Making withdrawals from your closely held corporation that aren’t taxed as dividends
Do you want to withdraw cash from your closely held corporation at a minimum tax cost? The simplest way is to distribute some money as a dividend. However, a dividend distribution isn’t tax-efficient since it’s taxable to you to the extent of your corporation’s “earnings and profits.” It’s also not deductible by the corporation. Fortunately, several alternative methods allow you to make cash withdrawls from a corporation while avoiding dividend treatment.
Here are five areas where you may want to take action:
1. Capital repayments
Suppose you’ve capitalized the corporation with debt. In that case, the corporation can repay the debt without the repayment being a dividend. That includes amounts you’ve advanced to the business. Additionally, the corporation can deduct interest paid on the debt. This situation assumes adequate documentation stating that the debt is, in fact, debt. It also considers that the corporation doesn’t have an excessively high debt-to-equity ratio. If not, you may be able to tax the debt repayment 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.
Reasonable compensation that you (or family members) receive for services rendered to the corporation is deductible by the business. However, it’s also taxable to the recipient. The same rule applies to compensation in the form of rent that you receive from the corporation for the use of property. In both cases, the amount of compensation must be reasonable concerning the services rendered or the value of the property provided. The excess will be nondeductible and treated as a corporate distribution if it’s excessive.
You may withdraw cash from the corporation tax-free by borrowing from it. However, you’ll want to avoid having the loan characterized as a corporate distribution. Then, there should be a loan agreement or a note with appropriate documentation. The terms should also be comparable to those on which an unrelated third party would lend money to you and include a provision for interest and principal. When required, you would make all interest and principal payments under the loan terms. Also, consider the effect of the corporation’s receipt of interest income.
4. Fringe benefits
Consider obtaining the equivalent of a cash withdrawal in fringe benefits deductible by the corporation and not taxable to you. Examples are life insurance, certain medical benefits, disability insurance, and dependent care. Most of these benefits are tax-free only if provided on a nondiscriminatory basis to other employees. You can also establish a salary reduction plan that allows you (and other employees) to take a portion of your compensation as nontaxable benefits rather than as taxable compensation.
5. Property sales
Another way to withdraw cash from the corporation is to sell property. However, you should avoid certain sales. For example, you shouldn’t sell property to a more than 50% owned corporation at a loss since the loss will not be allowed. And you shouldn’t sell depreciable property to a more than 50% owned corporation at a gain. The gain would then be ordinary income rather than capital gain. A sale should be on terms comparable to those on which an unrelated third party would purchase the property. You may need to obtain an independent appraisal to establish the property’s value.
Withdraw Cash at Minimum Tax Cost
If you’re interested in discussing any of these approaches, contact our RRBB accountants and advisors. We can help you get the most out of your corporation at the minimum tax cost.
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