Small Business Taxes & Management^TM--Copyright 2003, A/N Group, Inc.

Capital Gains and Dividends

Reduction in Capital Gain Rates

The new law reduces the tax on long-term capital gains to 15% (from 20%) for taxpayers in the 25% and higher brackets and to 5% (from 10%) for taxpayers in the 10% and 15% ordinary income tax brackets. This should simplify tax preparation in future years because the 18% rate on property held 5 years or more (which wouldn't apply for a few years anyway) won't apply, nor will the 8% rate for some taxpayers who held property 5 years or more and are in the 10% and 15% brackets. However, for 2003 returns, computations will be more complicated because the old rates will apply to sales of assets and payments received on installment sales occurring before May 6, 2003 while the new rates will apply to sales on or after May 6, 2003.

Long-term capital gain rates on sales and installment payments received through May 5, 2003:

 8% for taxpayers in the 10% and 15% bracket on assets held more than 5 years
10% for taxpayers in the 10% and 15% bracket on assets held more than 1 year
20% for taxpayers in higher brackets on assets held more than 1 year
25% on qualified depreciation recapture
28% on collectibles

Long-term capital gain rates on sales and installment payments received on and after May 6, 2003:

 5% for taxpayers in the 10% and 15% bracket on assets held more than 1 year
15% for taxpayers in higher brackets on assets held more than 1 year
25% on qualified depreciation recapture
28% on collectibles

Tax Tip--Since the differential between ordinary income rates and long-term capital gain rates is even larger than before (maximum of 20 percentage points (35% less 15%) vs. 18.6 percentage points (38.6% less 20%)) it makes more sense than ever to try and hold and gain assets for more than a year. Of course, investment considerations should come first. But, if you're close to the magic 12-month threshold, you should consider holding on for a little longer. The closer you are, the larger the effective return for holding the extra time. The best approach is to compute how much of the gain you can lose before you'd be just as well off by selling at the current price.

Example--You've held your Madison Inc. stock for 11 months and have a $20,000 gain. How much can the price of the stock decline before you'd be just as well off to sell it today? The amount is different for each tax bracket. You can compute the factor to apply by dividing 1-long-term capital gain rate by 1-ordinary income tax rate. For example, if you're in the 35% bracket the factor would be (1-.15)/(1-.35) or 1.3077. Divide this factor into the $20,000 gain to get $15,294. Thus, the stock could drop by $4,706 ($20,000 - $15,294) before holding for the long term doesn't make sense. We computed the factors for the various tax rates and put them in a table below.

Factor to Compute Equivalent Return for Long-Term Holding Period

Tax Bracket        Factor

   10%             1.0556
   15%             1.1176
   25%             1.1333
   28%             1.1806
   33%             1.2687
   35%             1.3077

Tax Tip--The lower long-term rates mean that you should be less reluctant to sell out stocks you've held at a gain to rebalance your portfolio.

Tax Tip--Since the capital gain rates are now lower, if you've got unrealized long-term losses but no offsetting long-term gains, take the losses currently. Net losses of up to $3,000 per year can be used to offset ordinary income. Thus, if you take losses that aren't offset, you can save taxes at the higher, ordinary income, rates. Long-term losses that are used against long-term gains only save taxes at 15% (or 5%). Talk to your tax or financial advisor.

Small business stock. Individual investors who sell qualifying small business stock can exclude up to 50% of the gain. Qualifying stock is stock issued after August 10, 1993 in a C corporation held for more than 5 years. At least 80% of the corporation's assets must be in an active trade or business. Under prior law, 42% of the excluded gain was a tax preference item for minimum tax purposes. Under the new law, only 7% of the 50% exclusion is a tax preference. The new rule applies to sales of small business stock on or after May 6, 2003.

This change will significantly reduce the alternative minimum tax liability for taxpayers selling qualifying small business stock.

Please see the section below for additional tax planning tips that are affected by both the capital gain and dividend rate cuts.

Dividend Rate Cut

The change here is simple. In an effort to reduce the potential double taxation of corporate dividends, qualifying dividends will now be taxed as a net capital gain and at the new rates--15% for taxpayers in the 25% and higher brackets and 5% for those in the 10% and 15% brackets. The reduced rates apply to dividends received from January 1, 2003 through December 31, 2008. For taxpayers in the 10% and 15% brackets, a 0% rate on dividends applies for the year 2008 only.

Note that, as opposed to the rate change for capital gains, the lower rates apply to dividends received during all of 2003, including dividends received before the date the law became effective.

Not all dividends qualify for the reduced rate. Only dividends from domestic corporations and qualifying foreign corporations. A qualifying foreign corporation is one whose stock is traded on an established U.S. securities market, incorporated in a U.S. possession, or if the corporation is incorporated in a country where certain treaty requirements are met.

The following dividends do not qualify for the new rates:

• Dividends paid by credit unions, mutual insurance companies, mutual savings banks, farmer's cooperatives, and tax-exempt cemetery companies.
  
• Dividends from any corporation exempt from federal income tax under Sec. 501 or 521.
  
• Dividends on employer securities owned by an employee stock ownership plan (ESOP).
  
• Dividends on stock owned for less than 60 days during the 120-day period before and after the ex-dividend date of the stock.
  
• Dividends where the taxpayer is obligated (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property.
  
• Where substitute payments are made in lieu of a dividend as in stock on loan in a short sale.

Some explanation is needed for several of the conditions above.

Minimum holding period. To prevent investors from buying the stock for the dividend and then selling, you must hold the stock for a minimum time period around the ex-dividend date. The reduced dividend rate only applies to stock held at least 60 days in the 120-day period beginning 60 days before the ex-dividend date. This is unlikely to affect most investors, since most dividend paying stocks tend to be less volatile and are often aren't traded. However, you could make a mistake and inadvertently sell the stock without meeting the holding period. Check the dividend dates before selling. Most traders won't care about the dividend; they're more interested in making money on stock price.

Example 1--You purchased 100 shares of Madison Inc. on June 1, 2003. The stock goes ex-dividend on June 25. You sell the shares on July 25, 2003. Since your haven't held the stock for 60 days in the 120-day period (the 120-day period started April 25 and ends August 25), the dividend is taxed at ordinary income rates.

Example 2--Assume the facts are the same as in the example above, except you purchased the stock on April 1, 2003. You've held the stock for more than 60 days in the 120-day period. In fact, you could have sold the stock June 26 and qualified for the preferential rates.

Example 3--Assume you bought the stock on June 24. You'd have to hold the stock till August 25 to comply with the 60-day rule.

Should you make the election to pay tax on the dividends at ordinary income rates? Since the interest expense that's not deductible in one year can be carried forward, there's probably no reason to make the election if you'll have additional qualifying investment income in succeeding years. If not, you've got to work through the numbers. Making the election can be beneficial in some circumstances.

Preferred stock. Dividends on true preferred stock will qualify for the lower rates. However, corporations have issued a type of hybrid preferred stock that is claimed to be debt by the issuer so that the interest payments are deductible to them. Taxes on these payments will be at the ordinary income tax rates.

Money market, real estate investment trusts, and mutual funds. The IRS has always said that amounts received from money market mutual funds are to be reported as dividends. Since the amounts actually represent interest, they won't qualify.

Generally, the income from real estate investment trusts (REITs) isn't taxed at the trust level. Thus, most dividends received from REITs won't qualify for the special dividend rates. There can be exceptions to this general rule. That is, some REIT income can be taxed. If so, the amount passed through to the shareholder will qualify for the special rate.

Most dividends passed through from mutual funds that invest in equity securities will qualify for the special rate. However, even stock funds could generate some interest income. That will not qualify for the special rate.

You'll have to check your 1099s for 2003 more carefully than ever. Income distributed by mutual funds will be reported in a number of different categories. Even the IRS isn't sure at this time how the income will be reported.

Tax Tip--For many funds, the reduced tax on dividends could be illusionary. Much of the dividend income generated by the fund could be offset by management fees before being passed through to the shareholders. Income funds would be the exception. The dividend yield should be high enough to more than offset the management and other fees.

Dividends on stock on which substantially similar positions are held. If you're required to make related payments on substantially similar property, the dividends received will not qualify for the special rate. While the most common situation where such related payments will be required is in a short sale, there are other types of transactions which could give rise to these payments.

Example--You own 1000 shares of Madison Inc. You've also sold short 800 shares of Madison Inc. On June 19 Madison pays a dividend of $2 a share, for a total of $2,000. You're required to make a payment of $1,600 ($2 X 800 shares) on shares sold short. Only $400 ($2,000 - $1,600) of the dividend qualifies for the reduced rate.

Tax Planning Under the New Rules

The lower rates on capital gains and dividends will dictate some important changes in tax strategy. Here are some thoughts.

S vs. C corporation. Should you be doing business as a C or S corporation? While the rules have changed, the outcome may still be the same. Dividends from C (regular) corporations will now be taxed at only 15%. That should be an advantage to C corporations. And the new 15% rate on personal holding company income and accumulated earnings reduces the penalty tax trap of C corporations. (See below.)

On the other hand, the individual tax rates on ordinary income are now lower, while the corporate rates have not changed. And, unless you take the earnings out of the C corporation as salary, you'll be subject to the double tax, either when taking a dividend or if you sell the assets and liquidate the corporation. Personal service corporations continue to be taxed at a flat 35%. The new law doesn't change the balance of the analysis for these special entities. In most cases they're better off doing business as an S corporation.

There's probably little or no reason to switch from an S to a C corporation. But the incentive to switch from a C to an S corporation may also be reduced. After doing a numbers analysis, be sure to examine other, intangible, factors.

Dividends from closely held corporations. Taking dividends from closely held C corporations is now less costly. Instead of a potential tax at 38.9%, the maximum rate is 15%. But, the dividends are still not deductible by the corporation. You may be able to find an optimal mix of salary and dividends that will minimize the combined taxes of the C corporation and the individual shareholders.

Example--You're the sole shareholder of Madison Inc. For 2003 the corporation has income after your salary, of $40,000. Your taxable income is $200,000. Taking a bonus of $10,000 would save the corporation only $1500 (the corporation is in the 15% bracket) and result in $3,300 of taxes on your individual return (33% rate). The net cost would be $1,800. On the other hand, if you take a $10,000 dividend there would be no tax saving to the corporation but you'd pay tax of only $1,500 on your individual return. The net tax saving of the dividend approach would be $300.

One thing is sure. You definitely don't want to generate dividend or capital gain income in the corporation. That is, if you want to invest in stocks or assets likely to appreciate and produce dividend or capital gain income, it's best to hold the asset in your own name. That's because capital gain income is taxed at ordinary income (or no more than 35%) when generated in a corporation and dividends, while they qualify for the 70% dividend exclusion, are still subject to the double tax.

Keep in mind that not every distribution from a corporation is a dividend. Dividends are only distributions paid out of earnings and profits. The definition of earnings and profits is complicated, but it's similar to retained earnings.

Dividends instead of salary. Some articles have suggested that paying a dividend in lieu of a salary is advantageous. That's generally not true. Moreover, the IRS can recharacterize the payments as salary instead of a dividend, just as they do in the case of S corporation distributions. You should take a reasonable salary.

Investing for the dividend. The reduced dividend and long-term capital gain rates will almost surely alter your investment strategy. But there's no reason to completely eliminate bonds or other fixed income investments to gain the lower rate on dividends. In the 35% bracket you'll need to get only a 3.82% dividend yield to equal a 5% interest rate. But in the 15% bracket you'll need a 4.47% dividend yield to do the same.

Example--How do you compute the equivalent dividend yield needed to equal a fully taxable interest? We've included two conversion tables, below. The first contains factors that allow you to find an equivalent dividend yield given a fully taxable interest rate. For example, you're in the 33% tax bracket. You can get 6% on a corporate bond. What would the dividend yield have to be on a stock that qualifies for the 15% dividend rate? The factor for the 33% bracket is 0.7882. Multiply .7882 by 6% and the dividend yield needed is 4.7292%. To compute the needed interest rate given a dividend yield, use the second table. At 33% the factor is 1.2687. If the dividend is 4%, you'll need to get 5.0748% for an interest return.

To Find an Equivalent Dividend Yield Given an Interest Rate

Tax Rate       Multiply Interest Rate By:

  10%                    0.9474
  15%                    0.8947
  25%                    0.8824
  28%                    0.8471
  33%                    0.7882
  35%                    0.7647

To Find an Equivalent Interest Rate Given a Dividend Yield

Tax Rate       Multiply Dividend Yield By:

  10%                    1.0555
  15%                    1.1177
  25%                    1.1333
  28%                    1.1805
  33%                    1.2687
  35%                    1.3077

Annuities, qualified plans, etc. Annuities and qualified pension plans (including deductible and nondeductible IRAs) are now relatively less attractive since distributions, whether from interest, dividends, or capital gains, will all be taxed at ordinary income rates. But, again, that doesn't mean they are no longer worthwhile vehicles. Annuities have other features which can more than outweigh the ordinary income tax consequences for some investors. And you should still generally try to maximize your contributions to qualified plans including 401(k)s. Roth IRAs still make considerable sense. But you might want to shift your investment strategy. Unless you're very young, you probably want a portion of your portfolio in fixed income vehicles. Use your IRA or qualified plan to invest in them first. Hold stocks that generate dividends and capital gains in your own name. And, as before, you've got to consider your current tax bracket and the bracket you'll be in at retirement. If you'll be in a much lower bracket, deferring income makes sense.

Qualified college savings plans (529 plans) also make sense because you can avoid all income if the funds are used for education purposes. But consider that your child may be paying tax at only 5% on dividends and capital gains. That could outweigh the fees and reduced flexibility in a 529 plan. You might want to hedge your bets. Put a portion of your college savings in a 529 plan; put some in custodial accounts.

Municipal bonds. Tax-exempt bonds now seem to be less attractive relative to dividend paying stocks. But there are many factors to consider. Currently, many municipal bonds pay a relatively attractive return and all the interest income is exempt. It may also be exempt on your state return. Many issues carry a low risk, but some are more risky than equity investments. One advantage of municipal bonds is that the interest generally does not increase your AGI (adjusted gross income). That can be important if you're near one of the AGI thresholds. For example, the child tax credit, education credits, etc. are phased out above certain income levels. If you're consistently near the threshold, keeping your AGI low by using tax-exempt bonds might result in significant tax savings.

Charitable contributions of appreciated property. While it generally still makes sense to gift appreciated property such as stock to a charity rather than selling it, paying tax on the gain and then contributing the cash, there can be situations selling is a smarter move. Talk to your tax or financial professional and do a thorough analysis.

Like-kind exchange. Like-kind exchanges can defer taxes on asset sales. But you also lose the fresh start basis and can be difficult to manage. You should give new consideration to paying tax on the gain, rather than jump for a like-kind exchange. Of course, there are many factors to consider, with the depreciation recapture rules an important one.

Restricted stock. Restricted stock in the company can be a vehicle for rewarding valued employees. The rules are complex, but the lower capital gain rates make the option more attractive than before. By making a special election, the gain can be taxed at capital gain rather than ordinary income rates.

Corporate Tax Changes

Collapsible corporation rules. The new law repeals the collapsible corporation rules (Sec. 341). While few corporations have been caught in this trap in recent years, the possibility always existed that what might have been a capital gain would be treated as ordinary income. The repeal of this provision expires at the end of 2008 unless extended.

Personal holding company tax rate. If 60% or more of a C corporation's income is personal holding company income (dividends, interest, capital gains, etc.) and certain other rules apply, the corporation can be subject to a penalty tax of 35%. Under the new law, that tax rate is reduced to 15% through 2008.

Accumulated earnings tax. C corporations that accumulate earnings and profits (similar to retained earnings) in excess of the needs of the business (plus $250,000 for most corporations; $150,000 for personal service corporations) could be subject to a penalty tax at 38.6% under prior law. While not often assessed, the impact on the corporation can be devastating. The new law reduces the tax rate to 15% through 2008.

While the change is significant, the tax is not gone entirely. And unfortunately, it's a tax on top of a tax. It's not instead of the regular tax on corporations, it's in addition to the regular tax. While the effect is not as horrendous as under the prior law, the tax can still cause financial havoc on a business unprepared to defend itself or pay the amount.

Corporate estimated tax payment. The new law defers the corporate estimated tax payment that would be due on September 15, 2003 to October 1, 2003. This is a one-time change. It's not the first time Congress has used this approach to move tax payments from one fiscal year to another.

--Last Update 06/17/03