Transcript Module 4 - TaxPoint 2001

Module 14
Transactions Between a
Corporation and Its
Shareholders
Module Topics
1. Capital distributions
2. Earnings and profits
3. Distributions to shareholders
4. Taxation of stock redemptions
5. Taxation of liquidating distributions
Capital Distributions
Key Learning Objectives
 Why corporations pay dividends
 Double taxation
 How corporations avoid double
taxation
 Constructive or disguised dividends
In Class Exercise: Taking Money
Out of a Corporation

Mary (the sole shareholder of a corporation)
needs $10,000
 Mary’s

MTR = 28%
The corporation taxable income = $40,000
 Corp’s
MTR = 15%
What are the tax consequences of taking
the money as salary, dividend, or loan?
 Any other legal ways to get the money out?

Solution: In Class Exercise:
Taking Money Out of a Corporation
Increase (decrease) in income tax liability
Corp
Mary
 Dividend
N/A
2,800
 Salary
(1,500)
2,800
 Loan
N/A
N/A
In Class Exercise: Taking Money
Out of a Corporation
Did you consider
Payroll taxes?
 Unreasonable compensation?
 §7872--gift loan?
 If the corporation could pay the $10,000
directly and deduct it?
 If there could there be a disguised
dividend under any of the alternatives?

Earnings and Profits
E&P
Key Learning Objectives
 Computing earnings and profits
 Record keeping and reporting
requirements
Two Types of E&P
 Current
E&P
Current tax year before any
distributions or redemptions are
subtracted
 Accumulated E&P
Sum of all previous years current
E&P (less distributions)
Common Items Increasing E&P
Tax-exempt interest income
 Full gain on installment sale in year of sale
 Dividends received deduction
 Current annual LIFO layer
 Excess depreciation
 Federal income tax refund
 All carryovers utilized during year

Common Items Decreasing E&P
 Federal
income taxes paid or accrued
 Excess charitable contribution
 Capital losses
 Current year ordinary losses
 Nondeductible expenses
 Fines and penalties
Common Items
Decreasing E&P
 Disallowed
portion of R&D
 Foreign tax credits
 §280C--certain expenses for which
credits are allowable
 Installment sale gain recognized
 Gains due to different adjusted bases
Record Keeping and Reporting
Requirements
Key Learning Objectives
§ 6042(d) requires corporations to furnish
information needed to determine E&P
 Names of stockholders
 Year-by-year basis
 File Form 5452 if distribution not from E&P

Distributions to Shareholders
Key Learning Objectives
Historical note: General Utilities Doctrine
 Dividend distributions
 Distributions taxability relative to earnings
and profits
 Other transactions between a corporation
and its shareholders

Historical Note:
General Utilities Doctrine
 In
a complete liquidation
 There was a distribution of property to
shareholder
 Distributing corporation had no gain or
loss recognition
 Repealed in 1986
Distribution is Taxable Dividend
to the Extent that
Distribution < current E&P
 Distribution > current E&P BUT
< current and accumulated E&P
 If current E&P < 0, AND distribution
< accumulated E&P

Distribution is Non-Taxable
Return of Capital
 If
distribution > current and
accumulated E&P
 Then distribution is return of capital to
extent of shareholder’s basis in stock
Distribution is Taxable as
Capital Gain
If distribution > current and accumulated
E&P AND shareholder’s basis in stock
 Then excess distribution is treated as a
capital gain

In Class Exercise: How Much is
a Taxable Dividend?
Current Accumulated
Case E & P
E&P
Cash
Distributed





A
B
C
D
E
(4,000)
5,000
7,000
(8,000)
2,000
5,000
(3,000)
15,000
(6,000)
7,000
3,000
4,000
12,000
1,000
15,000
Solution: In Class Exercise: How
Much is a Taxable Dividend?
 Case A:
$3,000 taxable as dividend
 Case B: $4,000 taxable as dividend
 Note that in both A and B you do not
net current and accumulated E&P to
determine the dividend
 Case C: $12,000 taxable as dividend
Solution: In Class Exercise
How Much is Taxable Dividend?
Case D
 No current or accumulated E & P

 If
No taxable dividend
shareholder’s basis in stock = $3,000
 $1,000
is non-taxable return of capital
Solution: In Class Exercise
How Much is Taxable Dividend?
Case E
 9,000 is taxable as dividend
 If shareholder’s basis in stock = $2,000
 $4,000
is taxed as a capital gain
 $2,000 is non-taxable return of capital
Property Distributions
Key Learning Objectives
Property distribution is valued at FMV
minus liabilities assumed by shareholder
 The shareholder’s basis of property received
is its FMV
 Property will have a new holding period

Compliance Query: Distribution
of Property Issues To Consider
For corporation
 If
complete liquidation,
§336--applies to gains and losses
 Some
 If
exceptions to loss recognition
non-liquidation distribution,
§311(b)--applies to gains only
Compliance Query: Distribution
of Property Issues to Consider
For shareholder
 Any
dividend?
 Any return of capital?
 Any capital gain?
 Basis in the new property?
 Holding period of new property?
Compliance Query: Distribution
of Property When FMV >Basis
 Current
E&P = $10,000
 FMV land
= $30,000
 Adjusted basis of land = $12,000
 Shareholder basis in stock = $5,000
 What are the tax consequences to
Corporation?
Shareholder?
Solution: Compliance Query
Distribution of Property
FMV > Basis
Both §336 and 311(b) apply to gains
 Gain of $18,000 is recognized by Corp so

 E&P is
increased by $18,000
 Reduced by taxes paid on the gain

E&P is then reduced by $30,000
 FMV
of distribution
Solution: Compliance Query
Distribution of Property
FMV >Basis
Total distribution to S/H is $30,000
 If nonliquidating distribution

 S/H
has dividend of $28,000
 Remaining $2,000 is return of capital
If liquidating distribution
 S/H has a $25,000 capital gain

 $30,000
- $5,000
Solution: Compliance Query
Distribution of Property
FMV > Basis
§336
E&P
Gain
E&P at Dist
Distribution
Dividend
10,000
18,000
28,000
30,000
N/A
Return of capital 5,000
Capital gain
25,000
§311 (b)
E&P
10,000
Gain
18,000
E&P at Dist
28,000
Distribution
30,000
Dividend
28,000
Return of capital 2,000
Capital gain/loss N/A
Compliance Query: Distribution
of Property When FMV < Basis
 E&P =
$10,000
 FMV land = $30,000
 Adjusted basis of land = $40,000
 Shareholder basis in stock = $5,000
 What are the tax consequences to
Corporation?
Shareholder?
Solution: Compliance Query
Distribution of Property
FMV < Basis
Only §336 applies to losses
 Loss of $10,000 is recognized by Corp if
complete liquidation

 E&P is

decreased by $10,000
In both cases, E&P is reduced by $30,000
 FMV
of distribution
Solution: Compliance Query
Distribution of Property
FMV < Basis
Total distribution to S/H is $30,000
 If nonliquidating distribution
S/H has dividend of $10,000
Return of capital of $5,000
Capital gain of
$15,000
 If liquidating distribution
 S/H has a $25,000 capital gain

 $30,000
- $5,000
Solution: Compliance Query
Distribution of Property
FMV > Basis
§336
E&P
Loss
E&P at Dist
Distribution
Dividend
10,000
-10,000
-030,000
N/A
Return of capital 5,000
Capital gain
25,000
§311 (b)
E&P
10,000
Loss
N/A
E&P at Dist
10,000
Distribution
30,000
Dividend
10,000
Return of capital 5,000
Capital gain
15,000
Other Transactions between a
Corporation and its Shareholders
Key Learning Objectives
 §1239--gain
from sale of depreciable
property
 §267--losses, expenses, and interest
 §482--allocations of income and
deductions
§1239--Gain from Sale of
Depreciable Property
 Sale
or exchange occurs between a
taxpayer and a related party
 Property is subject to the allowance for
depreciation or amortization
 Gain recognized is automatically
classified as ordinary income
§267
Losses, Expenses, and Interest
Prevent the artificial creation of losses and
deductions between related parties
 Disallowing the loss to the seller
 Requires the matching of income and
expenses for transactions between related
parties

§482--Allocations of Income and
Deductions Among Taxpayers
Allows the IRS to reallocate income,
expenses, and credits among two or more
taxpayers
 Requires taxpayers to conduct transactions
at arm’s length

Taxation of Stock Redemptions
Redemption vs. dividend income treatment
 Impact of redemption on corporate E&P
 Constructive stock ownership
 §306 stock

Stock Redemption
Key Learning Objectives





If certain requirements are met
Stockholder is entitled to capital gains
When a corporation redeems all or part of stock
No gain or loss is recognized by the corporation
Shareholder treats a redemption as a sale to the
corporation
Taxation of Liquidating
Distributions
Key Learning Objectives
Perspectives
 Parent subsidiary liquidations
 §338 election

Redemption vs. Dividend Income
Treatment
Key Learning Objectives






Redemption treated as a distribution in part or full
payment in exchange for the stock
§302(b)(1) Not essentially equivalent to a dividend
§302(b)(2) Major change in ownership quantitative
test
§302(b)(3) Complete liquidation of shareholder’s
interest
§302(b)(4) Partial liquidation provisions
§303 Redemption upon death
Impact of Redemption on
Corporate E&P
Key Learning Objectives
Corporate E&P is reduced
 By the lesser of the fair market value of the
assets distributed or the percentage of stock
redeemed multiplied by E&P
 Distributions reduce E&P first, followed by
redemptions

Constructive Ownership-Family Attribution
Key Learning Objectives
When computing the percentage ownership,
the stock held by related parties must be
considered
 Related family members
 Parents, spouse, children, and grandchildren
 Brothers, sisters, and in-laws are not
considered family members

Constructive Stock Ownership-Entity Attribution
Key Learning Objectives
If a corporation, partnership, estate, or trust
owns stock
 Partners or beneficiaries no minimum
ownership threshold
 Corporation, a 50% or greater (by value)

§306--Sale of Preferred Stock
Key Learning Objectives



Treats the sale of preferred stock by the
shareholder as ordinary income (not dividend
income)
To the extent that the receipt of the original
preferred stock would have been taxable as a
dividend
Any excess is a return of capital and then a capital
gain. No loss is allowed on the transaction.
Perspectives--Liquidating
Corporation
Key Learning Objectives



All the gains and losses are recognized as if the
corporation sold its assets
Unamortized balance in organizations costs is deductible in
the year of liquidation
If an item was previously expensed, such as supplies, and
was still on hand when the corporation is liquidated,


income must be recognized.
All of the tax attributes of the liquidating corporation will
be lost if they cannot be used before the corporation is
dissolved
Perspectives--Shareholder
Key Learning Objectives

Recognizes capital gain or loss on the
difference between
 Net
FMV of the property and cash received and
 The adjusted basis of the corporate stock
Basis in the new property is equal to its fair
market value
 Holding period starts anew

Parent-Subsidiary Liquidations
Key Learning Objectives






Subsidiary acquires at least 80% of the stock of another
corporation
Assets are now indirectly owned by the acquiring
corporation
§332 Parent corporation has no gain or loss recognized on
the receipt of property in return for its ownership interest
Tax attributes will be inherited by the parent company
Parent’s basis in the stock (called outside basis) of the
target disappears
§332 is mandatory
§338 Election
Key Learning Objectives





Permits an acquiring corporation to take a basis in the
assets upon the liquidation of a subsidiary equal to the
purchase price of the stock in the subsidiary
Beneficial when the adjusted basis of the subsidiary’s
assets is less than the purchase price of the stock
Subsidiary is deemed to have sold all its assets
Could be a significant tax liability
Tax attributes of the subsidiary disappear