The End Of Qualified Dividends For Small Business Owners

Prior to the implementation of Jobs Growth and Tax Relief Reconciliation Act of 2003 (JGTRRA, also known as the second "Bush tax cut"), dividends were taxed as ordinary income, in a similar manner to interest income from bonds; accordingly, the dividend tax rate varied with the individual's ordinary income tax brackets. With the passage of JGTRRA, new rules were implemented certain "qualified dividends" that would be eligible for favorable tax treatment.

If dividends were qualified, which required that the business be a domestic C corporation (or in some situations, a foreign corporation traded on a US stock exchange) and that the stock be held for at least 60 days before/after the dividend date (90 days for preferred stocks), the dividends were eligible to be taxed at the individual's long-term capital gains tax rate, rather than the higher tax rate for ordinary income. When the rules were implemented in 2003, this immediately (and in fact, retroactively back to the beginning of that year) reduced the individual's qualified dividend tax rate from his/her ordinary income tax bracket, to either the 15% (or 5% for the bottom two tax brackets) long-term capital gains tax rates. In addition, because the qualified dividend tax rate was tied directly to the long-term capital gains tax rate, subsequent changes to the latter rate affected the former too. Accordingly, since the 5% long-term capital gains tax rate for the bottom two tax brackets dropped to 0% in 2008, the qualified dividends tax rate moved down in sync.

The qualified dividend treatment was originally set to expire at the end of 2008, but was extended until 2010 (by the Tax Increase Prevention and Reconciliation Act of 2005) and then extended again through the end of 2012 (under the Tax Relief Act of 2010). If Congress does not act, the qualified dividend rules will lapse at the end of this year, reverting dividends back to ordinary income treatment.

Taxation of Owners of Closely-Held Businesses

While the shift in dividend tax treatment may affect some investor preferences for dividend-paying stocks, clients who are owners of closely-held businesses have a unique tax planning opportunity in light of the scheduled lapse of qualified dividends. After all, the reality is that a closely held business that is a C corporation is eligible for qualified dividend treatment, if it is in fact a C corporation, as the 60-day holding period requirement is easily met by what is typically a multi-year (or even multi-decade!) holding period. Except unlike stocks held in a portfolio, with a closely held business the client has some control over the timing of when dividends are paid!

Thus, for example, the owners of a closely held C corporation that has $1,000,000 of accumulated earnings that could be held in the business or paid out as a dividend, will face a maximum Federal tax liability of $150,000 in 2012 on that dividends, and a whopping $434,000 in 2013 (given a top ordinary income tax bracket of 39.6%, plus the new 3.8% Medicare unearned income contribution tax!)! The potential $284,000 difference (or more when accounting for itemized deduction phaseouts for high-income individuals that also returns in 2013) represents a real loss in wealth for any business owners who ever hoped/intended to distribute the funds as a dividend to owners at some point down the road.

Timing Dividend Distributions Around Tax Law Changes

As a result of the huge differential in tax treatment between 2012 and 2013, there is a tremendous incentive and opportunity for business owners of closely-held C corporations who can control the timing of dividends to make any available dividend distributions before the end of the year, rather than simply keeping the money inside the business to try to defer the impact of dividend taxation. Because the reality is that while there is benefit to deferring tax payments as long as possible (by keeping it inside the business), that benefit is dwarfed by a near tripling of the dividend tax rate. Mathematically, the affluent client who keeps $1,000,000 of earnings inside the business to defer that $150,000 of dividend taxes (at today's rates) would need to grow the money a whopping 189% just to make up for the leap to a 43.4% top tax rate! To say the least, earning 189% of cumulative growth on cash in the business will probably be difficult; even earning a generous 1% money market yield, it would 107 years to break even!

While the incentive is to extract cash out of the business as a dividend before the end of the year to avoid the tax increase, in some cases this may create a difficult challenge between balancing the desire of owners to save on dividend taxes, and the needs of the business to keep cash for future business needs or contingencies. Clearly, extracting so much cash that the business itself has difficulties is not positive in the long run, although in at least some situations, the business owners could potentially contribute cash back to the business again at some point in the future (receiving an associated cost basis adjustment), if it became necessary. Notwithstanding the delicate balance, though, the financial ramifications of leaving cash in the business to be distributed at much higher tax rates in the future makes it worthwhile to carefully consider just how much money really needs to remain in the business.

Future Tax Law Changes

Of course, the reality is that Congress could intervene and change the law before the qualified dividend treatment expires; in point of fact, it has already extended qualified dividends twice, although the current fiscal environment clearly makes extending qualified dividends more difficult because of the impact it would have on government revenue. In addition, given the election environment, it seems highly unlikely any tax laws extending qualified dividends could feasibly occur before a lame duck session in December at best. As a result, many clients and planners are simply preparing for the possibility of extracting cash out of the business now, but waiting until later in the year to actually pull the trigger.

On the other hand, it's notable that there is a significant risk for increases in the dividend tax rate even if qualified dividend treatment is extended, due to the fact that long-term capital gains rates are scheduled to rise in 2013 (to which the taxation of qualified dividends is anchored) - which means even the qualified dividend tax rates could still rise from 0%/15% to 10%/20%. Furthermore, higher income individuals will also face the 3.8% Medicare unearned income tax on dividends as well in 2013 - especially now that the health care legislation has been upheld by the Supreme Court - and the return of the phaseout of itemized deductions and personal exemptions further increases the qualified dividend tax rate on high income earners. Thus, even if qualified dividend treatment ultimately is extended, the top tax rate on such dividends would still rise from 15% to 23.8% (or even higher with phaseouts), which may be more than enough incentive for many businesses to consider distributing any available cash as a dividend.

So what do you think? Are any of your clients looking to extract dividends from their businesses before the tax rate increase? Or are they planning/expecting the rules to be extended? How much of a tax increase would it take to make it worthwhile?