Low Tax Rates Provide Opportunity to “Cash Out” Dividends

Under current tax law, the federal income tax rate for C corporations is a flat 21%. Under prior law, C corporations faced a graduated federal income tax-rate schedule with a maximum effective rate of 35%.

The flat 21% corporate tax rate is permanent, unless Congress passes legislation to repeal or modify it. In contrast, the reduced rates for individual taxpayers under the Tax Cuts and Jobs Act (TCJA) are scheduled to expire at the end of 2025. And they could end much sooner, depending on political developments.

In this favorable — but uncertain — tax environment, it could be advantageous for shareholders of profitable C corporations to arrange to pay corporate dividends to themselves. Here’s the story behind this potential tax-saving strategy.

C Corporation Taxes After the TCJA

To demonstrate the total amount of federal income taxes that would be paid on corporate income distributed as dividends to shareholders, consider this example.

ABC Company is a profitable business venture that’s owned by individual taxpayers and is operated as a C corporation. The corporation pays out most or all of its after-tax profits to the shareholders as taxable dividends that qualify for the 20% maximum federal rate.

ABC Co. pays corporate-level taxes at a rate of 21%. Plus, the shareholders pay individual-level federal income taxes on dividends at a rate of 23.8%, including the 3.8% net investment income tax (NIIT). So, the maximum combined effective federal income tax rate on the venture’s profits is 39.8% [21% + ((20% + 3.8%) x (100% – 21%))]. While this is double taxation made worse by the 3.8% NIIT, it’s still low compared to historical rates.

Before the TCJA, the maximum combined effective federal income tax rate in this scenario was 50.47% [35% + ((20% + 3.8%) x (100% – 35%))]. So, the current 21% corporate rate can significantly help lower the total tax bill for a profitable C corporation venture.

Individual Taxes after the TCJA

Through 2025, the TCJA sets forth seven tax rate brackets for ordinary income recognized by individual taxpayers. The rate brackets for 2019 and 2020, plus more information on tax brackets, can be found {continued}.