3 More C Corporation Tricks and Traps to Watch For

When a C Corporation goes over the $50,000 per year ($250,000 accumulated) retained earnings cap set by the IRS that money becomes subject to something called the “retained earnings tax.” This is a tax the federal government set up to make sure that C Corporations distribute profits from time to time.

The government’s view goes something like this:

  1. The more retained earnings a company has, the more attractive it becomes to investors.
  2. The more attractive the investment, the longer an investor will want to hang onto it.
  3. The longer an investment is static, the lower the tax revenue. Remember, the government doesn’t get paid until the stock gets sold and the investor pays the tax on the selling price less the basis and selling costs.

The government determined that by installing a tax on retained earnings, sooner or later, a C Corporation would rather put the onus on paying this tax onto its investors instead, and if the tax was high enough, even the largest investors wouldn’t be able to persuade a C Corporation not to distribute its profits at some point. And once those profits were distributed, the government could collect capital gains tax from the investors.

A great example of this is Microsoft. By 2004, Microsoft had retained earnings of approximately $60 billion and was paying dividends of around $0.16 per share each year. Investors were wondering if they would ever get some serious money out of the business, short of selling their shares. That year, Microsoft made a one-time dividend payout to its shareholders of about $32 billion, along with doubling its annual dividend rate to $0.32 per share.

Why had Microsoft held out so long? There are many reasons, but one of the most commonly-cited ones was that Bill Gates had held up the dividend payout because of the impact it would have on his taxes. Because of his position as a major shareholder, Mr. Gates had the clout to persuade the directors to hold off on paying out distributions. When they were paid out, Bill Gates received some $3.6 billion and donated the entire amount to charity, offsetting the tax hit he would otherwise have faced on such a huge windfall.

There are many variables when you’re structuring a business. That’s why it’s hard to go through a quick-service website. Unless you talk to someone who’s got some knowledge and experience on both the tax and the legal side, it’s hard to know what you don’t know. And that can leave you vulnerable.

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