for low-taxed distributions.

Other advantages may apply as well. Taking cash from your company might reduce your exposure to a tax on excess accumulated earnings and may reduce the value of the shares you hold for gift and estate tax purposes.

Smart moves for S corporations

Owners of S corporations also may benefit from low tax rates on dividends. There’s no double taxation of corporate earnings, but by paying themselves dividends rather than compensation, owner-employees may realize payroll tax savings.

Suppose, for example, Ann Jones is the sole owner of Ann Jones Corp. (AJC), which has elected S Corporation status. In 2006, AJC’s income exceeds expenses by $200,000.

S corporations are not subject to the corporate income tax. Therefore, AJC’s $200,000 as a dividend to herself, rather than as compensation. Such a dividend will avoid payroll tax and save Ann at least $5,800: the 2.9% Medicare tax on $200,000 in compensation.

Again, Ann must be able to justify her compensation. Here, she should have evidence to support the fact that her compensation is not unreasonably low, in order to avoid payroll tax on the dividend her company has paid to her.

Corporate Tax Rates