18-1

CHAPTER 18 - CORPORATE NONLIQUIDATING

(DIVIDEND) DISTRIBUTION
HOW TO DETERMINE THE "CURRENT EARNINGS & PROFIT" FROM TAXABLE INCOME
TAXABLE INCOME (Form 1120)
- Federal income tax paid.
- Charitable contribution in excess of 10% of adjusted taxable income.
- Capital loss over capital gain from capital asset (investment stock).
- Fines, penalties, political contributions.
- Interest expense on loan to purchase tax-exempt state bonds.
- Life insurance premium when the corporation is the beneficiary.
- Excess of book depreciation over tax depreciation.
- Loss from related party transaction.
+ Interest income from tax-exempt state and municipal bonds.
+ Life insurance proceeds when the corporation is the beneficiary.
+ Dividends-received deduction (70% or 80% of dividends received).
+ Domestic production activities deduction (9% of production income).
+ Federal income tax refund from prior year.
+ Capital loss carryover, charitable contribution carryover, net operating loss carryover.
+ Tax depreciation over book depreciation.
+ Deferred installment sales profit.
= CURRENT EARNINGS & PROFIT (= Book income, accounting income)

EXAMPLE 1-

DETERMINING CURRENT EARNINGS & PROFIT(accounting income) FROM TAXABLE INCOME

In the current year Ed Corporation has the following transactions. Determine its taxable income and tax refund/due by
preparing Form 1120 and also determine the "current earnings & profit" (accounting income) from taxable income:
1. Sales ................................................... ..$9,000
2. Dividends income from a 30% owned domestic corporation . .200
3. Interest income from a bank checking account ............. .. .300
4. Recovery of bad debt from last year .. .. . 400
5. Interest income from New Jersey state bonds ................. .500 (no)
6. Federal income tax refund from last year ..... 600 (no)
7. Life insurance proceeds from the death of the President .... 700 (no), which Ed corporation is the beneficiary.
8. Cost of goods sold ........................................,, ..(3,000)
9. Wages expense .............................................. (800)
10. Bad debt expense this year ............................... ...(150)
11. Charitable contribution ( < 10% x adjusted taxable income) ...(250)
12. Net operating loss carryover from last year (not accounting loss..(350)
13. Capital loss from sale of business truck this year ..... .. ...(450)
14. Capital loss from sale of IBM stock this year ............... ..(550) (no)
15. Interest expense on the loan to buy New Jersey state bonds.. .(650) (no)
16. Domestic production activities deduction.(140)
17. Federal income tax paid this year ........................... ..(726)
ANSWER: FORM 1120
GROSS INCOME:
1. Sales ................................................ 9,000
8. Cost of goods sold .................................... (3,000)
2. Dividends income ...................................... 200 a
3. Interest income from a bank checking account ...... .300
4. Recovery of bad debt from last year . .400
6,900
DEDUCTIONS:
9. Wages expense ......................................... (800)
10. Bad debt expense this year ............................. .(150)
11. Charitable contribution .............................. .(250)
12. Net operating loss carryover from last year .... .(350)
13. Capital loss from sale of business truck this year .(450)
16. Domestic production activities deduction.(140)
2. Dividends-received deduction (200 a x 80%) .... (160) (2,300)
TAXABLE INCOME ................................... 4,600
TAX LIABILITY (4,600 x 15%) =................. ... 690
.
- 17. Federal income tax paid this year .................... ...(726)
Tax refund .................................................. 36

18-2
CURRENT EARNINGS & PROFIT (= Accounting income)
TAXABLE INCOME ................................................$4,600
+ 2. Dividends-received deduction (200 a x 80%) ............+160
+ 5. Interest income from New Jersey state bonds ..........+500
+ 6. Federal income tax refund from last year ..................+600
+ 7. Life insurance proceeds from the death of the President .+700 Adams Corp. is the beneficiary
+ 12. Net operating loss carryover from last year (not accounting loss) +350
+ 16. Domestic production activities deduction..+140
- 14. Capital loss from sale of IBM stock this year .......... (550)
- 15. Interest expense on the loan to buy New Jersey state bonds .(650)
- 17. Federal income tax paid this year ................................ (726)
CURRENT EARNINGS & PROFIT (accounting income) ..............4,824

CASH DIVIDEND:
CORPORATIONS ACCOUNTS:
Capital stock (nontaxable)
^ - 103 d 100 a v
Accumulated earnings & profit (taxable)
^
-5c
5
v

STOCK HOLDERS ACCOUNTS:

Capita gain (taxable)
3d

Investment in stock (nontaxable)

100 a - 100 d
^

Current earnings & profit (taxable)

Dividend income (taxable)
^
-2b
2
v
7 (2 b+ 5 c) ^
-----110 = Distribution
= (2 b + 5 c) dividend income + 100 d return of capital + 3 d capital gain.
1. Taxable income = Ability to pay tax.
2. "Current earnings & profit" = Ability to distribute dividends to stockholders = Accounting income in the current year.
3. "Accumulated earnings & profit" = Retained earnings = Sum of undistributed current earnings & profit minus deficit
that has accumulated to date.
4. Dividends = Comes from the "current earnings & profit" first, and then from the "accumulated earnings & profit"
= Taxable dividends on the part of the stockholder if there is sufficient current earnings and accumulated earnings. If not,
the amount of distribution beyond the current earnings and the accumulated earnings is treated as a return of capital that
reduces the stockholder's adjusted basis of stock which is nontaxable. After the stockholder's adjusted basis of stock is
reduced to zero, any additional distribution is treated as a capital gain which is taxable on the part of the stockholder. If
there is a positive "current earnings & profit" and a negative "accumulated earnings & profit," no matter how large the
negative "accumulated earnings & profit" are, the distribution is treated as a taxable dividend income on the part of the
stockholder to the extent of the positive "current earnings & profit." That is because dividends come from the "current
earnings & profit" first. If there is negative current earnings & profit, but there is positive accumulated earnings &
profit, they must offset each other first, then determine the taxable dividend.

Is the dividend distribution taxable or a return of investment?

Current
earnings &
profits (A)

POSITIVE
NEGATIVE

Accumulated earnings & profits (B)

POSITIVE
NEGATIVE
Taxable, A first, B second. Beyond A+B,
Taxable from A first, none from B. Any
distribution is a return of investment
distribution beyond A is a return of
investment.
A and B are offset first. If positive, taxable
None is taxable.
income from B. If negative, none is
All distribution is a return of investment.
taxable; distribution is a return of
investment,

EXAMPLE 2 - CASH DIVIDEND

Ed owns 100% of King Corporation for an adjusted basis of $9,000 by 1-1-Year 2. In CASE 1 King Corporation has
$5,000 of "accumulated earnings & profit" at 1-1-Year 2 and $2,000 of "current earnings & profit" for the year ending
12-31-Year 2. On December 31, Year 2 King Corporation distributed $3,000 of cash dividends to its sole shareholder, Ed.
REQUIRED:
1. What is Ed's taxable dividend income in Year 2?

18-3
2. What is Eds return of capital in Year 2?
3. What is Eds taxable capital gain in Year 2?
4. What is Ed's adjusted basis of investment in King Corporations stock at 12-31-Year 2?
5. What is the balance of King Corporation's "accumulated earnings & profit" at 12-31-Year 2?
ANSWER: (Note that taxable dividend income is recognized to the extent of the distributing corporations current
earnings & profit plus accumulated earnings & profit. Beyond that, additional distribution is treated as a return of
capital that reduces the adjusted basis of investment in stock. And only after the adjusted basis of investment in stock
has been fully exhausted, can the remaining distribution be treated as capital gain).
CASE 1
CASE 2
CASE 3
CASE 4
a. Eds adjusted basis of investment, 1-1-Year 2
9,000
9,000
9,000
9,000
b. Accumulated earnings & profit, 1-1-Year 2
5,000
5,000
5,000
(5,000)
c. Current earnings & profit, Yer 2
2,000
2,000
2,000
2,000
d. Cash dividend to Ed, 12-31-Year 2
(3,000)
(7,500)
(16,500)
(1,700)
ANSWER:
e. Eds taxable dividend From current years earning,c
2,000
2,000
2,000
1,700
f.
From last years earning, b
1,000
5,000
5,000
0
g. Kings accumulated earnings & profit, 12-31-yr.2, b-f
4,000
0
0
(4,700) m
=
h. Eds return of capital = d e f = < a =
0
500
9,000 k
0
i. Eds taxable capital gain = d e f h =
0
0
500
0
j. Eds adjusted basis of stock, 12-31-Year 2 = a h =
9,000
8,500
0
9,000
ACCOUNTING ENTRY:
KING CORP:
Current earnings & profit, e
2,000
2,000
2,000
1,700
Accumulated earnings & profit, f
1,000
5,000
5,000
0
Common stock, h
0
500
9,500
0
Cash, d
3,000
7,500
16,500
1,700
ED: Cash, d
3,000
7,500
16,500
1,700
Dividend income From this years earning, e
2,000
2,000
2,000
1,700
From last years earning, f
1,000
5,000
5,000
0
Investment, h
0
500
9,000
0
Recognized capital gain on investment, I
0
0
500
0
k = 16,500 d dividend 2,000 e current earnings & profit 5,000 f accumulated earnings & profit
= 9,500 return of capital, but Eds adjusted basis of stock is only 9,000 a; therefore,
= 9,000 h is return of capital
+ 500 I capital gain for the dividend distribution beyond Eds adjusted basis of stock.
m =(5,000) b accumulated earning & prof (2,000 c current earning & prof 1,700 e current earning used up for dividend)
= (5,000) 300 remaining current earning & profit = (4,700) m.
= Note that as long as the 2,000 current earnings & profit, the 1,700 dividend paid out is a taxable dividend, even
though there is a negative (5,000) b accumulated earnings & profit (a loss).
ANSWER:
CASE 1
CASE 2
CASE 3
CASE 4
1. Taxable dividend
2,000 +
2,000 +
2,000 +
1,700
1,000
5,000
5,000
2. Return of capital
0
500
9,000
0
3. Recognized capital gain
0
0
500
0
4. Adjusted basis of stock
9,000
8,500
0
9,000
5. Accumulated earnings
4,000
0
0
(5,000) (2,000 1,700) = (4,700)

EXAMPLE 3 - CASH DIVIDEND

Ed owns 100% of King Corporation for an adjusted basis of $9,000 by 1-1-Year 2. In CASE 1 King Corporation has
$5,000 of "accumulated earnings & profit" at 1-1-Year 2 and ($2,000) of negative "current earnings & profit" for the year
ending 12-31-Year 2. On December 31, Year 2 King Corporation distributed $12,500 of cash dividends to its sole
shareholder, Ed.
REQUIRED:
1. What is Ed's taxable dividend income in Year 2?
2. What is Eds return of capital in Year 2?
3. What is Eds taxable capital gain in Year 2?
4. What is Ed's adjusted basis of investment in King Corporations stock at 12-31-Year 2?

18-4
5. What is the balance of King Corporation's "accumulated earnings & profit" at 12-31-Year 2?
ANSWER: (Note that taxable dividend income is recognized to the extent of the distributing corporations current
earnings & profit plus accumulated earnings & profit. Beyond that, additional distribution is treated as a return of
capital that reduces the adjusted basis of investment in stock. And only after the adjusted basis of investment in stock
has been fully exhausted, can the remaining distribution be treated as capital gain).
CASE 1
CASE 2
CASE 3
QUESTION:
a. Eds adjusted basis of stock, 1-1-Year 2
9,000
9,000
9,000
b. Accumulated earnings & profit, 1-1-Year 2
5,000
(5,000)
(5,000)
c. Current earnings & profit, Year 2
(2,000)
2,000
(2,000)
d. Cash dividend to Ed, 12-31-Year 2
(12,500)
(2,500)
(9,500)
ANSWER:
e. Eds taxable dividend From current years earnings, c
0
2,000
0
f.
From last years earnings, b
3,000 k
0
0
g. Kings accumulated earnings & profit,12-31-Year 2, bf =
0
(5,000) m
(7,000)
h. Eds return of capital = d e f = < a =
9,000
500
9,000
i. Eds taxable capital gain = d e f h =
500
0
500
j. Eds adjusted basis of stock, 12-31-Year 2 = a h =
0
8,500
0
ACCOUNTING ENTRY:
KING CORP:
Current earnings & profit, e
0
2,000 m
0
Accumulated earnings & profit, f
3,000
0
0
Common stock, h
9,500
500
9,500
Cash, d
12,500
2,500
9,500
ED: Cash, d
12,500
2,500
9,500
Dividend income From this years earning, e
0
2,000
0
From last years earning, f
3,000
0
0
Investment, h
9,000
500
9,000
Recognized capital gain on investment, I
500
0
500
k = Current years (2,000) loss must offset last years earnings 5,000, resulting in 3,000 (5,000 2,000) net accumulated
earnings & profit, which is less than the 12,500 dividend distribution. Therefore, taxable dividend = 3,000. The
remaining 9,500 (12,500 3,000) is a return of capital of 9,000 plus 500 capital gain.
m = As long as there is 2,000 current earnings & profit, even though there is (5,000) negative accumulated earnings &
profit, the 2,500 dividend is taxable to the extent of the $2,000 current earnings & profit. Therefore, the taxable
dividend is $2,000, and the remaining 500 (2,500 dividend distributed 2,000 taxable dividend) is a return of capital.
And the (5,000) negative accumulated earnings & profit remain.
ANSWER:
CASE 1
CASE 2
CASE 3
1. Taxable dividend
0 + 3,000
2,000 + 0 0 + 0
2. Return of capital
9,000
500
9,000
3. Recognized capital gain
500
0
500
4. Adjusted basis of stock
0
8,500
0
5. Accumulated earnings
0
(5,000)
(7,000)

EXAMPLE 4 CASH DIVIDEND WITH TWO SHAREHOLDERS

Andy owns 60% of Morrison Corporations stock for an adjusted basis of $19,000, while Bob owns the remaining 40%
for an adjusted basis of $10,000. Morrison Corporation has $70,000 of accumulated earnings & profit. Today, Morrison
Corporation distributed $60,000 cash dividend to Andy, and $40,000 to Bob (a sum of $100,000).
ANDY
BOB
a. % of ownership
60%
40%
b. Adjusted basis of stock
$19,000
$10,000
c. Share of profit = 70,000 x %, a
42,000
28,000
d. Cash dividend received = 100,000
(60,000)
(40,000)
e. Dividend over profit = c d =
(18,000)
(12,000)
REQUIRED: 1. What is Andys taxable dividend income?
2. What is Andys return of capital?

3. What is Andys taxable capital gain?

18-5
4. What is Andys adjusted basis of investment in Morrison stock after the dividend distribution?
5. What is Bobs taxable dividend income?
6. What is Bobs return of capital?
7. What is Bobs taxable capital gain?
8. What is Bobs adjusted basis of investment in Morrison stock after the dividend distribution?
9. What is Morrison Corporation accumulated earnings & profit after the dividend distribution?
ANSWER:
ANDY
BOB
Cash, d . 60,000
40,000
Dividend income, c
42,000
28,000
.
18,000
10,000 b
Investment ..
2,000
Recognized capital gain
0
(remainder)
ANSWER:
ANDY
BOB
1, 5 Taxable dividend income $42,000
28,000
2, 6 - Return of capital
18,000
10,000
3, 7 - Recognized capital gain
0
2,000 b e
4, 8 - Adjusted basis of stock
1,000 b
0
e
9 - Accumulated earnings & profit after the dividend = 0.

PROPERTY DIVIDEND (higher of cost or market)

If the fair market value is greater than the adjusted basis, the gain is recognized by the distributing corporation.
The stockholder's taxable dividend income, adjusted basis and the corporation's dividend distribution all are based on the
fair market value. The receiving shareholders adjusted basis of the property received is the distributing corporations
adjusted basis plus the gain recognized.
If the fair market value is less than the adjusted basis, loss is not recognized by the distributing corporation.
Therefore, the distributing corporation's dividend distribution is based on the adjusted basis of property given. However,
the receiving shareholder's taxable dividend income and the adjusted basis of the property received are based on the
market value of the property received. As a result, the loss lost its deductibility forever. This is designed to prevent the
transfer of property to recognize loss.
If a mortgage liability is assumed by the shareholder, the liability reduces the shareholder's taxable dividend income
and the distributing corporation's dividend distribution. If the liability is greater than the adjusted basis of the property, the
difference must be recognized as a gain, and the property is assumed to sold for no less than the liability.
Constructive dividends are treated as taxable dividends, e.g., excessive salary for the stockholder-employees, the
use of the corporation property, interest-free loan, bargain purchase of the corporation asset.
A = Adjusted basis of the property distributed.
B = Fair market value of the property distributed.
C = Mortgage liability on the property distributed.
IF GAIN (B > A)
IF LOSS (B < A)
Shareholders Taxable dividend income =

Adjusted basis of the property received

=
Corporations - Dividend distribution
=..
- Taxable capital gain (loss) =

EXAMPLE 5 - PROPERTY DIVIDEND WITHOUT LIABILITY

=BC
=B

=BC
=B

=BC
=B-A

=AC
= 0, Zero

Ed owns 100% of King Corporation for an adjusted basis of $9,000. In CASE 1 King Corporation has
$5,000 of accumulated earnings & profit at 1-1-Year 2, and $2,000 of current earnings & profit for the year
ending 12-31-Year 2. On 12-31-Year 2 King Corporation distributed a land with an adjusted basis of $2,500 and
a fair market value of $3,000 to Ed as a dividend.
REQUIRED:
1. What is King Corporations taxable capital gain from the land distributed in Year 2?
2. What is King Corporations amount of dividend distribution in Year 2?

3. What is King Corporation's balance of "accumulated earnings & profit" at 12-31-Year 2?

4. What is Ed's taxable dividend income in Year 2?
5. What is Eds adjusted basis of the land received?
6. What is Eds return of capital in Year 2?
7. What is Eds taxable capital gain on investment in Year 2?
8. What is Ed's adjusted basis of investment in King Corporations stock at 12-31-Year 2?

18-6
ANSWER: (Note that gain on the land is recognized, and the market value of the land becomes the basis to
measure the amount of dividend distributed and the adjusted basis of the land received. Loss is always not recognized;
and the old adjusted basis of the land measures the distributing corporations dividend distributed, but the market value
becomes the receiving shareholders adjusted basis of the land received).

QUESTION:
a. Eds adjusted basis of stock, 1-1-Year 2
b. Accumulated earnings & profit, 1-1-Year 2
c. Current earnings & profit, Year 2
d. Adjusted basis of the land distributed
e. Market value of the land distributed
ANSWER:
f. Kings capital gain on the land, e d > 0 =
g. Kings amount of dividend distribution = d + f =
h. Kings accumulated earnings & profit,12-31-yr.2,b+cg=
i. Eds taxable dividend From current year earnings, c
From last years earnings, gI=
k. Eds adjusted basis of the land received, d + f =
m. Eds return of capital = k i j =
n. Eds taxable capital gain = k I j m =
p. Eds adjusted basis of stock, 12-31-Year 2 = a m =
ACCOUNTING ENTRY:
KING CORP:
Current earnings & profit, I
Accumulated earnings & profit, j
Common stock, m
Land, d
Capital gain on land, f
ED: Land, k (2,500 + 500) (2,100 mkt) (2,500 +
10,000)=
Dividend income From this years earning, I
From last years earning, j
Investment, m
Recognized capital gain on investment, n

CASE 1

CASE 2

CASE 3

9,000
5,000
2,000
(2,500)
3,000

9,000
5,000
2,000
(2,500)
2,100

9,000
5,000
(2,000)
(2,500)
12,500

500
3,000
4,000

4,500

2,000
1,000
3,000 q
0
0
9,000

2,000
100
2,100 r
0
0
9,000

2,000
1,000
0

2,000
500
0

0
3,000 s
9,500

2,500
500
3,000 q

2,500 r
0
2,100 r

2,500
10,000
12,500

2,000
1,000
0
0

0
2,500 r

2,000
100
0
0

10,000
12,500
0
0
3,000 s
12,500
9,000
500
0

0
3,000
9,000
500

q = 2,500 d adjusted basis of the land + 500 f gain recognized = 3,000 e market value = 3,000 q.
r = The $400 loss (2,100 market value 2,500 adjusted basis) is not recognized by the distributing corporation.
Therefore, distributing corporations amount of dividend distribution is the $2,500 adjusted basis of the land.
However, the receiving shareholders adjusted basis of the land is the $2,100 market value. The $400 loss
lost its deduction forever.
s = 5,000 accumulated earnings & profit (2,000) current earnings & loss = Both must be offset first.
= 3,000 r accumulated earnings & profit.
ANSWER:
CASE 1
CASE 2
CASE 3
1. Kings capital gain on the land distributed
500
0 (no loss)
10,000
2. Kings amount dividend distribution
3,000
2,500
12,500
3. Kings accumulated earnings & profit after dividend
4,000
4,500
0
4. Eds taxable dividend
2,000 +
2,000 + 100 0 + 3,000
1,000
5. Eds adjusted basis of the land received
3,000
2,100
12,500
6. Eds return of capital
0
0
9,000
7. Eds recognized capital gain on investment
0
0
500
8. Eds adjusted basis of stock after dividend distribution 9,000
9,000
0

EXAMPLE 6 - PROPERTY DIVIDEND WITH MORTGAGE LIABILITY

Ed owns 100% of King Corporation for an adjusted basis of $9,000. In CASE 1 King Corporation has
$5,000 of accumulated earnings & profit at 1-1-Year 2, and $2,000 of current earnings & profit for the year
ending 12-31-Year 2. On 12-31-Year 2 King Corporation distributed a land with an adjusted basis of $2,500 and
a fair market value of $3,000 to Ed as a dividend. However, the land has an outstanding mortgage liability of $700,
and Ed must assume the liability.

18-7
REQUIRED: 1. What is King Corporations taxable capital gain from the land distributed in Year 2?
2. What is King Corporations amount of dividend distribution in Year 2?
3. What is King Corporation's balance of "accumulated earnings & profit" at 12-31-Year 2?
4. What is Ed's taxable dividend income in Year 2?
5. What is Eds adjusted basis of the land received?
6. What is Eds return of capital in Year 2?
7. What is Eds taxable capital gain on investment in Year 2?
8. What is Ed's adjusted basis of investment in King Corporations stock at 12-31-Year 2?
ANSWER: (Note that mortgage liability reduces the distributing corporations amount of dividend
distribution and also reduces the receiving shareholders amount of taxable dividend).
CASE 1
QUESTION:
a. Eds adjusted basis of stock, 1-1-2002
b. Accumulated earnings & profit, 1-1-2002
c. Current earnings & profit, 2002
d. Adjusted basis of the land distributed
e. Market value of the land distributed
f. Mortgage liability on the land
ANSWER:
g. Kings capital gain on the land, e d > 0 =
h. Kings amount of dividend distribution = d + g f =
i. Kings accumulated earnings & profit, 12-31, b+c-h =
j. Eds taxable dividend From current years earnings, c
.
From last years earnings, hj =
m. Eds adjusted basis of the land received, d + g =
n. Eds return of capital = m j k f =
p. Eds taxable capital gain = m j k n =
q. Eds adjusted basis of stock, 12-31-1998 = a n =
ACCOUNTING ENTRY:
KING CORP:
Mortgage payable, f
Current earnings & profit, j
Accumulated earnings & profit, k
Common stock, n
Land, d
Capital gain on land, g
ED: Land, m (2,500 + 500) (2,500 + 1,500) (1,500 mkt) =
Mortgage payable, f
Dividend income From this years earning, I
From last years earning, j
Investment, n
Recognized capital gain on investment, p

9,000
5,000
2,000
2,500
3,000
(700)
500

CASE 2

CASE 3

9,000

9,000

5,000
2,000

5,000
2,000

2,500
3,000
(4,000)

1,500

1,500 r
2,300

2,500
700
0t

1,800 t

4,700
2,000
300
3,000 y
0
0
9,000

7,000

9,000

9,000

700
2,000
300
0

4,000 r
0s
0s
0

700
1,800 t
0
0

2,500
500
3,000 y
700
2,000
300
0
0

5,200 u
0s
0s

4,000 r

800 t
0
1,500 t

0
0

0
0

2,500
1,500 r
4,000 r

2,500 t
0
1,500 t

4,000 r
0s
0s
0
0

700
800 t
0
0
0

y = 2,500 d adjusted basis of the land + 500 g gain recognized = 3,000 m.

r = When the $4,000 f, mortgage liability is greater than the $2,500 d, adjusted basis of the land, the land is
assumed to be sold for no less than the $4,000 mortgage liability. As a result, a gain of $1,500
(4,000 f 2,500 d) is recognized. And Eds adjusted basis of the land received is $4,000 f, mortgage liability.
s = Since the $4,000 f, mortgage liability is greater than the $2,500 d, adjusted basis of the land, it does not really benefit
the shareholder, Ed. Therefore, no dividend is really distributed = 0.
t = When the $1,500 e, market value of the land is less than the $2,500 d, adjusted basis, the loss of $1,000
(1,500 e 2,500 d) is not recognized. Therefore, the basis to measure Kings dividend is 2,500 d, adjusted basis
minus the $700 mortgage liability relieved = 1,800. Kings accumulated earnings & profit after this dividend
distribution on 12-31 is now 5,200 u = 5,000 b accumulated earnings & profit 1-1 + 2,000 c, current earnings & profit

1,800 dividend = 5,200 u. And the basis to measure Eds land received is the 1,500 e, market value of the land. As
a result, the 1,000 loss is never deducted and lost forever. Further, Eds taxable dividend is = 1,500 adjusted basis
of the land received 700 f, mortgage liability assumed = 800.
u = 2,000 c, current earnings & profit 1,800 t, dividend distributed that comes from the current earnings & profit first.

18-8
ANSWER:
1. Kings capital gain on the land distributed
2. Kings amount dividend distribution
3. Kings accumulated earnings & profit after dividend
4. Eds taxable dividend
5. Eds adjusted basis of the land received
6. Eds return of capital
7. Eds recognized capital gain on investment
8. Eds adjusted basis of stock after dividend distribution

CASE 1
500
2,300
4,700
2,000 + 300
3,000
0
0
9,000

CASE 2
1,500
0
7,000
0
4,000
0
0
9,000

CASE 3
0
1,800
5,200
800
1,500
0
0
9,000

EXAMPLE 7 CASH DIVIDENDS DISTRIBUTED SEVERAL TIMES A YEAR

(Note that if the amounts of dividend distribution are known, the current earnings are assumed to be
earned in proportion to the amounts of dividend). Dividend is taxable in the amount of lower of dividend or earnings).
John owns 100 % of King Corporation with an adjusted basis of $90,000. King Corporation has $10,000
accumulated earnings & profit and is expected to earn $80,000 of current earnings & profit for this year ending 12-31Year 2. In Year 2 King Corporation is expected to distribute $40,000 cash dividend to John on April 1, Year 2 and
additional $60,000 on December 31, Year 2, respectively.
REQUIRED: What is Johns taxable dividend income from the $40,000 cash dividend received on 4-1, Year 2,
and the return of capital, if any? And how about the $60,000 cash dividend received on 12-31-Year 2?
ANSWER: Taxable dividend = $40,000 and 50,000 in these two dates. Return of capital = $0 and 10,000.
Dividend date
Dividend amount Current profit earned
4-1 = 3 months $40,000 (40%),
$80,000 x 40% a = 32,000 a
12-31 = 9 months
60,000 (60%)
80,000 x 60% = 48,000 b
Total = 12 months
100,000 (100%)
80,000

KING CORP : Current earnings & profit.

Accumulated earnings &
profit
Common stock
(remainder)....
Cash
JOHN:
Cash
Dividend income...
Investment.

4-1-Year 2
32,000 a
8,000 c
..0
.40,000

12-31-Year 2
48,000 b
2,000 d
10,000
.60,000

40,000
....40,000
..0

60,000
.50,000
b+d
.10,000
c+d = 10,000 accumulated earnings & profit..

EXAMPLE 8 CASH DIVIDENDS DISTRIBUTED SEVERAL TIMES A YEAR

(Note that if the amounts of dividend are unknown, earnings are assumed to earned in proportion to the length of
time, not amounts of dividend. Dividend is taxable in the amount of lower of cash dividend or earnings).
Carl owns 100 % of Todd Corporation with an adjusted basis of $90,000. Todd Corporation has
no accumulated earnings & profit and is expected to earn $120,000 of current earnings & profit for this year ending
12-31-Year 2. In Year 2 Garrison Corporation is expected to distribute $40,000 cash dividend to Carl on April 1, Year 2
and additional unknown dividend on December 31, Year 2, respectively.
REQUIRED: What is Carls taxable dividend income from the $40,000 cash dividend received on April 1, Year 2, and
the return of capital, if any?
ANSWER: Taxable dividend = $30,000. Return of capital = $10,000 (40,000 30,000)
Dividend date
Dividend
Current profit earned
amount
4-1 = 3 months (25%), a $40,000
$120,000 x 25% a = 30,000 b
12-31 = 9 months (75%)
Unknown
120,000 x 75% = 90,000

Total = 12 months (100%)

120,000
CARL: 4-1:
TODD CORP: Current earnings & profit 30,000 b
Common stock
10,000
Cash
40,000
CARL:
Cash
40,000
Taxable dividend 30,000 b (40,000 cash taxable to the extent of 30,000 b,
earnings).
Investment in stock
10,000

EXAMPLE 9 TWO SHAREHOLDERS at the same time of dividend distribution

18-9

(Note that, if dividends are distributed to both shareholders at the same time, current E&P and accumulated E&P are
divided between two shareholders according their share of ownership. Each shareholder should account for their own
taxable dividend and return of investment).
Andy owns 80% of Todd Corporation having a $7,000 adjusted basis of stock, and Bob owns the remaining 20% for a
$3,000 adjusted basis of stock. Todd has $8,000 of current earnings & profits and $2,000 of accumulated earnings and
profits. Today Todd distributes $7,500 cash dividends to Andy and $2,100 to Bob.
REQUIRED: What is the taxable dividends and nontaxable return of investment to Andy and Bob, respectively?
What is adjusted basis of stock for Andy and Bob, respectively?
ANSWER: $7,500 taxable dividends and no return of capital to Andy; $2,000 taxable dividends to Bob and 100
(2,100 - 2,000) nontaxable return of investment to Bob. $7,000 (7,000 - 0) adjusted basis for Andy and $2,900 (3,000 100) adjusted basis for Bob.
Andy (80%)
Bob (20%)
TOTAL
Current earnings & profits
8,000 x 80% = 6,400 a 8,000 x 20% = 1,600 c
8,000 e
Accumulated earnings & profits 2,000 x 80% = 1,600 b 2,000 x 20% = 400 d
2,000 g
TOTAL
8,000
2,000
10,000
Todds entry:

Andys entry:
6-1
Bobs entry:
12-1

Current earnings & profits . 8,000 e

Accumulated earnings & profits (9,600 h - 8,000 e) . 1,600
Cash (7,500 to Andy + 2,100 to Bob)
9,600
h
Cash . 7,500
Dividends income (+R)(taxable)(current earnings & profits)... 6,400
a
Dividends income (+R)(taxable)(accumulate earnings & profits)(7,500 - 6,400 a) =
1,100
Cash ........... 2,100
Dividends income (+R)(taxable)(current earnings & profits)..........1,600 c
Dividends income (+R)(taxable)(accumulate earnings & profits) ... .. 400
d
Investment in stock(-A)(nontaxable)(return of investment)(2,100-1,600 c -400 d)=
100

EXAMPLE 10 TWO SHAREHOLDERS at different time of dividend distribution

(Note that current E&P are distributed before accumulated E&P. If dividends are distributed to both shareholders at
different times, current E&P are divided between them according to their share of ownership, but the accumulated E&P
are distributed to the shareholder who receives the dividend distribution first).
Andy owns 80% of Todd Corporation having a $7,000 adjusted basis of stock, and Bob owns the remaining 20% for a
$3,000 adjusted basis of stock. Todd has $8,000 of current earnings & profits and $2,000 of accumulated earnings and
profits. On June 1 Todd distributes $7,500 cash dividends to Andy. On December 1 Todd distributed $2,600 to Bob.
REQUIRED: What is the taxable dividends and nontaxable return of investment to Andy and Bob, respectively?
What is adjusted basis of stock for Andy and Bob, respectively?
ANSWER: $7,500 (6,400 + 1,100) taxable dividends and no return of capital to Andy; $2,500 (1,600+900) taxable
dividends to Bob and 100 (2,600 - 2,500) nontaxable return of investment to Bob. $7,000 (7,000 - 0) adjusted basis for
Andy and $2,900 (3,000 - 100) adjusted basis for Bob.
Andy (80%)
Bob (20%)
TOTAL
Current earnings & profits
8,000 x 80% = 6,400 a 8,000 x 20% = 1,600 c
8,000 e
Accumulated earnings & profits 2,000 x 80% = 1,600 b 2,000 x 20% = 400 d
2,000 g
TOTAL
8,000
2,000
10,000
Todds entry:

Current earnings & profits . 8,000 e

Andys entry:
6-1

Bobs entry:
12-1

Accumulated earnings & profits ... 2,000 g

Common stock (10,100 h - 8,000 e - 2,000 g) = 100 h
Cash (7,500 to Andy + 2,600 to Bob)
10,100 h
Cash . 7,500
Dividends income (+R)(taxable)(current earnings & profits). 6,400
a
Dividends income (+R)(taxable)(accumulate earnings & profits)(7,500-6,400 a) =
1,100
e
Cash ........... 2,600
Dividends income (+R)(taxable)(current earnings & profits)............1,600
c
Dividends income (+R)(taxable)(accumulate earnings & profits)(2,000 g -1,100 e)= . 900
d
Investment in stock(-A)(nontaxable)(return of investment)(2,600-1,600 c -900 d)=
100
h

18-10

STOCK DIVIDENDS:

If stock is distributed as dividend, it is nontaxable to the stockholder, and not deducted from the distributing
corporation current or accumulated earnings & profit, and the holding period includes the period before the distribution (=
the same as the old stock). In that case the old adjusted basis of the stock must be allocated between the old stock and
the new stock in proportion to shares or fair market value If the market values are different. However, if the stockholder
has the option to choose cash dividend, or the distribution of stock dividends to cause disproportion in ownership, the
stock dividends becomes taxable which is measured at its fair market value; and the holding period starts from the date
after the stock distribution.

EXAMPLE 11 -

STOCK DIVIDENDS
Todd Corporation gives its stockholder, John, 50 shares of stock as dividends at a fair market value of $40 per share.
REQUIRED: Are these 50 shares of stock dividend a taxable income on John?
ANSWER: No, because John did not receive cash. The $2,000 (50 shares x $40) stock is an additional investment
to John at no cost.
Todd CORP : Current earnings &
2,000
profit
2,000
Common stock (to John)
(50x$40)
JOHN:
Investment...
2,000
Investment (nontaxable)
2,000

EXAMPLE 12 -

CASH DIVIDENDS + STOCK DIVIDEND

Todd Corporation gives its stockholder, John, $1,000 cash dividend plus 50 shares of stock as dividends at a fair
market value of $40 per share.
REQUIRED: What is taxable or nontaxable to John?
ANSWER: $1,000 cash dividend is taxable, while $2,000 (50 shares x $40) stock dividend is nontaxable
Todd CORP : Current earnings & profit (cash dividend)
Current earnings & profit (stock
dividend)
Cash..
Common stock (to John)(50x$40)
JOHN:
Cash
Investment....................................
Dividend income (taxable)
Investment (nontaxable)

EXAMPLE 13 -

1,000
2,000
.1,000
2,000
1,000
2,000
1,000
2,000

CASD DIVIDEND + STOCK DIVIDEND

Todd Corporation gives its stockholders the option to receive either cash dividends or stock dividends. Today it
distributed $1,000 cash dividends to its stockholder, John, and 50 shares of common stock dividends with a fair market
value of $40 per share to another stockholder, Mike.
REQUIRED: Are these 50 shares of stock dividend a taxable income on Mike?
ANSWER: Yes, because Mike has the option to receive cash dividend at a market value of $2,000 (50 shares x $40).

Todd CORP : Current earnings &

profit
Current earnings &
profit...
Cash (to John)
..
Common stock (to Mike)
(50x$40)
JOHN:
Cash...
Dividend income (taxable)
MIKE:
Investment
Dividend income (taxable)

1,000
2,000

1,000

2,000
1,000
...1,000
2,000
...2,000

EXAMPLE 14 - PREFERRED STOCK DIVIDEND

Ed owns 100 shares of King Corporation's common stock for an adjusted basis of $3,000 and fair
market value of $4,000. Today Ed received 10 shares of preferred stock as a nontaxable stock dividend
with a fair market value of $1,000 at no cost to Ed.
REQUIRED: What is the adjusted basis of Ed's investment in common stock and in preferred stock, respectively?
ANSWER: Market value of common + preferred = 4,000 + 1,000 = 5,000.
a. Adjusted basis of common stock = 3,000 x (4,000 / 5,000) = 2,400.
b. Adjusted basis of preferred stock = 3,000 x (1,000 / 5,000) = 600.
1-1- Investment in common stock 3,000
12-31- Investment in preferred stock
600
Cash
3,000
Investment in common stock
600

18-11

STOCK RIGHTS:

Stock rights are the privileges to purchase the common stock at no cost. The value is nontaxable to the
stockholders. But the old adjusted basis of investment in stock must be allocated between the common stock and the
stock rights. If the value of the rights is 15% or more of the value of the underlying stock, its value must be accounted
for by allocating the old adjusted basis of common stock between the common stock and the stock rights according to
their fair market values. If the value of the rights is less than 15%, no allocation is required. If the rights are exercised,
its value is added to the stock acquired. If the stock rights are sold the value of the rights is subtracted from the gain. If
the rights are lapsed, its value is added back to the underlying stock. The holding period of the stock acquired through
exercise starts the date after the exercise.

EXAMPLE 15 -

STOCK RIGHTS
Jerry owns 100 shares of Davis Corporation's common stock with an adjusted basis of $3,000 and fair market value
of $4,000. Today Davis distributed 100 stock rights with a fair market value of $10 per right to Jerry to enable him to
purchase Davis' common stock at a price of $30 per share.
REQUIRED: 1. Should the value of the stock rights be accounted and how?
2. If all 100 stock rights are exercised to buy common stock, how much is the adjusted basis of the new
common stock acquired?
3. If all 100 stock rights are sold at a price of $$11 each, what is the gain or loss?
4. If all 100 stock rights are lapsed, what is the adjusted basis of the old 100 shares of the common stock?
ANSWER: 1. Yes, because the value of the stock rights is more than 15% of the fair market value of the underlying
stock, i.e., (100 rights x $10) > (15% x $4,000 common stock market value) i.e., $1,000 > $600.
1. Investment in old common stock
Cash

3,000
3,000

Market value of the stock rights = 100 rights x $10 = $1,000.

Market value of common stock + stock rights = $4,000 + $1,000 = 5,000.
Adjusted basis of common stock = 3,000 x (4,000 / 5,000) = 2,400.
Adjusted basis of stock rights = 3,000 x (1,000 / 5,000) = 600.
1. Investment in old common stock . 2,400
Investment in stock rights 600
Investment in old common stock .. 3,000
2. Investment in new common stock
3,000
Cash (100 shares x $30)
3,000
Investment in new common stock
600

Investment in stock rights

3. Cash (100 rights x $11) .. .1,100
Investment in stock rights ..
600
Recognized Gain on the sale of stock rights
500

600
4. Investment in old common stock 600
Investment in stock rights
600

STOCK REDEMPTION

(= Treasury stock) = DIVIDEND OR SALE OF STOCK?

A corporation may repurchase its own stock by paying cash or property. If it is treated as a dividend, it is taxable on
the part of the stockholder only up to the corporation's current and accumulated earnings & profit; beyond that it is treated
as a return of capital, which is nontaxable. However, if it is treated as a sale of stock, only the difference between the
sale price and the adjusted basis of the stock is treated as a taxable capital gain. From the stockholder's point of view, it
is more beneficial to treat the stock redemption as a sale of stock rather than a dividend. That is because in the case of
sale, the cost of stock reduces the capital gain, and if it is a long-term capital gain, the gain is taxed only at a maximum
of 20% rather than 35% as the case of dividend as an ordinary income.
On the other hand, to the distributing corporation, if the stock redemption was treated as a dividend by
the shareholder, the corporation's current and accumulated earnings & profit are reduced by the amount of
dividends. If property other than cash is distributed, the amount of dividend is measured at higher of fair market value
or adjusted basis of the property distributed which means that gain is always recognized, but loss is not recognized by the
distributor corporation. However, if the stock redemption was treated as a sale by the shareholder, the amounts of
current and accumulated earnings & profit are reduced in proportion to the percentage of the stock redeemed, and the
remaining
amount of distribution reduces the capital stock account. In other words, if 10% of the stock is redeemed as a sale, the
amount of earnings is reduced by 10%, and the remaining amount of distribution reduces the capital stock account.

CONDITIONS FOR STOCK REDEMPTION TO BE QUALIFIED

AS SALE, NOT AS DIVIDEND:

18-12

If the stock redemption satisfies any one of the following conditions, it is qualified as a sale rather than dividend:
1. The redemption is substantially disproportionate, which means the redemption has reduced the ownership to less
than 50% of the corporation's stock, and it also has reduced the ownership to less than 80% of the ownership before the
redemption.
The ownership includes the constructive ownership from spouse, children, grandchildren and parents, but not
brothers, sisters, or grandparents. It further include the ownership from partnership, estate and trust, stock rights, and
corporation with at least 50% ownership.
2. The ownership is completely terminated. In this case, the constructive ownership due to family attribution (e.g.,
spouse) is waived if the shareholder agrees not to acquire this same stock in 10 years.
3. The distribution of stock redemption comes from a partial liquidation of one of the product lines or proceeds from
a particular event, e.g., insurance proceeds (safe harbor rule).
4. The distribution of stock redemption is in the amount to pay for the decedent's death taxes, such as estate and
inheritance taxes and funeral and administrative expenses. But the redemption amount must be at least 35% of the
decedent's adjusted gross estate value which is the gross estate minus debt, estate and inheritance taxes and funeral
and administrative expenses. Further, the treatment of this stock redemption applies only to the person responsible for
the payment of the estate and inheritance taxes and funeral and administrative expenses, and only up to the amount of
these death expenses. In other words, the amount of stock redemption within the amount of the decedent's death
expenses is treated as a sale; any amount beyond that is treated as a dividend.

EXAMPLE 16

- STOCK REDEMPTION AS A SALE OR AS A DIVIDEND?

Andy owned 70 shares of 100 shares of Adams Corporation's stock having an adjusted basis of $7,000 in the past
two years. Adams has $5,000 of accumulated earnings & profit and $10,000 of common stock.
REQUIRED: For each case below, should it be qualified as a cash dividend distribution or as a sale? Is there any
taxable dividend on Andy? Is there any taxable long-term capital gain on Andy? What is the new adjusted basis of
Andy's investment in stock after the redemption? What are Adams' accumulated earnings and profit after the
redemption?
CASE 1. Adams redeems all 70 shares of Andy's stock by paying $7,100 in cash to Andy?
CASE 2. Adams redeems only 10 shares of Andy's stock by paying $1,100 in cash to Andy?
CASE 3. Adams redeems only 50 shares of Andy's stock by paying $5,100 in cash to Andy?
CASE 4. Adams redeems only 35 shares of Andy's stock by paying $3,600 in cash to Andy?
CASE 5. Suppose Andy owned the entire 100 shares of Adam's stock, instead of 70 shares, having an adjusted basis
of $10,000, and Adams redeems 80 shares of Andy's stock by paying $8,900 in cash to Andy?

ANSWER: Symbols: a. Ownership before the redemption = 70 / 100 = 70%.

b. 80% test of the ownership before the redemption = 80% x 70% = 56%
c. < 50% test? = < 50% of all stock after the redemption.
d. < 80% test? = < 80% of the ownership before the redemption.
e. YES = qualified as a sale.
f. NO = Not qualified as a sale, but as dividend.
SOLUTION:
c,
< 50% test?
d, < 80% test?(70% x 80%= 56%)
Before
After
After ( < 56%?)
CASE 1 70%
(70 70) / (100 70)= 0%<50%, Yes
0% < 56%, Yes
CASE 2 70%
(70 10) / (100 10)= 67%>50%, No 67% > 56%, No
CASE 3 70%
(70 50) / (100 50)= 40%<50%,Yes 40% < 56%, Yes
CASE 4 70%
(70 35) / (100 35)= 54%>50%, No 54% < 56%, Yes
CASE 5 100%
(100 80) / (100 80)=
100% > (100% x 80%), , No
100%>50%,No

Sale?
ANSWER:
YES, sale
NO, dividend
YES, sale
NO, dividend
NO, dividend

ACCOUNTING ENTRY:
ADAMS CORP:
Accumulated earnings...
Common stock
Cash.
ANDY:
Cash.
Dividend income.
Investment..
Recognized capital gain

CASE 1
(Sale)

CASE 2
(Dividend)

CASE 3
(Sale)

CASE 4
(Dividend)

CASE 5
(Dividend)

3,500 a
3,600 b
7,100

1,100 d
0
1,100

2,500 e
2,600
5,100

3,600 g
0
3,600

5,000 h
3,900
8,900

7,100

1,100

5,100

3,600

8.900

0
7,000 c
100

1,100
0
0

0
5,000 f
100

3,600
0
0

5,000
3,900
0

18-13
- CASE 1 results in complete termination of Andy's interest in Adams. Therefore, it must be a sale, not a dividend.
- CASE 5 does not change Andy's percentage of interest. Andy still owns 100% before and after the redemption.
Therefore, it must be a dividend rather than a sale.
a = 5,000 Accumulated earnings x (70 shares / 100) = 3,500.
b = 7,000 cash paid - 3,500 allocated earnings = 3,600 return of capital.
c = 7,000 adjusted basis x (70 shares / 70 shares) = 7,000.
d = 5,000 accumulated earnings > 1,100 dividend payout.
e = 5,000 accumulated earnings x (50 shares / 100) = 2,500.
f = 7,000 adjusted basis x (50 shares / 70 shares) = 5,000.
g = 5,000 accumulated earnings > 3,600 dividend paid out.
h = Only 5,000 accumulated earnings out of 8,900 dividend paid out are available for dividends income.
The remaining 3,900 distribution is a return of capital which is nontaxable.
AFTER REDEMPTION:
Andys new adjusted basis of stock
CASE 1
7,000 - 7,000 = $0 for 0 shares (70 - 70).
CASE 2
7,000 0 = $7,000 for 60 shares (70 - 10).
CASE 3
7,000 - 5,000 = $2,000 for 20 shares (70 - 50).
CASE 4
7,000 0 = $7,000 for 35 shares (70 - 35).
CASE 5 10,000 - 3,900 = $6,100 for 20 shares (100 - 80).

Adams new Accumulated earnings & profit

5,000 3,500 a = $1,500.
5,000 1,100 d = $3,900.
5,000 - 2,500 e = $2,500.
5,000 3,600 g = $1,400.
5,000 5,000 h =
$0.

EXAMPLE 17 MULTIPLE REDEMPTION (Two shareholders redeem at the same time)

Jackson Corporation has 100 shares of stock outstanding having $5,000 of accumulated earnings & profit and
$10,000 of common stock. Andy owns 60 shares having an adjusted basis of $6,000, Bill owns 30 shares having an
adjusted basis of $3,000, and Carl owns 10 shares having an adjusted basis of $1,000. Today, Andy redeems
20 shares receiving $1,800 cash from Jackson, Bill redeems 18 shares receiving $1,900 cash from Jackson, and
Carl redeems nothing.
REQUIRED: For each redeeming shareholders, Andy and Bill, should the transactions be qualified as a cash
dividend distribution or as a sale? Is there any taxable dividend on Andy and Bill, respectively? Is there any taxable
long-term capital gain on Andy and Bill, respectively? What is the new adjusted basis of their investment in stock
after the redemption for Andy and Bill? What are Jacksons accumulated earnings and profit after the redemption?

ANSWER: Symbols: a. Ownership before the redemption.

b. 80% test of the ownership before the redemption.
c. < 50% test? = < 50% of all stock after the redemption.
d. < 80% test? = < 80% of the ownership before the redemption.
e. YES = qualified as a sale.
f. NO = Not qualified as a sale, but as dividend.
SOLUTION:
c.
< 50% test?
d.
< 80% test?
Befor
After
After
e
Andy 60%
(60 20) / (100 20 - 18) = 65% > 50%, No
65% > (60% x 80%), No
Bill
30%
(30 18) / (100 20 - 18) = 19% < 50%, Yes 19% < (30% x 80%), Yes
Carl
10%
No redemption
ANDY (20 shares)
(Dividend)
1,800 a
1,800
0
0

Sale?
ANSWER:
NO, dividend
YES, sale

BILL (18 shares)

(Sale)
1,900
0
1,800 b
100

Cash.
Dividend income.
Investment..
Recognized capital gain
ADAMS CORP:
Accumulated earnings... 1,800 a
900 c
Common stock
0
1,000 d
Cash.
1,800
1,900
a = 5,000 accumulated earnings > 1,800 dividend paid out.
b = 3,000 adjusted basis x (18 shares / 30 shares) = 1,800.
c = 5,000 Accumulated earnings x (18 shares / 100) = 900.
d = 1,900 cash paid - 900 allocated earnings = 1,000 return of capital.

18-14
ADJUSTED BASIS FOR THE REMAINING INVESTMENT IN STOCK:
Andy = 6,000 0 = $6,000 for 40 shares (60 - 20).
Bill = 3,000 1,800 = $1,200 for 12 shares (30 - 12).
Carl = 1,000 0 = $1,000 for 10 shares (10 0).
JACKSONS REMAINING ACCUMULATED EARNINGS & PROFIT AFTER REDEEMPTION:
= 5,000 1,800 a 900 c = $2,300.

STOCK REDEMPTION WITH FAMILY ATTRIBUTION: Note that by ownership it includes the constructive
ownership from spouse, children, grandchildren, and parents, BUT NOT BROTHERS AND SISTERS.

EXAMPLE 18 - STOCK REDEMPTION WITH FAMILY ATTRIBUTION

Father, mother, son, and an unrelated person, John, each own 25 shares of Jackson Corporation's 100 shares of
stock having an adjusted basis of $2,500 each. Jackson has $2,000 of accumulated earnings & profits and $10,000 of
common stock. Jackson redeemed all the father's 25 shares by paying $2,600 in cash to the father.
REQUIRED: Should this stock redemption be treated as a cash dividend distribution or as a sale of the father's
stock? Is there any taxable dividend (2,000) or return of investment (600) or capital gain (0) on the part of the father?
ANSWER: With respect to the father's ownership, he directly and indirectly owns 75 shares (25 father + 25 mother +
25 son), but not the third party, Johns 25 shares. With the family attribution, it is treated as a dividend, not a sale,
because the fathers
a. Ownership before redemption = (25 + 25 + 25) / 100 = 75%.
b. Ownership after redemption = (25 mother + 25 son) / (100 - 25) =
67%.
c. 67% b > (80% x 75% a).
The father's ownership after the redemption is not less than 50%, and the ownership after the redemption is not less
than 80% of the ownership before the redemption. Therefore, it is a dividend, not a sale.
JACKSON CORPORATION (dividend)
FATHER (dividend)
Accumulated earnings & profit (maximum)..2,000 d
Cash2,600
Common stock (2,600 2,000 d)..600
Dividend income.....2,000
Cash...
d
.2,600
Investment in stock600

STOCK REDEMPTION WITH PARTIAL LIQUIDATION = SALE

If a corporation discontinues a line of product and distributes the proceeds to the shareholders, the noncorporate
shareholder treats it as a sale, while the corporate shareholder treats it as a dividend.

EXAMPLE 19 -

PARTIAL LIQUIDATION = SALE

John and Garrison Corporation each owns 50 shares of Madison Corporation's 100 shares of stock having an
adjusted basis of $5,000 each. Madison has $4,000 accumulated earnings and $10,000 of common stock. .Madison
discontinued its computer parts department by selling its machinery for $2,200 cash. Therefore, it decided to redeem
10 shares of stock each from John and Garrison by paying them $1,100 each in cash.
REQUIRED: Is there any taxable dividend or capital gain to each of them, and what is the adjusted basis of
investment in Madison stock after the redemption?
ANSWER:
MADISON'S ENTRY FOR THE CASH PAID TO JOHN (SALE):
Accumulated earnings & profit...400 (4,000 accumulated earnings & profit x (10/100
shares)
Common stock..700
Cash (to John)1,100
MADISON'S ENTRY FOR THE CASH PAID TO GARRISON CORPORATION (DIVIDEND):
Accumulated earnings.1,100 ( < 4,000 accumulated earnings &
profit)
Cash (to Garrison).1,100
JOHN'S ENTRY FOR THE CASH RECEIVED (SALE):
Cash1,100
Investment in stock...1,000 (5,000 adjusted basis x (10 / 50 shares)
Recognized capital gain..100
Adjusted basis for the remaining 40 shares (50 - 10) = 5,000 - 1,000 = $4,000.
GARRISON CORPORATION'S ENTRY FOR THE CASH RECEIVED (DIVIDEND):
Cash...1,100
Dividend income..
.1,100
Adjusted basis for the remaining 40 shares (50 - 10) = 5,000 0 = $5,000.

18-15
STOCK REDEMPTION BY A CONTROLLED CORPORATION
A 50% ownership results in a related party, and 80% ownership constitutes a controlled group (parent-subsidiary
controlled group or sister-brother controlled group). If the stock redemption results in a situation where the shareholder
still maintains at least 50% ownership and the ownership after the redemption is also at least 80% of the ownership
before the redemption, the stock redemption is considered to be a dividend to the extent of the accumulated earnings of
the acquiring corporation and the issuing corporation; otherwise, it is a sale.

EXAMPLE 20 -

STOCK REDEMPTION BY BROTHER-SISTER CORPORATION

John owns 65 shares of Adams Corporation's 100 shares of stock and 60 shares of Barry Corporation's 100 shares of
stock. Adams and Barry have $20,000 and $30,000 of accumulated earnings & profits, respectively. John transferred 30
shares of Adams' stock having an adjusted basis of $15,000 to Barry for $18,000 cash.
REQUIRED: Is this stock redemption qualified for dividend or sale? What is John's taxable dividend?
ANSWER:
John
65%
60%
Adams Co.
Berry Co.
Transfer 30 shares
Qualified for dividend. John owns Adams. Before = 65 / 100 = 65%.
After

= (65 - 30) shares + (60% x 30) from Barry

= 35 shares + 18 shares
= 53 shares
= 53 shares / 100
= 53% > 50%, NO, not a sale, but a dividend.

And also 53% after > (80% x 65% before)

53%
> 52%, NO, not a sale, but a dividend.
John's ownership with Adams was not substantially disproportionate. Therefore, it is qualified as a dividend, not a sale.

BARRY ENTRY FOR THE CASH PAID (dividend):

Accumulated earnings & profits18,000 (< 20,000 Adams accumulated earnings and profits).
Cash...18,000
JOHN'S ENTRY FOR THE CASH RECEIVED (dividend):
Cash.18,000
Dividend income18,000 (< 20,000 Adams accumulated earnings and profits).

EXAMPLE 21 - STOCK REDEMPTION BY A CONTROLLED CORPORATION

Assume the same fact as in EXAMPLE 20 except that John transferred 50 shares of Adams' stock having an
adjusted basis of $15,000 to Barry for $18,000 cash.
REQUIRED: Is this stock redemption qualified for dividend or sale? What is John's taxable dividend or taxable
capital gain? ANSWER: Qualified for sale. John owns Adams.
Before = 65 shares / 100 = 65%.
After

= (65 - 50) shares + (60% x 50 shares) from Barry

= 15 shares + 30 shares
= 45 shares
= 45 shares / 100 shares
= 45% < 50%, YES, a sale, not a dividend.

And also 45% after < (80% x 65% before)

45%
< 52%, YES, a sale, not a dividend.
John's ownership with Adams has become substantially disproportionate. Therefore, it is qualified for sale, not dividend.
BARRY'S ENTRY FOR THE CASH PAID (sale):
Investment in Adams stock.....18,000
Cash...18,000
JOHN'S ENTRY FOR THE CASH RECEIVED FROM STOCK REDEMPTION (sale):
Cash.18,000
Investment in Adams stock...
..15,000
Recognized capital gain.
3,000

18-16

EXAMPL 22 - STOCK REDEMPTION BY A PARENT-SUBSIDIARY CORPORATION AS A DIVIDEND

Mike owns 60 shares of Father Corporation's 100 shares of stock having an adjusted basis of $6,000. Father owns
70 shares of Son Corporation's 100 shares of stock. Father has $2,000 of accumulated earnings & profits and $10,000 of
common stock. Son has $3,000 of accumulated earnings & profits and 15,000 of common stock. Mike sold 15 shares of
the Father stock to Son for a price of $1,600.
REQUIRED: Should this transaction be treated as a sale? Is there any taxable dividend or capital gain on the part
of Mike? What is Mike's adjusted basis of the remaining 45 shares of the Father stock?
ANSWER: NO, it is not a sale, but a dividend.
Mike
60%
Father Co.
70%
Son Co.
Mike owns Father.

Sell 15 shares

Before = 60 / 100 = 60% before.

After = 45 shares (i.e., 45% now directly)
+ (15 shares of Father x 45% now x 70% Father on Son) indirectly
= 45 shares + 4.7 shares
= 49.7 shares
= 49.7 shares / 100 shares of Father
= 49.7% after.
Since 49.7% after < 50%, YES, a sale, not a dividend.
And also 49.7% after > (80% x 60% before),
49.7% > 48%, NO, not a sale, but a dividend.

Mike's ownership on Father has not become substantially disproportionate. Therefore, the 15 shares
of stock redemption is not to be treated as a sale but as a dividend.
MIKE'S ENTRY FOR THE CASH RECEIVED (dividend):
Cash1,600
Dividends income1,600 ( < 2,000 Fathers accumulated earnings & profit)
Mike's adjusted basis for the remaining 45 shares (60 - 15) is still $6,000.
SON CORPORATIONS ENTRY FOR THE CASH PAID (dividend):
Accumulated earnings and profit.1,600
Cash1,600

EXAMPLE 23 - STOCK REDEMPTION BY A PARENT-SUBSIDIARY CORPORATION AS A SALE

Assume the same fact as EXAMPLE 22 except that Mike sold 20 shares of the Father's stock to Son for a price of
$2,100 in cash.
REQUIRED: Should this transaction be treated as a sale? Is there any taxable dividend or capital gain on the part
of Mike? What is Mike' adjusted basis for the remaining 40 shares of the Father's stock?
ANSWER: YES, it is treated as a sale, not as a dividend.
Mike owns Father:

Before = 60 shares / 100 = 60% before.

After

= 40 shares (i.e., 40% now directly)

+ (20 shares of Father x 40% now x 70% of Father on Son) indirectly,
= 40 + 5.6 shares
= 45.6 shares
= 45.6 shares / 100 shares
= 45.6% after.

Since 45.6% after < 50%, YES, a sale.

And also 45.6% < (80% x 60% before,
45.6% < 48%, YES, a sale.

18-17
Mike's ownership on Father has become substantially disproportionate. Therefore, the 20 shares of stock redemption
is to be treated as a sale, not as a dividend.
MIKE'S ENTRY FOR THE CASH RECEIVED (sale):
Cash..2,100
Investment in Father's stock..2,000 (6,000 adjusted basis x (20 / 60 shares)
Recognized capital gain.100
Mike's basis for the remaining 40 shares of investment in Father's stock is now $4,000 (6,000 - 2,000).
SON CORPORATION'S ENTRY FOR THE CASH PAID (sale):
Investment in Father's stock.2,100
Cash.2,100

EXAMPLE 24 COMPREHENSIVE CORPORATE TAXABLE INCOME

Ford Motors Corporation is engaged in domestic car manufacturing activities (production) and car rental business
(non-production). Ford has enough Accumulated Earnings & Profit for dividend distribution.
REQUIRED: From the following income and deductions in the current year, determine its domestic production
activities deduction (12,600), taxable income (130,930), tax liability (33,413), and tax refund (6,587).
ANSWER:
1
Sales revenue from car production.
$200,000
2
Cost of goods sold for car production.
(40,000)
3
Wage expense for car production.
(20,000)
4
Losses from car rental business.
(10,000)
5
Dividend received from an 85%-owned subsidiary corporation.
+ 1,000
6
Dividend received from a 75%-owned subsidiary corporation
+ 2,000
7
Dividend received from a 15%-owned subsidiary corporation.
+ 3,000

8
9
10
11
12
13
14
15
16
17
18
19
20
21
22

Short-term capital gain from sale of GM stock.

Short-term capital loss from sale of GE stock.
Long-term capital loss from sale of GW stock.
Long-term capital gain from sale of RCA stock.
Short-term capital gain from sale of a business-use machine.
Long-term capital loss from sale of a business-use equipment.
Distributed cash dividend to stockholders in the amount of
Distributed a 11-month old land to stockholders as dividend having a $11,000 adjusted basis and
a market value of
Distributed a 13-month old truck to stockholders as dividend having a $8,000 adjusted basis and
a market value of
Contributed a 13-month old land to a church having a $20,000 adjusted basis and a market value
of
Claimed dividend-received deduction in Item 5 above.
Claimed dividend-received deduction in Item 6 above.
Claimed dividend-received deduction in Item 7 above.
Claimed domestic production activity deduction for car production activities in Items 1, 2 & 3
above.
Paid federal income tax in the amount of

800
(100)
(600)
200
300
(900)
10,000
40,000
7,400
21,000
?
?
?
?
(40,000)

18-18 end
ANSWER FORM 1120
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

Sales revenue from car production.

- Cost of goods sold for car production.
- Wage expense for car production.
PRODUCTION INCOME
- Losses from car rental business.
+ Dividend received from an 85%-owned subsidiary corporation.
+ Dividend received from a 75%-owned subsidiary corporation
+ Dividend received from a 15%-owned subsidiary corporation.
+ Short-term capital gain =
- Short-term capital loss =
+ Long-term capital loss =
- Long-term capital gain =
NET SHOR-TERM CAPITAL GAIN
+ Short-term capital gain =
- Long-term capital loss =
NET LONG-TERM CAPITAL LOSS
- Cash dividend distribution to stockholder is not deductible.
+ Short-term capital gain for property distribu=40,000 11,000=29,000
taxable
- Long-term capital loss for property distrib=7,4008,000=(600) not
deductible
NET SHORT-TERM CAPITAL GAIN
TAXABLE BEFORE CHARITABLE CONTRIBUTION

200,000
(40,000)
(20,000)
140,000 a
(10,000)
+ 1,000
+ 2,000
+ 3,000
800
(100)
(600)
+ 200
+ 300
300
(900)
(600)
(0)
29,000
(0)
+ 29,000
164,700
b

17

- Charitable contribution = 21,000 > Limit 10% x 164,700 b =>

(16,470)

18
19
20

- Dividend-received deduction from 85%-owned corporation = 1,000 x 100%

=
- Dividend-received deduction from 75%-owned corporation = 2,000 x 80% =
- Dividend-received deduction from 15%-owned corporation = 3,000 x 70% =
TAXABLE INCOME before domestic production activities deduction

(1,000)
(1,600)
(2,100)
143,530
c

21

22

- Domestic production activities deduction

= 9% x (lesser of 140,000 a or 143,530 c = 9% x 140,000
=
TAXABLE INCOME
TAX LIABILITY = 22,250 + 39%X(130,930 100,000) = 22,250 + 11,163 =
- Federal income tax paid.
TAX REFUND (33,413 - 40,000) =

(12,600)
130,930
33,413
(40,000)
6,587