When owners of C corporations need cash, dividend distributions often are the first solution that comes to mind. However, dividends are taxable to both the corporation (as earnings) and the shareholder (generally as capital gains), plus they’re not deductible by the corporation.

Fortunately, there are some alternative methods that may provide the opportunity to withdraw cash from your corporation without triggering dividend treatment. Consider the following four tax-efficient sources of cash instead of making dividend payments:

1. Increasing Shareholder Compensation

Because corporations can claim a business expense deduction for “reasonable compensation,” cash distributed in the form of compensation is taxed only once. Excessive compensation isn’t deductible, though, and will be considered dividends.

That said, many entrepreneurs under-pay themselves when they first launch a business, when cash is tight. If that’s the case, you may be able to pay yourself a little extra in subsequent years to catch up. Your tax advisor can help you determine what’s reasonable under IRS guidelines, including both salary and bonus, and advise on adjustments to earlier years’ compensation.

2. Lending to Shareholders

Corporations can make loans to shareholders, but the IRS may reclassify these arrangements as dividends if they aren’t “bona fide loans.” The IRS and the U.S. Tax Court have relied on several objective factors to determine if a loan is bona fide, including:

• The shareholder-borrower’s ability to repay,
• Whether repayments are actually made,
• Whether a debt instrument (such as a note) is created, and
• Whether the instrument requires security (a pledge of collateral or personal guarantee), interest at a rate no lower than the applicable federal rate, a fixed repayment date and a repayment schedule.

However, these factors will be disregarded if the substance of the arrangement indicates it wasn’t truly a loan.

3. Leasing Property from Shareholders

Shareholders can lease their personal property to the corporation in exchange for rent payments. The payments are deductible by the corporation, and the shareholder receives rental income.

Rental income must be reported on the shareholder’s individual income tax return. But it usually won’t be subject to self-employment or FICA taxes (assuming the rental activity doesn’t rise to the level of a trade or business). It’s also worth noting that the IRS may reclassify rental payments as constructive dividend payments for tax purposes if the rent is notably higher than market rates, so you must determine a fair rental rate.

4. Offering Additional Fringe Benefits

Certain fringe benefits are deductible for the corporation and tax-free for recipients. When the corporation pays for them, it frees up the cash that shareholders would otherwise have to pay out of pocket. Examples potentially include:

• Health insurance,
• Life and disability insurance, and
• Nondiscriminatory contributions to qualified retirement plans.

Limitations and restrictions may apply to some fringe benefits. For example, group life insurance coverage that exceeds $50,000 generally is subject to Social Security and Medicare taxes. The corporation must include the excess amount in the shareholder’s reported wages, reduced by the amount, if any, that the shareholder paid toward the coverage.

The corporation also can use a salary reduction plan to make pre-tax contributions to certain retirement plans. The contributions are immediately deductible for the business, and the shareholder’s tax liability will be deferred until withdrawal.

Tread carefully

As noted, the IRS won’t hesitate to reclassify arrangements it believes are nothing but dividends by another name.