Tax Planning Opportunities Hot Topics - July, 2003 part two of a two-part series. [an error occurred while processing this directive] Corporate Dividends: [an error occurred while processing this directive] Corporations would often structure financial transactions as debt which meant the interest paid (often to shareholders or related corporations) would be fully-deductible. IRS, of course, would attempt to restructure these transactions as equity with the resulting payments taxed as dividends.

With non-public corporations, many taxpayers would structure transactions to avoid dividend treatment whereas the tax code would attempt to characterize those same transactions as dividends. Dividend treatment was the congressional cure-all when a corporation either retained earnings, paid them out as tax-deductible expenses or individuals formed corporations to avoid taxes on their individual earnings.

Now that dividend treatment is no longer a scourge (in many cases, the 15% tax will approximate the payroll taxes for compensation), corporations with retained earnings now can disgorge those earnings with minimal tax consequences. Going forward, the corporate tax rate for the first $50,000 in pre-tax income is 15% and the dividend rate is 15% for a combined tax rate of 30%. The highest individual tax rate is 35% so in many instances, there is a lower overall tax if corporate earnings are paid out as dividends rather than as compensation to the corporate shareholders.

[an error occurred while processing this directive] ISOs and AMT [an error occurred while processing this directive] Incentive Stock Options (ISOs) are subject to AMT upon exercise. Although Congress has increased the AMT exemptions , the tax can reach as high as 28%. Taxpayers, in general, will receive and AMT credit for the AMT paid and may use the credit when they sell their stock in a later year. However, with the new lower capital gains rate of 15%, if a taxpayer sells ISO stock for the same price as the date of exercise, the regular tax rate will be 15%, and just a little more than 50% of the AMT will be used. This means that the taxpayer must generate capital gains profits in the future in order to use the AMT credits. Put another way, taxpayers are paying 28% AMT on a transaction that later generates only 15% in tax. This distortion should discourage the use of ISO with respect to employee compensation.

Note: The spread between the ordinary income tax on non-qualified stock options of 35% compared to the AMT of 28% is just 7 percentage points. With non-qualified stock options, there is withholding of taxes at 28% so the employee is at risk as to 8% if the stock collapses. In contrast, the employee who exercises an ISO is at risk at to 28% if the stock value evaporates since there is no required withholding when an ISO is exercised.

[an error occurred while processing this directive] Children over age 14 [an error occurred while processing this directive] With the changes in capital gains rates and the expansion of the 15% tax bracket, shifting income to children over age 14 becomes an excellent tax-planning tool. A child is taxed at 10% for the first $7,000 of income and then at 15% for income between $7,000 and $28,400. Consequently, if a child over age 14 receives $29,150 in unearned income will be taxed as follows:

Standard Deduction: $750

Taxable Income $28,400

10% bracket $700

15% bracket $3,210

Total Federal Tax: $3,910

Effective tax rate on $29,150 of income – 11%

Compare: Tax on $29,150 at the highest tax bracket (35%) = $10,202

Savings: $6,992

[an error occurred while processing this directive] Gifts of Appreciate Assets [an error occurred while processing this directive] Example: A parent or grandparent gifts stock worth $11,000 to a child. Parent’s basis in the stock is $1,000. If parent sold the stock, the federal tax would be $1,500 under the new long-term capital gains rate. If child (who inherits a carryover basis – the donor’s basis in the stock) sells the stock, the tax is 5% or $500 – a tax savings of $1,000. Note: the 5% rate applies while the taxpayer is in the 10% or 15% bracket, which means that if the child has no other income, the 5% rate applies to the first $29,150 of gains, per year.

[an error occurred while processing this directive] Closely-held corporation [an error occurred while processing this directive] Corporation has $75,000 of taxable income. Parent gifts or transfers cash to child over age 14 who then loans the money to the corporation. Assume the corporation pays the child $25,000 in interest payments. The balance of the $50,000 is paid to parent as a dividend. The result, the $75,000 in corporate earnings are taxed as follows: 11% to child since the corporate deducts the interest payments from its income; and 30% to parent – corporate tax of 15% on the first $50,000 of taxable income and 15% tax payable by the parent on the dividend received. Again, this example can be scaled to produce larger savings: A trust for the shareholder’s children is formed and the trust loans money to the corporation and receives interest payments. The trust distributes the interest received to the children at their 10%-15% tax brackets.

Instead of loan interest payments, the corporation sells IP (Intellectual Property) to a trust set up for the shareholder’s children. The corporation them pays royalties to the trust and the royalty payments are taxed at the children’s tax brackets [ Effective rate of 11% on income of $29,150, see above example].

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© 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.