You’ve heard it in the news. Not every company out there is struggling, and some are still doing quite well. But hiring is not coming around because many companies are hording cash in an effort to hedge against a still-uncertain future. Fiscal conservatism and old-fashioned savings are never a bad plan in uncertain times. But for those small business persons holding on to excess cash reserves in their companies, there may be a different route to consider for some of that cash.

The maximum 15% rates on qualified dividends and long-term capital gains now in effect are scheduled to expire at the and of this year under the sunset provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003. Barring congressional and presidential action, maximum rates of 39.6% and 20% will go into effect for dividends and long-term capital gains, respectively, for 2011transactions. Small business owners with cash sitting idle in their corporations should consider pulling some of it out before the end of 2010 to avoid the higher rates that may go into effect next year.

Taking money out of the corporation. A lot of complicated rules make it very 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 will apply in 2010 whether the distribution in redemption is treated as a dividend or as a payment for stock entitled to long-term capital gains treatment. Even though the maximum rate is the same for both dividends and long-term capital gains, there is an extra benefit in getting capital gain treatment in that basis in the stock redeemed will reduce the amount subject to tax. This is not so if the redemption distribution is treated as a dividend.

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). A redemptions payment is a distribution taxable as a dividend unless it is (1) a complete termination of a shareholder’s interest in the corporation, (2) a distribution that is substantially disproportionate in its effect on the shareholder, or (3) a distribution that is not substantially equivalent to a dividend. Other provisions provide non-dividend treatment of certain partial liquidation payments to non-corporate shareholders, and payments to pay the estate tax of a deceased taxpayer. 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 2010 transactions since the 15% maximum rate will apply in any case.

As noted above, the 15% maximum rate is available this year whether the redemption route is followed or if outright distributions are made. However, in addition to applying basis to reduce the taxable amount of the distribution, using a redemption that qualifies for capital gain treatment also has the advantages of (1) accomplishing a shift in relative ownership percentages (e.g., where the object is to shift control to younger family members), and (2) not having to make a distribution to all shareholders.

Caution: The downside of a pre-2011 distribution is that it is impossible to know at present whether the 15% rates will simply expire and be replaced by higher rates in 2011, or be extended, or be replaced by another set of rates somewhere in between. As a result, if the 15% rates are extended for all taxpayers, the taxpayer who pulls money out of his corporation in 2010 will just have paid his taxes a year earlier. This is a risk associated with any tax-based financial decision where future legislative action is uncertain.

Your head may be spinning right now, and we are here to help you find your way through the complex tax code and use it to your advantage as much as possible. Our office, along with your accountant, will work to achieve the best possible tax advantage for you in uncertain legislative times.