# 5-1

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

27.

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.