Chapter 5, Problem 51 – Your client, Heron Corporation, has a deficit in accumulated E & P of $300,000.

Starting this year, it

expects to generate annual E & P of $150,000 for the next four years and would like to distribute this amount to its
shareholders. How should Heron Corporation distribute the $600,000 over the four-year period to provide the least amount of
dividend income to its shareholders (all individuals)? In a letter to Martin Morales (Heron’s president), make appropriate
suggestions on how this should be done. Also prepare a memo for your firm’s file. Heron Corporation’s address is 12 Nature Trail
Way, Daytona Beach, FL 32114.

NOTES

“Earnings and Profits” is the factor that fixes the upper limit on the amount of dividend income shareholders recognize as a
result of a distribution from the corporation. It represents the corporation’s economic ability to pay a dividend without impairing
its capital. ‘‘Earnings and Profits’’ is similar to the accounting concept of ‘‘Retained Earnings.’’ However, E & P and retained
earnings differ because E & P is computed using tax rules while retained earnings is computed using financial accounting rules.
For example, a stock dividend that decreases the retained earnings account does not decrease E & P. E & P is increased for all
items of income. It is decreased for deductible and nondeductible items, such as capital losses, income taxes, and expenses
incurred to produce tax-exempt income.

Distributions not treated as dividends (because of insufficient E & P) are treated as a nontaxable return of capital to the extent
of the shareholder’s stock basis, which is reduced accordingly. If the distribution exceeds the shareholder’s basis, the excess is
treated as a gain from sale or exchange of the stock.

Additional difficulties arise when either the current or the accumulated E & P account has a deficit balance. When current E & P is
positive and accumulated E & P has a deficit balance, accumulated E & P is not netted against current E & P. Instead, the
distribution is deemed to be a taxable dividend to the extent of the positive current E & P balance.

Heron Corporation

Attn: Martin Morales

12 Nature Trail Way

Daytona Beach, FL 32114

Dear Martin,

Per your letter, Heron Corporation’s 2019 accumulated E&P has a deficit of $300000. Starting this year, Heron Corporation expects
to generate annual E&P of $150000 for the next four years ($150000 x 4 years = $600000) and would like to distribute the least
amount of dividends to your shareholders (individuals). Heron Corporation should make distributions every other year –

- 2020: No distributions
- 2021: Distribute $300000
- 2022: No distributions
- 2023: Distribute $300000

By distributing every other year, only half of the distribution ($150000) is taxed to the shareholders as dividend income.

2020 E&P ($150000) is netted with the deficit in accumulated E&P ($300000), the deficit will be $150000 by 12/31/20.

In 2021, when $300000 is distributed, only $150000 will be taxed as dividend income is limited to current E&P ($150000).

This trend will continue again for 2022 (no distribution) and 2023 (distribution of $300000).

NOTE: If $150000 is to be distributed each year, the shareholders will be taxed on the entire distribution because it is covered by
current E&P.
Feel free to reach out to me with any further questions or concerns.

Best,

Janet Mark

MEMORANDUM

At issue: Heron Corporation has a deficit in accumulated E&P (current E&P is available), can corporation distribution be structured
to minimized dividend income?

Conclusion: By not making distributions in 2020 and 2022, only half of the distribution ($300000) is considered as dividend
income. The first $150000 will be netted against the deficit in the accumulated E&P ($300000), reducing the deficit to $150000.
When Heron Corporation distributes $300000 in 2021, only $150000 is considered dividend income (reducing the remaining
deficit in accumulated E&P and the distribution is taxed to the extent of current E&P).

This letter is in response to your question concerning the tax consequences on the planned distribution of $600,000 to your
shareholders over the next four years. Our conclusion is based upon the facts as outlined in your April 1 letter and any change in
these facts may cause such conclusion to be inaccurate.

Heron Corporation has a deficit in accumulated E&P of $300,000 as of January 1, 2012. Starting this year, Heron Corporation
expects to generate annual E&P of$150,000 for the next four years and would like to distribute this amount to its shareholders.
The corporation’s objective is to make the distribution in a manner that causes the least amount of dividend income to its
shareholders.

Heron Corporation should not make a distribution in 2012 but distribute $300,000 on December 31, 2013. Again, make no
distribution in 2014 but distribute the remaining $300,000 on December 31, 2015. By distributing every other year, only half of
the distribution ($150000) is taxed to the shareholders as dividend income. Because E&P for 2012 ($150,000) is netted with the
deficit in accumulated E&P ($300,000), at the end of 2012 there is a deficit in E&P ($150,000). When a distribution of $300,000 is
made in 2013, only $150,000 is taxed, as dividend income is limited to current E&P ($150,000). This is again the case in 2014 and
2015. On the other hand, if $150,000 is distributed each year, the shareholders are taxed on the entire distribution because it is
covered by current E&P. The deficit in accumulated E&P does not cause part of the distribution to be nontaxable.