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If your family business operates as a C corporation, watch out for double taxation whenever you withdraw cash from the company. If the corporation has current or accumulated earnings and profits, the IRS generally considers payments to shareholders to be taxable dividends -- unless there's proof they were for another purpose (such as compensation for services or payments on a loan to the company).

The problem: Dividends mean double taxation. Your corporation gets taxed once on the income that produces the dividend and you get taxed again upon receiving it. Fortunately, there are strategies to prevent double taxation. Here are five to consider.

1. Include Third-Party Debt in the Corporation's Capital Structure

Occasionally, your company may need cash to pay for capital improvements or to finance growing levels of receivables and inventory. You generally have two choices. You can inject your own cash into the company or arrange for the company to borrow the money from a third-party lender. From a tax perspective, it's usually better to go the loan route. Why? There's less chance you'll need to withdraw double-taxed dividends later on because you have less of your own cash tied up in the business.

Tip: Be sure third-party loans are taken out in the corporation's name and not in your name. If you borrow personally and then contribute the loan proceeds to the company's capital, you may be forced to withdraw taxable dividends later on to pay the interest and principal on the personal loan.

2. Don't Contribute Capital -- Make Company Loans Instead

Let's say you and the other shareholders have more than enough cash to personally fund your family C corporation's growing capital needs. In that case, it's generally wise to include debt in the company's capital structure (as opposed to contributing more equity capital). Arrange for the debt to be owed to you and other shareholders personally, rather than to a third-party lender. This way, you'll receive taxable interest payments on the loan without double taxation because your corporation receives an offsetting interest expense deduction. You'll also collect tax-free principal payments on the loan. In contrast, if you make a capital contribution and then need to withdraw cash from the business later on, the withdrawals may effectively be double taxed.

3. Charge Your Corporation for Guaranteeing its Debt

As a shareholder of your family C corporation, you may be required to guarantee company debt. When this happens, consider charging the company a fee. You deserve to be compensated for issuing a guarantee that puts your personal assets at risk. (The guarantee fee is a deductible expense for the company.) Of course, you are taxed on the fee you receive and it must be reasonable, but double taxation is avoided because the company gets an offsetting deduction. You can continue charging the fee as long as the guarantee remains in force. (Source: Tulia Feedlot, Inc. v. U.S.,Ct. Cl. 1982)

Tip: Corporate minutes should reflect that you demanded a guarantee fee.

4. Lease Assets to the Company

It's generally not a good idea for your family C corporation to own assets that are likely to appreciate in value. Why? If the company later sells an appreciated asset and distributes the profit to you, it may be treated as a double-taxed dividend.

A smarter tax alternative is to keep personal ownership of business assets that are expected to appreciate (such as real estate). Then, lease the assets to your C corporation. If other family members are also shareholders, set up a partnership or LLC to own the assets and lease them to the company. The payments are a deductible expense for the corporation so cash comes to you in the form of lease payments, without double taxation.

For you personally, the lease payments are taxable income, but you may be able to claim offsetting deductions for depreciation or amortization, interest expense on mortgaged assets, property taxes and so forth. Even better, if the asset is eventually sold for a profit, it won't be hit with double taxation.

5. Collect Generous Company-Paid Salary and Perks

Two more ways to avoid double taxation are with:

  • Salary and bonus paid to you as a shareholder-employee of your family C corporation.

  • Company-paid fringe benefits provided to you as a shareholder-employee.

As long as the salary, bonus and benefits represent reasonable compensation for your services, the company can deduct them as business expenses. Therefore, double taxation is avoided. Plus, some company-paid benefits are tax-free to you (such as contributions to a qualified retirement plan and health insurance coverage).

Beware: When a shareholder-employee receives a generous package of salary, bonuses and benefits from a closely held corporation, the IRS might claim the compensation is unreasonably high. The tax agency can then argue that excess amounts are actually disguised dividends subject to double taxation.