For the last couple of years, farmers and other taxpayers have enjoyed a very low tax rate on dividend income. This income used to be taxed at regular income tax rates (as high as 50% when combined with some state and city taxes). However, starting a couple of years ago, the top rate on dividend income was 15% for federal and if you were in the 15% tax bracket, this rate was zero.
Beginning January 1, 2011, this special rate is scheduled to disappear. The problem is that we are not sure what the new rate will be. There is a chance that dividend tax rates will continue to be taxed the same as capital gains. These rates are currently scheduled to go from 15% to 20%. There is also a good chance that dividend tax rates will go back to the regular tax rates.
Under this scenario, the top tax rate on dividends would probably by 39.6% in 2011 and beginning in 2013, this top rate would go up another 3.8% if your income exceeds $200k or $250 for married couples. This extra rate is due to the new Health Care Reform Law that was recently enacted.
In that law, the current Medicare tax of 2.9% on wages and self-employment income is scheduled to increase by .9% for people earning more than $200k or $250k for married couples. In addition, Congress decided to make the Medicare tax due on almost all unearned income for those taxpayers making the same amount of money.
Therefore, there is potential for the top tax rate on dividends to go from 15% federal to a minimum of 43.5% (plus there are some other phase-outs that might get the top rate over 45%).
What does this mean for you for 2010. The key thing is to review your income tax situation and if you have a C corporation, determine whether you need to distribute retained earnings a s a dividend to take advantage of the current low rates. If you are in the 15% tax bracket, make sure to distribute enough dividends to soak up this tax bracket since they would be tax free.
Let's take an example of a farmer with a C corporation who is nearing retirement and wants to liquidate his corporation. Lets assume there is $400,000 of retained earnings. If they distribute the income in 2010, there total tax bill would be $60,000 (assuming no state income taxes). If they wait until 2011, and pay the maximum rate, then the tax bill might be about $158,000 and if they wait until 2013, then the tax bill might be as high as $174,000. As you can see, it makes sense to consider distributing the income this year.
We should know in the next few months what Congress plans to do, however, the surest thing I know now is that the dividend tax rate will most likely be higher in 2011.