S corporation tax planning now

Situation: Your client owns a small business that operates as a subchapter S corporation. She elected S corporation status when the individual tax rates were lower than those for a C corporation. When an S election is made, the prior retained earnings are trapped in the company unless a second tax is paid on the distribution of the retained earnings as a dividend. Your client wants to know how the policies of the new administration under President-elect Barack Obama could affect her taxes. Solution: While it appears that taxpayers are safe in 2008 and probably 2009, the 2010 tax year will most likely bring a tax increase. The ordinary income tax rates will likely increase to almost 40%, which was the rate in effect before tax cuts were put in place by President Bush. Further, dividends may no longer get the preferential tax rate of 15%. Your client should consider paying out accumulated earnings in the form of a dividend. The top tax rate on dividends is currently 15% and is almost certain to increase by 2010. Why should an individual pay a tax voluntarily? First, consider the rate will be higher in the near future. Second, some small business owners who intend to sell or wind down their businesses and want to continue to invest the sales proceeds in the existing company may find themselves in a tax trap. A little known tax law subjects S corporations to a special tax that is imposed only on S corporations that have prior accumulated profits. It is levied on S corporations that generate more than 25% of their earnings from passive sources — that is, interest, dividends and capital gains. This tax can be avoided by making sure the S corporation has no earning and profits, which can be accomplished by paying the 15% tax now on any so-called trapped earnings. By paying the tax at this low tax rate, the S corporation could save taxes in the future.