The simplest way to withdraw cash from closely-held corporations is to distribute the cash as a dividend. However, a dividend distribution isn’t tax-efficient because it is taxable to you to the extent of your corporation’s “earnings and profits,” It is also not deductible by the corporation. Fortunately, there are alternate methods that may allow you to withdraw cash from a corporation while avoiding dividend treatment:
Fortunately, several alternative methods may allow you to withdraw cash from a corporation while avoiding dividend treatment. Here are five areas where you may want to take action:
- Capital repayments. To the extent that you’ve capitalized the corporation with debt, including amounts 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 method assumes that the debt has been properly documented with terms that characterize the debt and that the corporation doesn’t have an excessively high debt-to-equity ratio. If not, the debt repayment may be 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.
- Salary. 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 any compensation in the form of rent that you receive from the corporation for the use of the property. In both cases, the amount of compensation must be reasonable in relation to 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.
- Loans. You may withdraw cash from the corporation tax-free by borrowing from it. However, to avoid having the loan characterized as a corporate distribution, it should be properly documented in a loan agreement or a note and be made on terms that are comparable to those on which an unrelated third party would lend money to you. This should include a provision for interest and principal. All interest and principal payments should be made when required under the loan terms. Also, consider the effect of the corporation’s receipt of interest income.
- Fringe benefits. Consider obtaining the equivalent of a cash withdrawal in fringe benefits that are 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 of the corporation. 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.
- Property sales. Another way to withdraw cash from the corporation is to sell the property to it. However, you should avoid certain sales. For example, you shouldn’t sell the 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 a capital gain. In addition, a sale should be on terms comparable to those on which an unrelated third party would purchase the property. Finally, you may need to obtain an independent appraisal to establish the property’s value.
Keep taxes low
If you’re interested in discussing any of these approaches, contact us. We’ll help you get the most out of your corporation at the minimum tax cost.