A Secret Hiding Place for Tax-free Money
Tax laws related to corporations long have held relieving provisions to treat fairly certain kinds of irregular incomes. The objective of these provisions is to subject taxpayers to the same consequences, whether the income is earned personally or through a corporation.
These kinds of income most commonly include capital gains and life insurance proceeds. (Capital gains are the more common of the two). Since 1972, our tax system has treated capital gains/losses in a particular fashion: only a portion of gains is taxable. An individual taxpayer merely pockets the untaxed portion tax-free!
A complication arises, however, when such gains are earned in a corporation. While the corporation itself similarly only pays tax on a portion of the gain, the issue is how to pass along that preferred tax treatment to the shareholders when dividends are paid out. The answer is the “capital dividend account“.
If a corporation earns a capital gain of, say, $100, the untaxed portion goes into the capital dividend account. Special tax-free dividends can be declared and paid from this account. There are a few important points to note. The timing and procedures for declaring a “capital dividend” are very specific, and different from those for a normal dividend. In particular, the capital dividend account balance must be calculated on the precise day of the dividend declaration. Improperly calculated capital dividends can result in penalties from the government.
There is no ongoing tracking or reporting of the corporation’s capital dividend account balance.Thus, it is incumbent upon the shareholders to keep track. In corporations with lots of capital transactions (e.g. holding companies), tracking of the capital dividend account balance can be quite involved. We have learned that the government has a dedicated department to keep track of these balances. Therefore, we recommend it is prudent to confirm the corporation’s balance with their records before declaring capital dividends.
If you didn’t know about the capital dividend account before and your company has had capital gains in the past, it would be worthwhile to check this out.