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Chapter 5 Solutions Corporations: Earnings & Profits and Dividend Distributions (2012) 24.

updated: August 8, 2011

Sarah and Mason each have dividend income of $200,000 {[$240,000 (accumulated E & P) + $160,000 (current E & P)] ÷ 2}. The dividend income will be subject to the reduced tax rate on dividends available to individuals. The remaining $40,000 of the $440,000 distribution reduces the basis ($20,000 each) in the shareholders’ stock with any excess treated as a capital gain. Thus, Sarah reduces her $8,000 stock basis to zero and has a capital gain of $12,000, while Mason reduces his stock basis from $32,000 to $12,000 and has no income tax consequences. Example 1

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a.

b.

Capon reports the $600,000 dividend as gross income but claims a dividends received deduction under § 243 of $420,000 (70% × $600,000). None of the other items affect taxable income. Thus, taxable income is $1,380,000 ($1,200,000 taxable income before dividends + $600,000 dividend – $420,000 dividends received deduction). Capon Corporation’s E & P as of December 31 is $2,240,000, computed as follows: $400,000 (beginning balance in E & P) + $1,380,000 (taxable income) + $420,000 (dividends received deduction) + $90,000 (tax-exempt interest) – $50,000 (interest on indebtedness to purchase tax-exempt bonds).

pp. 5-3 and 5-4 26. Robert reports a $500,000 taxable dividend and a $300,000 capital gain. The $600,000 gain on the sale of the land increases current E & P. Current E & P before the distribution is $500,000 [$600,000 (gain on sale) – $100,000 (current year deficit)]. The current E & P balance triggers dividend treatment for $500,000 of the distribution. Of the remaining $450,000 distributed, $150,000 is a tax-free recovery of basis and $300,000 is taxed as capital gain. After the distribution, Robert’s stock basis is $0. pp. 5-4, 5-9, and Examples 1 and 6 Sparrow Corporation’s current E & P is computed as follows: Taxable income Federal income tax liability Interest income from tax-exempts Disallowed portion of meals and entertainment expenses Life insurance premiums paid, net of increase in cash surrender value ($3,500 – $700) Proceeds from life insurance policy, net of cash surrender value ($130,000 – $20,000) Excess capital losses Excess of MACRS depreciation over E & P depreciation ($26,000 – $16,000) Allowable portion of 2010 § 179 expenses (20% × $100,000) Organizational expense amortization Dividends received deduction (70% × $25,000) LIFO recapture adjustment Installment sale gain Current E & P *($14,000 organizational expenses/180 months) × 12 months **[($40,000 sales price – $32,000 adjusted basis)/$40,000 sales price] × $15,000 Concept Summary 5.1 $330,000 (112,000) 5,000 (1,500) (2,800) 110,000 (13,000) 10,000 (20,000) 933* 17,500 10,000 (3,000)** $331,133

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100 is currently deductible for E & P purposes ($300 × 7 months).000 $21. Bunting is only taxed on $6. To determine the amount of dividend income.000) No effect $9.000 dividends received deduction).000.000 dividend generates a dividends received deduction of $21. h. its current E & P ($65.000 is then netted against the deficit in accumulated E & P of $150.000. and any excess over basis results in capital gain.000) No effect ($90. To determine Sparrow Corporation’s accumulated E & P at the end of the year.000 in accumulated E & P is reduced by $230. b.000 distribution – $24. c.000/120 months).000. tax-free recovery of basis is $40.000).000** $60.900* $140.000) *Although mining exploration costs are deductible in full under the income tax. †† ADS straight-line depreciation is allowed for E & P purposes. Example 11 Cardinal Corporation has no accumulated E & P at the time of the distribution. Sparrow Corporation’s current E & P is $65.000*** ($12. the $330. which was $80. leaving a net deficit of $145.000 with a net effect on taxable income of a $9. For E & P purposes.000 of the distribution is recovery of capital. E & P is decreased by $10. Dividend income is $100. i. she pays tax on the entire dividend.000 – $2. The remaining $5.900 is added back to E & P ($36.1 30. Concept Summary 5.000 (80% × $30. 33. thus. 32.000) is reduced by the amount of the distributions ($60.000 $48. $40.000). †In each of the four succeeding years.000 income tax deduction. of the $36. 5-8 to 5-10 a.000) No effect E & P Increase (Decrease) No effect $33.000 increase. thus. **The receipt of a $30. subject to the preferential 15%/0% tax rates if the dividend is qualifying. Since $300 per month is amortizable ($36. Bunting Corporation and Jennifer each have a taxable dividend of $30. the entire distribution is a taxable dividend even though Sparrow has no accumulated E & P. the balances of both accumulated and current E & P as of June 30 must be netted because of the deficit in current E & P.000. ***Only 20% of current-year § 179 expense is allowed for E & P purposes. f. Thus. the dividends received deduction is added back. 20% of the § 179 expense is allowed as a deduction for E & P purposes.000.5-2 28. Bunting Corporation is entitled to a dividends received deduction of $24.000.000.000 ($60.000)†† ($50. Taxable Income Increase (Decrease) $20.000) ($60. reduces the shareholder’s basis in the stock.000 (the excess of ADS depreciation over the amount allowed under MACRS). The balance of the distribution. d.000 balance in E & P triggers dividend income. The shareholder has a taxable dividend equal to the current E & P determined at year-end. . Assuming the taxable income limitation does not apply.000 ($30. $33.000) is deemed to have occurred on June 30.000. The $100.000 ($36. Because Jennifer is an individual. g. e. The remaining $100. a. Thus.100 deduction allowed). pp. reducing basis to zero and then triggering capital gain.000. As one-half of the loss (or $230. they are amortized over 120 months when computing E & P.000. b. Thus. 80% of the amount deducted for income tax purposes is added back. $2.000)† ($10. and capital gain is $60.

Accumulated E & P and current E & P are netted on the date of distribution. While Silver realizes an $8.000 $ –0– $50. b.000 of accumulated E & P available to apply to the distribution.e. Consequently. Heather receives a $54. d. $100.000 $140. There is a dividend to the extent of any positive balance.800 of accumulated E & P at the start of the 38.000 ($76.000. a.800 ($14.000 loss.000 dividend will be taxed to Judy as ordinary income.000 distribution is taxed as a dividend.000 [current E & P is a deficit of $20.000 of current E & P.000 dividend and takes a $14.000 adjusted basis of the land or $54.000 ($54. . it will have $12. The amount deemed distributed is the fair market value of the land. When the result in current E & P is a deficit for the year.000 [$76. the entire $8. 5-8 to 5-10 37.000 fair market value – $5.000.000) netted with accumulated E & P of $120. d. leaving accumulated E & P with a beginning balance for the following year of $80.000]. Example 12 a.000 mortgage). Silver recognizes $12. On June 30. as a result of the distribution of appreciated land.000 fair market value – $46. 5-8 to 5-11 34.000 Taxed to the extent of current E & P.000 basis in the furniture.000 of accumulated E & P ($88.000 $30. Silver recognizes gain on the distribution of $12. or $8. Since Silver’s gain increases its E & P.000 fair market value – $42.000 fair market value)]. Because she did not hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. Heather’s basis in the land is its fair market value ($54. none of the loss is recognized on the distribution.000 $ 80.000 (i. Taxed to the extent of current and accumulated E & P.800 for income tax purposes ($14.000 accumulated E & P + $12.000 distribution) as the beginning balance for next year.200 adjusted basis for E & P).000 pp. e.200 adjusted basis for income tax purposes).000).000 $70.000. Heather receives a $14. Silver recognizes a gain on the distribution of the land to Heather. Dividend Income $ 70.000 and is a tax-free recovery of capital. The $1. c.000 adjusted basis). The entire value of the land ($54.000 e. Silver has accumulated E & P at the beginning of the following year of $14.000 accumulated E & P – $62. leaving $34.5-3 pp. c.000 ($54.000 Return of Capital $60..000 current E & P – $8. the dividend does not qualify for the preferential 15%/0% tax rates. the distribution generates a $12.000 in the land. the deficit is allocated on a pro rata basis to distributions made during the year. $150. Since there is $12.000). Current E & P is increased to $8.000 of accumulated E & P.000 of current E & P and $76. The amount of the gain is $12. E & P is $100.000 of gain and increases current E & P by $12.000 of current E & P and $76. 1/2 of $40. The remaining $42.000 (greater of $62.000 fair market value – $1.000 dividend and she takes a basis of $54.000 of the value of the land decreases Heather’s stock basis from $56.000 dividend to Heather (to the extent of current E & P).000 distribution.000 of gain to Silver and creates $12. Heather’s basis in the land is $54. leaving $70. Silver’s E & P is reduced by $14. Accumulated E & P and current E & P netted on the date of distribution.000 to $14.000 total E & P at yearend – $54. The distribution triggers $12. b.000) is a dividend to Heather. net of the mortgage. Current E & P is reduced by the $8. Heather’s basis in the land is its fair market value ($54.000 distribution).

000 (adjusted basis of the land) – $130.000 bonus would cost Robin Corporation 51. she would be $1.000) and a constructive dividend of $25.125 ($250. 5-15 to 5-18 48.000 fair market value and the $275.800) with a dividend. she would receive $10. c.000 – $9.000 bonus. If Ivana were paid a bonus. Penguin Corporation does not recognize a loss on the distribution and its E & P is reduced by $80.000. This would be better than receiving a $15. a dividend payment is not deductible.000. The constructive dividend also reduces E & P.000 (cost of a dividend) – $9.000 × 28% tax rate)]. c.800 after tax [$15. her basis in the newly acquired shares is equal to its fair market value of $40. The amount of imputed interest is $13.000 (the difference between the $300. Thus. A $20.900 [$15. which would provide $12. Because the distribution of preferred stock is taxable to Katie. Parrot cannot recognize the realized loss but it does reduce E & P. Michael has a taxable dividend of $170. 5-13 to 5-15 a. The loan to Jerry generates imputed interest since no interest was charged. pp. If Robin Corporation paid Ivana a $15.000 bonus – $5.000 and fair market value of $300.750 after tax.000 (the difference between basis of $350.000 bonus – ($20. The deductibility of the interest by Jerry depends on how the loan proceeds are used. Tom has $42.000 × 7% × 3/4 year) and that amount is deemed paid as interest to the corporation.000 paid for the office building).900 (cost of a bonus)] better off if it paid a bonus. she would receive $14. If Robin paid Ivana a $20. 5-13 to 515 Holly has a $65. it would receive a deduction for the payment. If she received a dividend. The result of this transaction is a realized loss of $50.000)]. In contrast. . b. Therefore. This would reduce Robin’s tax liability.000 (160 hours × $350 hourly rental rate). 47. Parrot has taxable interest income of $13. the amount of constructive dividends to both Tom and Jerry equals the fair rental value of the airplane.000 (the sum of the $50. Due to the application of § 267.000.000 (liability assumed by Michael)].000 dividend. The $11. b.750 – $10. pp. Michael’s basis in the land is $300.000 dividend – ($15.125 and is deemed to pay a dividend to Jerry equal to the amount of interest.000 (120 hours × $350 hourly rental rate) of dividend income and Jerry has dividend income of $56. she would receive $12.100 tax savings (34% tax rate × $15.800 current E & P – $14. 5-19 a.000 taxable dividend and a $65. The net after-tax cost of the bonus would be $9.000 distribution).000) paid to Tom by Parrot over the fair rental value of the equipment is treated as a constructive dividend taxable to Tom and reduces Parrot’s E & P. Robin would be $5. d. Parrot’s E & P is increased by the amount of interest income and reduced by the amount of deemed dividend payment.000 × 15% tax rate)].000 basis in the land. Bargain rentals create constructive dividends to shareholders. 42.000 constructive dividend).000 bonus – ($15.950 better off ($12. but the distribution reduces its E & P account by $210. Green Corporation does not recognize a loss on the distribution.000 (liability assumed)].000 [$300.000 [$340. pp.000 bonus.000 (fair market value of the land) – $130.400 after tax [$20. Thus.100 [$15.000.000 accumulated E & P + $8.000 × 28% tax rate)]. E & P is reduced by $75.5-4 following year ($76. pp.750 after tax [$15. p. In the present case. The cost of the dividend would be $15. Thus.000 disallowed loss and the $25.000 excess amount ($20. 5-13 to 5-15 40. so no taxes would be saved by Robin. The holding period of the preferred stock begins on the date of receipt. Parrot’s E & P is reduced by the same amounts.

000)].000 bonus – (34% tax rate × $20. This is less expensive than a nondeductible $15.000 dividend. d.5-5 $13.000 bonus than they are with a $15. Since both Robin Corporation and Ivana are better off with a $20. the corporation should pay a bonus.200 after tax [$20. Examples 28 and 29 .000 dividend.