Transcript Slide 1

Chapter 5.
Corporate
Distributions
Howard Godfrey, Ph.D., CPA
Professor of Accounting
Updated January 31, 2012
Copyright 2012
The student should be able to:
1. Compute current earnings and profits
(E&P). Pg-3
2. Understand the difference between
current and accumulated E&P. Pg-8
3. Determine the tax consequences of
nonliquidating cash distributions and
property distributions. Pg-10+
4. Determine the tax consequences of
stock dividends and distributions of
stock rights. Pg-18+
1. Calculate
current
earnings
& profits (E&P).
Nonliquidating Distributions - General.
A distribution can be in money,
securities, or any other property
except stock or stock rights of the
distributing corporation.
As a result of the 2003 Act,
qualified dividends received by a
noncorporate shareholder are
temporarily subject to a maximum
tax rate of 15%.
Nonliquidating Dist. in General. Cont’d
1. Shareholder includes in gross income as a
dividend any nonliquidating distribution by a
corp to the extent that it is out of earnings and
profits (E&P).
2. To the extent a distribution exceeds E&P, it is a
return of capital and reduces the shareholder's
basis in his stock.
3. To the extent that a distribution exceeds E&P
and stock basis, gain is recognized that is a
capital gain if the stock is a capital asset in the
shareholder's hands.
Sections 301(a), 301( c) and 316
5
Dahl Corp. had this Information:
Accum. E&P at 1-1-2012
$120,000
Earn. & Profits for 2012
160,000
Cash dividends to individual
stockholders in 2012
360,000
What is amount of dividend income
taxable to stockholders in 2012?
a. $0
b. $160,000
c. $280,000 d. $360,000 CPANov1995
Sec. 301(a), 317(a), 316
6
Dahl Corp. had this Information:
Accum. E&P at 1-1-2012
$120,000
Earn. & Profits for 2012
160,000
Cash dividends to individual
stockholders in 2012
360,000
What is amount of dividend income
taxable to stockholders in 2012?
c. $280,000
Sec. 301(a), 317(a), 316
7
C corp. -nonliquidating dist.
Cash distribution to shareholders
Total current & accum. E&P
Total paid-in capital was
1 of 2
$1,000
$750
$10,000
Impact on shareholders:
I. Taxable as ordinary income of:
$750
II. Reduced adj. bases in stock by:
$250
a. I only. b. II only. c. Both I and II.
d. Neither I nor II.
CPA-Nov-95
8
C corp. -nonliquidating dist.
Cash distribution to shareholders
Total current & accum. E&P
Total paid-in capital was
2 of 2
$1,000
$750
$10,000
Impact on shareholders:
I. Taxable as ordinary income of:
$750
II. Reduced adj. bases in stock by:
$250
c. Both I and II.
Sec. 301( c)(1), 301( c)(2)
9
Bob-Stock Redemption – 1 of 2
Jan. 2, 2011. An investor (Bob) paid $40,000
for all 4,000 shares of newly organized ABC
Corporation. Price: $10 per share
Jan. 3, 2011. Bob found that ABC would not
need the entire $40,000 for its initial asset
acquisitions.
Jan. 3, 2011. Bob sold 1,000 of his shares
back to the corporation at his cost of $10
per share, or a total of $10,000.
ABC had taxable income (and E&P) of
$100,000 for 2011, and made no further
distributions to Bob.
How does Bob treat the Redemption?
10
Bob-Stock Redemption – 2 of 2
The redemption will be treated as a
dividend of $10,000.
Bob will not be able to show that this
is “not essentially equivalent to a
dividend.”
[70-1 USTC ¶9289]United States,
Petitioner v. Maclin P. Davis]
Sec. 302(a) and (b)(1)
11
Sue’s Investment – 1 of 2
Jan. 2, 2011. An investor (Sue) paid
$40,000 for all 1,000 shares of new
ABC Corporation
In 2011, ABC had a net loss
(and deficit E&P) of $100,000.
In 2011, ABC had a net profit
(and E&P) of $20,000 .
January 1, 2011. Sue received a
distribution of $10,000.
How does Sue report the distribution?
12
Sue’s Investment – 2 of 2
Sue will report dividend
income of $10,000,
because it is covered by
current earnings and
profits.
Sec. 301, 316(a)
13
Two Blocks of Stock- 1 of 2
Investor purchased 1,000
shares of ABC Corp at $40 per
share and an additional 1,000
shares at $50 per share.
(Total cost of $90,000)
ABC has no current or Accum.
E &P, but makes a distribution
of $44 per share ($88,000).
What is impact on investor?
14
Two Blocks of Stock- 2 of 2
Total distribution does not
exceed total basis, and there is
no E&P.
However, you must compute
the gain using each block of
stock (you may not combine
the two blocks of stock).
W.Taylor Johnson, 71-7 USTC 9148
435 F. 2d 1257 reversing 303 F. Supp.
1, 69-2 USTC 9602
15
Lan Corporation 1 of 2
Lan Corp. made a $40,000 cash distribution
to its sole shareholder this year.
Lan’s current year E&P (as of the close of
the year and without reduction for
distributions during the year) is $25,000.
Accumulated E&P from prior years is
$10,000.
What amount of dividend should be
reported on Form 1099-DIV issued to the
shareholder for the year?
a. $ 40,000. b. $ 5,000.
c. $ 0.
d. $35,000.
16
Lan Corporation 2 of 2
What amount of dividend should be
reported on Form 1099-DIV issued to
the shareholder for the year?
d. $35,000.
Does it make a difference if the
dividend is paid on January 1, before
the company has current earnings?
No.
17
Earnings and Profits.
The term E&P is not defined in the
Code.
Its meaning must be determined
from judicial decisions, Treasury
regulations, and some rules
provided in the Code.
The purpose is to measure a
corporation's economic ability to
pay dividends.
18
New Corp.- First year operations (2012)
Sales
$10,000,000
Expense other than Depreciation
(6,000,000)
Fixed Assets cost
$20,000,000
Depreciation – S/L
(2,000,000)
Extra Deprec – DDB
(2,000,000)
(4,000,000)
Taxable Income
$0
Income Tax Paid
$0
GAAP Net Income (Used S/L Dep.)
$2,000,000
May corporation pay a dividend of
$2,000,000
on 12-31-12, & identify the dividend as a tax-free
return of capital, because there is no E&P?
Section 312(k). Regulation 1.312-15
19
New Corp.- First year operations (2012)
Sales
$10,000,000
Expense other than Depreciation
(6,000,000)
Fixed Assets cost
$20,000,000
Depreciation – S/L
(2,000,000)
Extra Deprec – DDB
(2,000,000)
(4,000,000)
Taxable Income
$0
Income Tax Paid
$0
GAAP Net Income (Used S/L)
$2,000,000
New Corp sells its fixed assets for
$19,000,000
on 1-1-2013. No depreciation is claimed in 2013.
What is gain in 2013 for income tax purposes?
What is the gain in 2013 for E&P purposes?
20
Bought asset for $10,000, w/ 5-year life.
Regular depreciation is DDB (200%DB), with
half-year depreciation in year of acquisition.
Alternate depreciation is 150% DB.
Regular Tax
E&P
Yr Book Val Dep-Tax Book Val Dep-E&P
1 $10,000
$2,000 $10,000
$1,500
2
$8,000
$3,200
$8,500
$2,550
3
$4,800
$5,950
Vehicle is sold on 12-31-year 2 for $6,000.
What is regular tax gain and E&P gain?
Sec. 312(k)(3). Section 168(g)(2)
Bought asset for $20,000.
Expensed the asset under Sec. 179.
What adjustment to taxable income
is needed to compute
current earnings and profits?
Yr Adjustment
Explain
1
2
Sec. 312(k)(3). Section 168(g)(3)(B)
Bought asset for $20,000.
Expensed the asset under Sec. 179.
What adjustment to taxable income
is needed to compute
current earnings and profits?
Yr Adjustment
Explain
1 $20,000 Eliminate write-off
($4,000) Deduct over 5 years.
2
($4,000) Deduct over 5 years.
Sec. 312(k)(3). Section 168(g)(3)(B)
X Corp. results In 2012, its first year:
Installment Sales
$10,000,000 $10,000,000
Cost of sales
(6,000,000)
(6,000,000)
Gross Margin
4,000,000
4,000,000
Percentage Collected
40%
Gross Margin-Tax Return
Expenses
GAAP Income before tax
1,600,000
(600,000)
(600,000)
$3,400,000
Taxable Income
$1,000,000
What is its E&P at 12-31-12?
How is a $2,000,000 dividend reported?
(Credits covered tax liability)
Sec. 312(n)(5)
Note about preceding slide.
The preceding slide illustrates the
concept that the installment sales
method is not used for E&P purposes,
even if it is used for regular income tax
purposes. (Sec. 312(n)(5)).
Same for completed contract method.
[Sec. 312(n)(6)]
[In many situations the installment
method is not allowed to be used for
regular income tax purposes.]
25
2. Understand the
difference between
current and
accumulated E&P.
Current E&P.
E&P consists of two parts - current and
accumulated E&P.
Current E&P is calculated annually.
Accumulated E&P is the sum of
undistributed current E&P for all prior tax
years less distributions made out of
accumulated E&P and prior year current
E&P deficits.
Distributions come first from current E&P
and then from accumulated E&P if current
E&P is insufficient.
Computing Current E&P.
The starting point for computing
current E&P is the corporation's
taxable income or NOL for the year.
This must be adjusted to arrive at
economic income or loss (current
E&P) for the year.
Page 7 provides a partial listing of the
adjustments that must be made to
taxable income to derive current E&P.
28
Income Excluded from Taxable Income
but Included in E&P.
Income that is specifically
excluded from gross income
must be included in current
E&P if it increases the
corporation's ability to pay a
dividend and is not a
contribution of capital.
29
Income Deferred to a Later Period.
Gains and losses on property
transactions are often included in
E&P when they are recognized for
tax purposes.
Exception: installment sales.
Gain is recognized in the year of
sale for E&P purposes in the case
of an installment sale.
30
Income and Deduction Items That Must be
Recomputed When Computing E&P.
Tangible personal property must be
depreciated using the alternative
depreciation system for E&P purposes.
Realty is depreciated using the straight-line
method over 40 years.
Other adjustments must be made for
percentage depletion, intangible drilling
costs and the completed contract method
of accounting.
31
Deductions That Reduce Taxable
Income But Are Not Allowed in
Computing E&P.
Some deductions claimed in
computing taxable income are not
allowed when computing E&P.
These include the dividends-received
deduction, NOL carryovers, charitable
contribution carryovers, and capital
loss carryovers from other tax years.
32
Expenses and Losses that are not
Deductible in Computing Taxable Income
but that Reduce E&P.
When computing E&P, federal income taxes
are deductible in the year accrued or paid.
Charitable contributions are deductible
without regard to the 10% limitation.
Other deductible items for E&P purposes
are life insurance premiums on key
employees, capital losses in excess of
capital gains, nondeductible expenses
incurred to earn tax-exempt income, losses
on sales to related parties, & nondeductible
fines, penalties and political contributions.
Adjust taxable income to get E & P:
Transaction
Effect on Taxable Income?
Tax-exempt income
Life insurance proceeds
Deferred installment gain
Excess charitable contribution
Charity Deduction- carryover
Federal income taxes
Officer’s life insurance premium
Accelerated depreciation
Add
X?
Subtract
X?
34
Adjust taxable income to get E & P:
Transaction
Effect on Taxable Income?
Tax-exempt income
Life insurance proceeds
Deferred installment gain
Excess charitable contribution
Charity Deduction- carryover
Federal income taxes
Officer’s life insurance premium
Accelerated depreciation
Add
X?
X
X
X
Subtract
X?
X
X
X
X
X
35
Note that a distribution
reduces E&P down to
zero, but may not push
E&P into a negative
amount.
Sec. 312(a) (to the extent)
36
Han, Inc. reported for 2010:
Accum. E & P at 1-1-10
Cash dividend paid
Taxable income for year
Fed. income taxes for 2010
Mun. bond interest earned
Accumulated E&P- 1-1-11?
a. $15,000 b. $25,000
c. $30,000 d. $35,000
$20,000
30,000
50,000
7,500
2,500
Han, Inc. reported for 2010:
Accum. E & P at 1-1-10
Cash dividend paid
Taxable income for year
Fed. income taxes for 2010
Mun. bond interest earned
Accumulated E&P- 1-1-11?
a. $15,000 b. $25,000
c. $30,000 d. $35,000
$20,000
(30,000)
50,000
(7,500)
2,500
$35,000
Boone Corp, accrual method taxpayer,
reports the following for 2010
Taxable income per return
$150,000
Tax exempt interest received
3,500
Federal income taxes
(41,750)
Political cont. (not deducted)
(25,000)
Dividends declared and paid (115,000)
Change in Accum. E. & P.
Accum. E. & P. - 1-1-2010?
225,000
Accum. E. & P. - 1-1-2011?
39
Boone Corp, accrual method taxpayer,
reports the following for 2010
Taxable income per return
$150,000
Tax exempt interest received
3,500
Federal income taxes
(41,750)
Political cont. (not deducted)
(25,000)
Dividends declared and paid (115,000)
Change in Accum. E. & P.
(28,250)
Accum. E. & P. - 1-1-2010?
225,000
Accum. E. & P. - 1-1-2011?
$196,750
40
In 2011 Davis had the following:
Sales
$700,000
Cost of sales
$400,000
Municipal bond interest
2,000
Compensation
100,000
Entertainment (Gross)
20,000
Miscellaneous Expense 140,000
Subtotal
660,000 702,000
Net Income before
42,000
Total
$702,000 $702,000
AE&P at 12-31-2010:
$100,000
Davis does not have carryover of loss, etc.
Ignore state taxes. What is AE&P at 12-31-11?
a. $134,500 b. $187,000 c. $250,000 d. $313,000
41
Continue Davis Case
Compute Income Tax
Net Income before tax
Mun. bond interest
50% of entertainment
Taxable income
Income Tax
42,000
42
Continue Davis Case
Compute Income Tax
Net Income before tax 42,000
Mun. bond interest
(2,000)
50% of entertainment 10,000
Taxable income
50,000
Income Tax
7,500
43
Continue the Davis Case
Compute E&P at 12-31-2011
Taxable Income-2011
$ 50,000
Tax-exempt income
2,000
Federal income taxes
(7,500)
Entertain. (not deducted)
(10,000)
Equals: Current E&P
Add: AE&P at 1-1-2011
100,000
Total
Less: Dividends paid
E&P at 12-31-2011
44
Continue the Davis Case
Compute E&P at 12-31-2011
Taxable Income-2011
$ 50,000
Tax-exempt income
2,000
Federal income taxes
(7,500)
Entertain. (not deducted)
(10,000)
Equals: Current E&P
34,500
Add: AE&P at 1-1-2011
100,000
Total
134,500
Less: Dividends paid
E&P at 12-31-2011
$ 134,500
45
Current vs. Accumulated E&P.
Nonliquidating distributions are treated as
coming first out of current E&P.
When distributions exceed current E&P, current
E&P is allocated to distributions on a pro rata
basis regardless of when in the year the
distributions were made.
Distributions in excess of current E&P are
deemed to come from accumulated E&P in
chronological order.
Distributions in excess of accumulated E&P are
treated as a return of capital and reduce the
shareholder's basis in their stock (but not below
zero).
These distributions do not create an E&P deficit.
Deficits arise only because of losses.
46
Kee Corp. is a C Corp.
AEP deficit at 1-1-2011 $50,000
Current E & P in 2011
$10,000
Cash div. paid in 2011 $30,000
How much dividend income
is reported by shareholders?
a. $30,000 b. $20,000
c. $10,000 d. $0
[CPAM-95]
47
Kee Corp. is a C Corp.
AEP deficit at 1-1-2011 $50,000
Current E & P in 2011
$10,000
Cash div. paid in 2011 $30,000
How much dividend income
is reported by shareholders?
c. $10,000
Section 301( c)(1), 316(a)(2)
48
Kee Corp. is a C Corp.
AEP deficit on Jan-1-2011
$50,000
Current E & P in 2011
$10,000
Cash dividend paid in 2011 $30,000
Stockholder basis in the
stock before the dividend
$3,000
How much capital gain
is reported by shareholders?
a. $30,000 b. $20,000
c. $17,000 d. $0
[CPAM-95]
49
Kee Corp. is a C Corp.
AEP deficit on Jan-1-2011
$50,000
Current E & P in 2011
$10,000
Cash dividend paid in 2011 $30,000
Stockholder basis in the
stock before the dividend
$3,000
How much capital gain
is reported by shareholders?
c. $17,000
Sec. 301( c)(3)
50
Stock bought after dividend declared
On January 2, 2011, an investor
purchased, 1,000 shares of ABC stock
at $40 per share.
On January 10, 2011 the investor
received dividends of $2 per share,
declared on December 1, 2010,
payable to stockholders of record on
January 5, 2011.
How does the investor report this
$2,000 – as income or as return of
capital?
51
Stock bought after dividend declared
Sec. 301 focuses on
payment of the dividend, not
declaration of the dividend.
See also Reg. 1.61-9(c)
52
When is Dividend Reported?
A dividend check is received on
January 2, 2010.
Dividend was declared on
December 1, 2009, payable to
stockholders of record on
December 15, 2009, with check
written and mailed on December
31, 2009?
Reg. 1.451-2(b)
3. Determine the tax
consequences of
non-liquidating
Cash and NonCash property
distributions.
54
Consequences of Nonliquidating Property
Distributions to the Shareholders.
Property is defined as money, securities, and any
other property except stock or stock rights of the
corporation making the distribution.
Amount of a distribution is generally the amount
of money plus the FMV of any nonmoney property
received.
Any liability assumed reduces the amount of the
distribution, but not below zero.
Distribution is considered a dividend to the extent
that it is out of E&P.
Shareholder's basis in the property is its FMV
unreduced by liabilities assumed.
Holding period begins on the day after the
distribution date.
55
Consequences of Property Distributions to
the Distributing Corporation.
A corporation must recognize gain when it
distributes property that has appreciated in
value. Sec. 311(b).
A loss will not be recognized on a
nonliquidating distribution of property that
has declined in value.
If distributed property is subject to a
liability or the shareholder assumes a
liability in connection with the distribution,
the FMV of the property is deemed to be at
least equal to the amount of the liability.
56
Consequences of Property Distributions
to Distributing Corporation.
Gain recognized is taxable to the
corp. and results in an increase in
E&P equal to the E&P gain which is
the excess of the property’s FMV
over its adjusted basis for E&P
purposes.
E&P gain may differ from the corp.’s
recognized gain (for income tax
purpose) upon distribution.
57
Consequences of Property Distributions to the
Distributing Corporation.
If the adjusted basis of the noncash asset
that is distributed equals or exceeds its
FMV, E&P is reduced by the asset’s
adjusted basis.
If the FMV of asset distributed exceeds its
adj. basis, E&P is reduced by asset's FMV.
In either case the E&P reduction is net of:
(1) any liability that the asset is subject to
or which is assumed by the shareholder
in connection with the distribution, and
(2) the income taxes incurred on the gain
recognized.
58
Distribution of Property-Tank Corp.
Tank Corp. had E & P of
$500,000
Tank made a non-liquidating
property distribution
to shareholders:
Property had adj. basis of
$20,000
Property had FMV of
$30,000
Tank Recognizes a gain of:
a. $30,000 b. $20,000
c. $10,000 d. $0
[CPA 11-94]
Sec. 311(a), (b)
59
Distribution of Property - Tank Corp.
Tank Corp. had E & P of
Tank made a non-liquidating
property distribution
to shareholders:
Property had adj. basis of
Property had FMV of
Tank Recognizes a gain of:
$500,000
$20,000
$30,000
c. $10,000
Sec. 311(a), (b)
60
Property Distributions- Red Corp. -1
On 12-31-2011, Red Corp. distributed land
to Mr. Smith (its sole shareholder).
Adjusted basis of land
$ 6,500
Fair Market Value of land
14,000
Mortgage on land
5,000
For year ended 12-31-2011, Red had E&P of
$50,000. How much dividend income is
recognized by Mr. Smith?
a. $1,500 b. $6,500
c. $9,000 d. $14,000 e. none of these
Reg. 1.301-1(g), Sec. 301
61
Property Distributions- Red Corp. -2
On 12-31-2011, Red Corp. distributed land
to Mr. Smith (its sole shareholder).
Adjusted basis of land
$ 6,500
Fair Market Value of land
14,000
Mortgage on land
5,000
For year ended 12-31-2011, Red had E&P of
$50,000. How much dividend income is
recognized by Mr. Smith?
c. $9,000
Reg. 1.301-1(g), Sec. 301
62
Cole Corporation -1
Distributions to shareholders
Cash
$75,000
Land - FMV
60,000
Land - Adj. Basis
50,000
Cole's recognize gain?
a. $10,000 b. $75,000
c. $ 25,000 d. $ - 0 –
Sec. 311
63
Cole Corporation -1A
Distributions to shareholders
Cash
$75,000
Land - FMV
60,000
Land - Adj. Basis
50,000
Cole's recognized gain? 10,000
a. $10,000
Sec. 311
64
Cole Corporation -2
E & P balance
$90,000
Distributions to shareholders
Cash
$75,000
Land - FMV
60,000
Land - Adj. Basis
50,000
Dividend income
for shareholders
a. $75,000
b. $125,000
c. $ 135,000 d. $ 100,000
Sec. 301(b), 316
Cole Corporation -2A
E & P balance
Distributions to shareholders
Cash
Land - FMV
Land - Adj. Basis
Amt distributed-Sec. 301(b)
Gain for corp. -Sec. 311
Revised E & P - Sec. 312
Stockholder Div. - Sec. 316(a)
Assum es no incom e tax on gain
Sec. 301(b), 316
$90,000
$75,000
60,000
50,000
135,000
10,000
100,000
100,000
Cole Corporation -3
Distributions to shareholders
Cash
$75,000
Land - FMV
60,000
Land - Adj. Basis
50,000
Shareholders' basis
in the land
a. $0
b. $50,000
c. $60,000
d. $125,000
Sec. 301(d)
67
Cole Corporation -3A
Distributions to shareholders
Cash
$75,000
Land - FMV
60,000
Land - Adj. Basis
50,000
Shareholders' basis
in the land
60,000
Excess of Amt Distributed over
dividend amount reduces basis
of stock. Sec. 301( c)(2). 301(a)
Sec. 301(d)
68
Morris - Non-Cash Property Dividend -1
Morris Corp. has current E&P of $100,000. It
distributes land with a FMV of $30,000 and
basis of $10,000 to its sole shareholder,
Mary, who has $70,000 basis in her Morris
Corp. stock. This is not a liquidation or
redemption. Which statement is true?
a. Morris will recognize gain of $20,000 and
Mary a taxable dividend of $20,000.
b. Morris will recognize gain of $20,000 and
Mary a taxable dividend of $30,000.
c. Morris will recognize gain of $20,000 and
Mary will have a non-taxable return of
capital reducing her basis by $30,000.
d. None of the above.
69
Morris - Non-Cash Property Dividend -2
Morris Corp. has current E&P of
$100,000. It distributes land with a
FMV of $30,000 and basis of $10,000
to its sole shareholder, Mary, who has
$70,000 basis in her Morris Corp.
stock. This is not a liquidation or
redemption. Which statement is true?
b. Morris will recognize gain
of $20,000 and Mary
a taxable dividend of $30,000.
70
Effect Property Dist. on shareholder:
Amount of Distribution is FMV.
If debt assumed >FMV, then
FMV is assumed to be = debt.
Reduce distribution by debt assumed.
Taxable dividend to extent of E & P.
Excess is return of capital (basis).
After basis is recovered, Capital gain.
Basis of distributed property = FMV.
71
Effect of Property Distribution on E & P:
Increase E & P for excess of FMV over basis
of property distributed (Sec. 311 gain).
Reduces E & P by FMV of property
distributed (or basis, if greater)
less liabilities on the property .
Distributions of cash or property cannot
create or add to a deficit in E & P.
E & P deficits arise from corporate losses.
In the next three examples,
Earnings and profits are more
than enough to cover the
dividend paid, so it does not
change our answers when we
ignore that gain on distribution
of property results in an income
tax liability on that gain, and that
tax is a reduction in E&P.
73
Property Distribution to Individual
Effect on Corporation
Case 1
E & P Balance
$100,000
Basis of property
$20,000
FMV of property
$60,000
Liability on property
-0-
Gain (loss) recognized -§ 311
E & P increased by gain §312(b)
E & P decrease on dist.-§312(a)
74
Property Distribution to Individual
Effect on Corporation
Case 1A
E & P Balance
$100,000
Basis of property
$20,000
FMV of property
$60,000
Liability on property
-0-
Gain (loss) recognized -§ 311
$40,000
E & P increased by gain §312(b)
$40,000
E & P decrease on dist.-§312(a)
$60,000
75
Property Distribution to Individual
Effect on Corporation
Case 2
E & P Balance
$100,000
Basis of property
$20,000
FMV of property
$10,000
Liability on property
-0Gain (loss) recognized §311(a)
E&P increased by gain
E&P decrease on dist. §312(a)
76
Property Distribution to Individual
Effect on Corporation
Case 2A
E & P Balance
$100,000
Basis of property
$20,000
FMV of property
$10,000
Liability on property
-0Gain (loss) recognized §311(a)
-0E&P increased by gain
-0E&P decrease on dist. §312(a)
$20,000
77
Property Distribution to Individual
Effect on Corporation
E & P Balance
Basis of property
FMV of property
Liability on property
Gain (loss) recog. §311(b)(1)
E&P increase-gain - §312(b)(2)
E&P decrease -§1.312-3
Case 3
$ 100,000
20,000
40,000
15,000
78
Property Distribution to Individual
Effect on Corporation
E & P Balance
Basis of property
FMV of property
Liability on property
Gain (loss) recog. §311(b)(1)
E&P increase-gain - §312(b)(2)
E&P decrease -§1.312-3
See also §311(b)(2) and 336(b)
Case 3A
$ 100,000
20,000
40,000
15,000
20,000
20,000
25,000
79
West Corporation - 1
West Corp. distributes land with a
basis of $1,000 and FMV of $4,000
subject to a debt of $6,000 to Jeff, a
shareholder.
What gain or loss must West
recognize from the distribution?
a. $3,000 gain. b. $1,000 loss.
c. $5,000 gain. d. $ - 0 -.
§311(b)(1), §311(b)(2) and 336(b).
80
West Corporation - 2
West Corp. distributes property
with a basis of $1,000 and FMV of
$4,000 subject to a debt of $6,000
to Jeff, a shareholder.
What gain or loss must West
recognize from the distribution?
c. $5,000 gain.
§311(b)(1), §311(b)(2) and 336(b).
81
Property Dividends
Effect on Shareholder.
1
2
3
4
5
6
7
FMV of property distributed
Less: Liability assumed by stockholder
Net value of dividend (Amount distributed)
Earnings & Profits Balance
Income: (Lesser of Line 3 or Line 4)
Return of capital (reduce stock basis):
(Excess of Line 3 over line 4)
Basis of Property (Line 1)
It is assumed here that basis is
greater of (1) FMV or (2) liability assumed.
Some say the basis should be FMV.
Property Dividends
Gain for Corporation.
1
FMV of Property Distributed
2
Debt on Property Distributed
3
Greater of Line 1 or Line 2
4
Corp.'s Basis in property
5
Gain (Line 3 minus Line 2)
[Loss not allowed]
Property Dividends
Effect on Corporate E. & P.
1
Beginning Earnings & Profits
2
Add: Gain on appreciated property
3
Adjusted Earning & Profits Balance
4
Greater of Basis or FMV of prop. distributed
5
Subtract: Debt on property
6
Net asset transfer
7
New Earnings & Profits. (Line 3 - Line 6)
Does not consider the impact on
income taxes and related impact on E & P.
Constructive Dividends.
A constructive dividend is an
indirect payment to a
shareholder without the benefit
of a formal dividend
declaration.
They usually arise in the
context of a closely held
corporation.
85
Intentional Efforts to Avoid Dividend Treatment.
Excessive salaries or loans to shareholders are
often devices used to avoid dividend treatment
while benefiting the shareholder. They may be
reclassified as a dividend, fully taxable to the
shareholder and not deductible by the
corporation in computing its taxable income.
With the “current” reduced rate on dividends, the
corporation will still lose the deduction on
reclassification.
Shareholder/employee will obtain a partially
offsetting tax reduction on the dividend, for
example, from 35% on compensation to 15% on
the dividend.
Dividend will not be subject to incremental payroll
taxes.
Unintentional Constructive Dividend
Shareholders are not always aware
that the benefits that they are
receiving are really constructive
dividends. When they are discovered
by the IRS or a tax advisor, the books
and records of both the corporation
and the shareholder will have to be
adjusted. A CPA should always be an
advocate for his client if the question
of whether a constructive dividend has
been paid or not is in doubt.
87
Loans to Shareholders
Loans to shareholders will be considered
disguised dividends unless it can be shown
that the loan is bona fide and the
shareholder intends to repay it.
If inadequate interest is charged, interest is
imputed on the loan.
The corporation will report interest income
from the loan and the shareholder may
have a deduction for interest deemed paid.
The imputed interest is treated as a
dividend paid to the shareholder, thereby
resulting in no offsetting deduction for the
corporation.
Excessive Compensation Paid to
Shareholder-Employees.
Excessive compensation received by a
shareholder-employee is generally treated
as a dividend.
Excessive Compensation Paid to
Shareholders for the Use of Shareholder
Property.
Rents, interest and royalties that are paid to
shareholders which are excessive in amount
are generally recast as constructive
dividends.
89
Corporate Payments for the Shareholder's
Benefit.
If a corporation pays a shareholder's
personal obligation, the payment may be
treated as a constructive dividend.
Disallowed corporate deductions may also
be treated as constructive dividends.
Bargain Purchase of Corporate Property.
If a shareholder purchases property from a
corporation for less than its FMV, the
discount amount may be treated as a
constructive dividend.
90
Shareholder Use of Corporate
Property.
If a shareholder is allowed to use
corporate property (e.g., an
automobile, airplane or yacht) without
paying adequate compensation to the
corporation, the FMV of such use
(minus any amounts paid) may be a
constructive dividend to the
shareholder.
91
Effect of Unreasonable Salary? -1
Corp reported taxable income of $500,000
for the year, after deducting salary of
$300,000 to the owner. The IRS determined
that reasonable comp. was $200,000.
Ignoring payroll taxes, what is the effect of
this IRS action on taxable income of Corp
and Gross income of owner?
For Corporation
For Owner
a. Increase
No effect
b. Increase
Increase
c. Decrease
Decrease
Effect of Unreasonable Salary? -2
Corp reported taxable income of $500,000
for 2009, after deducting salary of $300,000
to the owner. The IRS determined that
reasonable comp. was $200,000.
Ignoring payroll taxes, what is the effect of
this IRS action on taxable income of Corp
and Gross income of owner?
Corporation
a. Increase
Owner
No effect
However, dividend income will have 15% max rate.
Excessive Salary-1
XYZ is a successful C corp. with substantial
earnings and profits. When the IRS determines
that XYZ's salary to its major shareholder is
unreasonably high, the resulting audit
adjustments will have the following effect(s):
a. Increased revenue on the corporate return
for XYZ
b. Decreased deductions on the corporate
return for XYZ
c. Increased income on the non-corporate
stockholder's returns
d. Decreased income on the non-corporate
stockholder's returns
e. Both b and c
94
Excessive Salary-2
XYZ is a successful C corp. with substantial
earnings and profits. When the IRS determines
that XYZ's salary to its major shareholder is
unreasonably high, the resulting audit
adjustments will have the following effect(s):
b. Decreased deductions on the corporate
return for XYZ
95
A.M. Medlin , T.C. Memo. 1998-378.
Medlin owns profitable auto dealership. Medlin is
president and wife has served as V.P. (nonowner) for many years. They have recently
divorced. Under the terms of the divorce, wife
gets:
• Some investment real estate valued at
$1,000,000.
• A new automobile each year until she dies or
remarries.
• Dealership will pay the annual lease costs
($10,000 per year on the auto) and the auto
insurance ($4,000 per year) for auto provided to
her.
96
A.M. Medlin Cont’d – Constructive Dividend
… Under the terms of the divorce, wife gets:
• Coverage for medical, accident, and life
insurance. She will be covered by group
policy at the dealership, and in the event that
the coverage must be discontinued,
dealership will purchase separate individual
policies that continue her current coverage.
The cost of such coverage is about $5,000 per
year.
• Client and former spouse have asked you for
tax advice regarding these transactions.
97
4. Determine the tax
consequences of
stock dividends
and distributions
of stock rights.
Stock Dividends and Stock Rights.
In 1919, the Supreme Court ruled in Eisner
v. Macomber that a stock dividend was not
income to the shareholder because it took
nothing from the property of the
corporation and added nothing to the
property of the shareholder.
This is the general rule today with some
exceptions for tax-avoidance schemes.
The dividend is taxable when a stock
dividend has the potential to change the
shareholder's proportionate interest in the
distributing corporation.
99
Tax-free Stock Dividends. § 305, 307
If a stock dividend is nontaxable, the
basis of the stock with respect to
which the distribution is made must be
allocated between the old and new
stock in proportion to their relative
FMVs on the distribution date.
The holding period of the new shares
includes the holding period of the old
shares.
100
Tax-free Stock Rights. -1 § 305, 307
A distribution of stock rights is tax-free
unless it has the potential to change the
shareholders' proportionate interests in the
distributing corporation. If the value of the
stock rights is less than 15% of the value of
the stock with respect to which the rights
were distributed, the basis of the rights is
zero unless the shareholders elect to
allocate basis to those rights. If the value
of the rights is 15% or more of the value of
the underlying stock, the shareholder must
allocate the basis of the stock between the
stock and the stock rights based on the
relative FMVs of the stock and stock rights.
101
Tax-free Stock Rights. -2
If the stock rights are sold, gain or loss is
measured by subtracting the allocated
basis of the rights (if any) from the sale
price.
If the rights are exercised, the basis
allocated to the rights is added to the basis
of the stock purchased with those rights.
If basis is allocated to the rights and the
rights are allowed to lapse, the allocated
basis is returned to the underlying shares.
No loss can be claimed.
102
Effect of Nontaxable Stock Dividends
on the Distributing Corporation.
Nontaxable distributions of stock or
stock rights have no effect on the
distributing corporation.
The corporation does not recognize
any gain or loss on the distribution
and its E&P is unaffected.
Please note that, for financial
accounting purposes, stock dividends
may reduce retained earnings.
103
Taxable Stock Dividends & Stock Rights.
If the distribution is taxable, the
amount of the distribution
equals the FMV of the stock or
stock rights that are distributed
on the distribution date.
It is a dividend to the extent it is
made out of E&P.
104
Stock Dividends and Stock Splits
2003 Ms. K bought 100 ABC shares for $1,650.
2010 ABC declared stock dividend
of 1 share of common stock
for each 10 common shares owned.
2011 ABC had 2 for 1 split of common stock
when FMV was $30 per share.
Basis of 100 Shares
$ 1,650.00
Basis per share of 100 shares
Basis per share of 110 shares
Basis per share of 220 shares
105
Stock Dividends and Stock Splits
2003 Ms. K bought 100 ABC shares for $1,650.
2010 ABC declared stock dividend
of 1 share of common stock
for each 10 common shares owned.
2011 ABC had 2 for 1 split of common stock
when FMV was $30 per share.
Basis of 100 Shares
$ 1,650.00
Basis per share of 100 shares
Basis per share of 110 shares
Basis per share of 220 shares
$
$
$
16.50
15.00
7.50
106
Which of the following statements
regarding distributions of stock is not
true?
a. Distributions of stock and stock rights
are never treated as property.
b. Stock rights are distributions by a
corporation of rights to acquire its stock.
c. Distributions of stock dividends and
stock rights are generally tax free to
shareholders.
d. Expenses of issuing a stock dividend are
not deductible but must be capitalized.
107
Ann - Stock Dividends- Preferred
2003 Bonnie bought 100 shares of ABC
common stock at $60/share.
$6,000
2010 ABC declared stock dividend
of 1 share of preferred stock for
each 10 common shares owned.
Common stock FMV/share
$50
Preferred stock FMV/share
$100
2011 Sold 10 shares of perferred
at price of $160 per share
$1,600
This is a not preferred stock bailout.
What is Bonnie's gain?
a. $100 b. $150 c. $200 d. $600
108
Ann- Stock Distributions
Cost of Common Shares
Common- Number of Shares
Common -FMV per share
Total FMV of common stock
Pfd. Number of Shares
Pfd. FMV per share
Total FMV of preferred stock
Total value of all stock
Percent of cost - to common
Percent of cost - to preferred
Cost allocated to common stock
Cost allocated to preferred stock
Selling price of preferred stock
Gain on sale of preferred stock
$ 6,000
100
$50
10
$100
Ann- Stock Distributions
Cost of Common Shares
Common- Number of Shares
Common -FMV per share
Total FMV of common stock
Pfd. Number of Shares
Pfd. FMV per share
Total FMV of preferred stock
Total value of all stock
Percent of cost - to common
Percent of cost - to preferred
Cost allocated to common stock
Cost allocated to preferred stock
Selling price of preferred stock
Gain on sale of preferred stock
$ 6,000
100
$50
$5,000
10
$100
$1,000
$ 6,000
83.33%
16.67%
$ 5,000
1,000
1,600
$600
Effect of Stock Div. on E&P?-1
A corporation has 1,000 shares of
$100 par outstanding.
• Stock (1,000 shares)$100,000
• Retained Earnings $100,000
• FMV per share
$200
May the corporation pay a 50%
stock dividend (500 shares) and
eliminate E&P?
And later pay a tax-free cash
dividend of $100,000?
111
Effect of Stock Div. on E&P?-2
A corporation has 1,000 shares of
$100 par outstanding.
• Stock (1,000 shares)
$100,000
• Retained Earnings
$100,000
• FMV per share
$200
May the corporation pay a 50% stock
dividend (500 shares) and eliminate
E&P?
And later pay a tax-free cash dividend
of $100,000? NO.
Sec. 312(d)
112
The
End