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Take Advantage of Tax Rate Arbitrage!

Published on: 07:10AM Mar 02, 2011

Many farmers created a corporation several years ago to operate their farm.  Many of these corporations have been converted over the years into S corporations.  However, one of the potential drawbacks is the retained earnings inside of the corporation that need to be distributed at some point in time.

Normally, S corporation basis is fixed at December 31 each year.  If the corporation has a large loss, the shareholders may not be able to deduct the loss on their personal tax return.  However, if the S corporation has retained earnings from its regular corporation period, the shareholders can elect to "distribute" this as a dividend and the technically recontribute the distribution back to the corporation as additional paid in capital.
 
The tax arbitrage feature of this strategy is that the dividend is taxed at a maximum rate of 15% (for federal purposes) and the ordinary loss that will flow through to the shareholders will be deductible at their marginal tax rate which could be as high as 35%.  For example, if the corporation distributes a dividend of $200,000, the tax would be $30,000, and if the taxpayer is in the highest rate, the loss that flows through would save $70,000 of taxes or a total of $40,000 in net tax savings.
 
If this applies to you, make sure to discuss with your tax advisor.  Certain elections need to be made on the S corporation tax return and all shareholders must agree.
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