Multiple Persons

With “Basic Tax Rate Concepts” as essential background, this lesson covers decisions where two or more related persons pay income tax on the same earnings. To determine the MTR, build a simple model or equation that appropriately blends each person’s separate MTR. This lesson focuses on corporate earnings distributed to: (1) individual shareholders and (2) corporate shareholders.


Distributions to Individual Shareholders

The United States follows a classical system that taxes corporate earnings twice—once when earned and again when owners receive dividends. The United States traditionally has taxed dividends individuals receive the same as other ordinary income. However, since 2003, the Code has taxed qualified dividend income of individuals at 15% or, for recipients in tax brackets below 15%, such lower tax rate. Unless extended or made permanent, the lower individual rates for qualified dividend income expire after 2008, and dividend income once again will become subject to the higher rates applicable to other ordinary income.

If a corporation distributes earnings and profits (E&P) when earned, Equation 1 shows how to calculate the MTR of an individual shareholder from corporate-level income:

(1)

In effect, the formula treats the corporation and shareholder as one taxpayer even though the Code considers them to be separate taxable persons. The equation’s second term recognizes that individual shareholders receive only what remains of a corporation’s income after the government takes its initial cut. In other words, a corporation’s E&P represents the amount available for paying dividends and, as such, is net of corporate-level taxes.

Example 1:

Alicia owns all stock in Metallurgy, Inc. and performs nummary services as the firm’s sole employee. Her annual compensation from Metallurgy is $80,000, which does not vary for contracts the company does or does not enter. Metallurgy has an opportunity to earn an additional $100,000, but the decision hinges on Alicia’s MTR from this incremental corporate-level income. Metallurgy expects taxable income of $400,000 before considering the $100,000 opportunity, and Alicia expects taxable income that places her in the 35% tax bracket. Assuming Metallurgy distributes all earnings and profits each year as dividends, Alicia’s MTR from Metallurgy’s incremental income is determined as follows:

 

 

MTR = .34 + .15 (1 - .34) = 43.9%

 

Thus, this opportunity, if taken, should enrich Alicia by $56,100 or $100,000 (1 - 43.9%).

Especially with closely held businesses, numerous opportunities exist to reduce a shareholder’s MTR related to corporate earnings. For instance, corporations can distribute earnings in deductible form. Though corporations cannot deduct dividends, arm’s length distributions as compensation, interest, rent, or royalties can avoid the corporate-level income tax. If deductible, these amounts reduce a corporation’s taxable income on a dollar-for-dollar basis.

Example 2:

Assume the same facts as those in Example 1 except that Alicia will receive a $66,000 bonus if Metallurgy accepts the yearend opportunity to earn an additional $100,000. The bonus wipes out the $66,000 E&P attributable to this contract [i.e., $100,000 (1 - 34%)] and, thus, the incremental corporate-level tax. So, Alicia’s MTR from Metallurgy’s incremental income can be calculated as follows:

 

 

MTR = 0 + .35 (1 - 0) = 35%

 

Thus, this opportunity, if taken, should enrich Alicia by $65,000 or $100,000 (1 - 35%).

Example 2 elicits several caveats. First, the bonus must be reasonable in amount to avoid reclassification as a nondeductible dividend. Second, FICA taxes will reduce or possibly eliminate the tax advantage of paying a bonus rather than dividends. To reduce corporate-level taxes while avoiding additional FICA taxes, shareholders can enter agreements to receive corporate earnings as interest, rent, or royalties. Third, Example 2 conveniently set the bonus amount equal to the Metallurgy’s incremental E&P from the $100,000 contract. Allowing these amounts to differ requires you to appropriately weight Equation 1 so that only a portion of the contract amount attracts income tax at both levels.

Example 3:

Assume the same facts as those in Example 1 except that Alicia will loan funds to Metallurgy sufficient to generate a $25,000 interest deduction if Metallurgy accepts the opportunity to earn an additional $100,000. The interest deduction assures that corporate income tax applies only to 75% of the corporation’s $100,000 income. So, incremental profit (after subtracting interest and corporate tax) flows to Alicia as a dividend. Weighting Equation 1 for the two portions of the $100,000 incremental income—the 25% part subject only to shareholder-level tax and the 75% part subject to both corporate- and shareholder-level tax—Alicia’s MTR attributable to the incremental income of Metallurgy is determined as follows:

 

 

MTR = .25 [0 + .35 (1 - 0)] + .75 [.34 + .15 (1 - .34)] = 41.7%

  Not surprisingly, 41.7% lies between the result in Example 1 (with no tax planning) and the result in Example 2 (after eliminating the entire corporate income tax). Comparing this rate to the 43.9% MTR in Example 1 reveals that the interest deduction decreased the MTR by more than two percentage points.

These examples suggest a common theme underlying many tax plans—shifting taxable income from a person with a relatively high overall MTR to a related person subject to lower tax rates. In Examples 1 and 2, taxable income shifted from Metallurgy to Alicia via the loan agreement caused the MTR to decline from 43.9% to 35%. However, loaning funds to Metallurgy is not the only way to shift income to Alicia. For instance, Alicia could license technology or lease real estate to Metallurgy to reach a similar result. In effect, Metallurgy would deduct the royalty or rental payment, and Alicia would include it in her gross income.

As a practical matter, closely held businesses often distribute corporate earnings to owners using a variety of deductible payments rather than depending solely on bonuses or interest. However, to avoid high MTRs on corporate earnings that cannot be extracted in deductible form (e.g., 43.9% in Example 1), many corporations retain earnings. Deferring dividends reduces the present value of the shareholder’s tax liability and, thus, the overall MTR on current corporate income.

Distributions to Corporate Shareholders

Under our classical tax system, the United States taxes corporate profit twice. Corporations pay an entity-level tax on income, and the after-tax income increases E&P. Distributions from E&P to individuals result in a second tax at the shareholder level. As Example 1 showed, the shareholder’s MTR related to corporate profit can exceed 40%.

But what if corporate profit passes through a chain of corporate entities before reaching individual shareholders? Absent some remedy, each intermediate entity would pay income tax on dividends it received before passing along the after-tax residual to the next higher corporation. By the time profit reached individual owners at the chain’s pinnacle, very little of the original income might remain, and the overall MTR would be very high. Indeed, assuming corporate MTRs of 35%, corporate profits distributed to a second corporation and then to a third corporation before distribution to an individual shareholder generates a final shareholder-level MTR on the initial corporation’s profits of 76.7% or 1 - (1 - .35) (1 - .35) (1 - .35) (1 - .15).

Fortunately, §243 allows corporate shareholders a dividend received deduction (DRD) to mitigate the burden beyond two levels of tax. Generally, the DRD equals 70% of dividends received. However, when corporate shareholders own at least 20% of the distributor corporation’s stock value or voting power, the DRD increases to 80%. Further, dividends between affiliated corporations (via 80% ownership) entitle the recipient to a 100% DRD. Equation 2 shows how a corporate shareholder determines its MTR related to the profit another corporation earns and, after paying income tax, distributes as a dividend to the corporate shareholder:


(2)

Example 4:

Bankhead Corporation earns $7 million before considering the possibility of a new client that, if negotiations prove successful, would add $2 million of taxable income. Collinwood, Inc. owns 50% of Bankhead and earns $16 million taxable income before considering dividends from Bankhead. Each year, Bankhead distributes all E&P to its shareholders. Collinwood’s MTR related to its $1 million share of Bankhead’s incremental income is determined as follows:

 

 

MTR = .34 + .38 (1 - .34) (1 - .8) = .34 + .05 = 39%

Equations 1 and 2 can be combined to determine the MTR of an individual shareholder attributable to profit of a second- or lower-tier corporation. For instance, the following formula shows the calculation when an individual owns shares in a corporation that, in turn, owns shares in a second-tier corporation:


(3)

The three terms in Equation 3 correspond with the three levels of tax. The individual and corporate shareholders’ tax rates apply to the amount of dividends each receives.

Example 5:

In addition to the facts in Example 4, assume Deanne (a single individual in the 35% tax bracket) owns all shares of Collinwood. Using Collinwood’s 39% MTR from Example 4, Deanne’s MTR attributable to her share of Bankhead’s incremental income is:

 

 

MTR = .39 + .15 (1 - .39) = 48.2%

This lesson explains how to combine MTRs of related persons receiving income and paying tax to a single jurisdiction within one taxable year. The last lesson explores more involved MTR calculations. However, before proceeding to the “More Complex Situations” lesson, please take the self-tests covering multiple persons to assure your understanding. Also, please complete the “Short Exit Questionnaire” before leaving the site.