Under current law, higher-income taxpayers will face a 3.8%surtax on their investment income and gains. Additionally, if the EGTRRA and JGTRRA sunsets go into effect, all taxpayers will face higher taxes on investment income and gains, and the vast majority of taxpayers also will face higher rates on their ordinary income. This second part of a multi-part year-end planning article explains how taxpayers with cash sitting idle in their corporations should consider pulling some of it out before the end of 2012 to avoid higher rates next year.

Taking money out of the corporation. A lot of complicated rules make it difficult to take money out of a corporation by means of a stock redemption and have the transaction produce capital gains. However, the good news here is that a maximum 15% rate (Code Sec. 1(h)(1)(C)) will apply in 2012 whether the distribution in redemption is treated as a dividend or as a payment for stock entitled to long-term capital gains treatment, or indeed if a prorata distribution is made to all the shareholders without regard to any redemption.

When a corporation buys stock from a shareholder, he may be treated as exchanging the stock for the redemption proceeds (capital gain) or the redemption proceeds may be treated as a dividend to the extent it does not exceed earnings and profits (E&P). (Code Sec. 317(b)) A redemption payment is a distribution taxable as a dividend unless it is (1) a complete termination of a shareholder’s interest in the corporation (Code Sec. 302(b)(3)), (2) a distribution that is substantially disproportionate in its effect on the shareholder (Code Sec. 302(b)(2)), or (3) a distribution that is not substantially equivalent to a dividend (Code Sec. 302(b)(1)). Other provisions provide non-dividend treatment of certain partial liquidation payments to noncorporate shareholders (Code Sec. 302(b)(4)), and payments to pay the estate tax of a deceased taxpayer (Code Sec. 303(a)). These rules are complicated and difficult to negotiate, and often make it hard to take money out of a corporation at anything other than ordinary dividend rates. On the other hand,as pointed out above, it doesn’t matter as much for 2012 transactions since the 15% maximum rate will apply in any case.

However, if the cash is taken out of the corporation after 2012,under current law it will face the 3.8% surtax on investment income and gains.(Code Sec. 1411) And the picture gets bleaker if the EGTRAA/JGTRRA sunsets actually take place at the end of 2012 (or take place for higher-income taxpayers only); If the transaction yields capital gain, it could be exposed to a higher maximum rate (apart from the surtax). And if the withdrawal is treated as a dividend, it could be taxed as ordinary income, subject to a higher marginal tax rate, and face a 3.8% surtax.

The downside of making a pre-2013 distribution now is that it is impossible to know what the rates will look like next year. The best strategy, if possible, would be to do the groundwork now for a possible pre-2013 corporate distribution, and then be in the position to quickly execute such a distribution late this year if it becomes clear that a substantial tax increase on capital gains and dividends will go into effect next year.