February 2003



Revenue Ruling 74-44 states that the IRS will re-characterize small business corporation dividends paid to shareholders as salary when such dividends were paid to the shareholders in lieu of reasonable compensation for services.

Generally, the courts have backed up the IRS determinations and ruled that dividends can be re-characterized, regardless of the stated intentions of the S Corporation, if the shareholders have performed services. And the courts have considered such factors as the nature and scope of the shareholder’s work, the corporation’s compensation policy for all employees, and the prevailing rate of compensation for comparable positions in comparable companies.

For more information, please refer to the IRS Web site at www.irs.gov and use the search terms "paying yourself" for the IRS position on this important topic, which was the subject of an issued IRS Consumer Alert.



According to The College Board, a organization that tracks tuitions costs, the average cost for a four-year private college will exceed $ 18,000 for the 2002-2003 academic year. So one planning option is the 529 or College Saving Plan, which has no income or age limits and federal tax exemption. This translates to transferring money to the children’s account (utilizing annual gift tax exclusions) and out of the parent’s estate and still maintaining control of the funds. But as with many investment strategies, the 529 plans are not without drawbacks, e.g., plans can impact on financial aid eligibility and one can’t double dip by taking tax-free withdrawals and utilizing HOPE and Lifetime education credits on the same fees. Furthermore, monies in a 529 that is not used for qualified higher education expense is subject to both a 10% penalty and the ordinary tax rate. Then there are the fees (on plans sold by financial advisers or imposed by the plans themselves), lack of control over investments and the investment that may become more conservative as college days become closer, thereby lowering the rate of return.

You must research the available plans to ascertain the pros and cons and determine whether state plans (which may have some state tax benefits for residents) have higher fees that may offset the tax benefits or that they may have a poor track record or other restrictive provisions. And one must not overlook features such as portability (the ability to roll money over to another state plan), investment options, acceptance of out-of-state students, etc.

Some of the online resources that address the issue of 529 plans are as follows: www.collegesavings.org, www.529directory.com and www.savingsforcollege.com.

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