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Chapter 7

Corporate Distributions

Types of distributions
• Shareholders contribute cash to a corporation in
exchange for ownership (in the form of stock) and the
expectation of income distributions
• Distributions to shareholders will be taxed as either:
• Dividends - taxed as part of shareholder’s gross income
• Return of capital – non dividend distribution that reduces the
shareholder’s basis in corporate stock
• Capital gains – non dividend distribution in excess of the
shareholder’s basis in the corporate stock is treated as a
capital gain as if the stock was sold

Tax Consequences of Distributions
• If a distribution is in the form of a dividend, the corporation
cannot deduct the dividend in computing taxable income and the
shareholder pays tax on dividend income – double taxation
• If a distribution is not in the form of a dividend but instead
structured as a payment to the shareholder (such as salary,
bonus, interest and rent payments), the corporation can deduct
the payment, avoiding double tax as long as the payments are
reasonable in amount. The shareholder would pay tax on
ordinary income
• If payment is not “reasonable” in amount, then the IRS can
recharacterize such a deductible payment into a “constructive
dividend” which cannot be deducted by the corporation

What are examples of constructive dividends? • Unreasonable compensation • Shareholder use of corporate assets without an arm’s-length payment • Interest paid to shareholder at excessive interest rates • Payments made by the corporation on behalf of a shareholder . . But payroll taxes on compensation might make it less desirable. sometimes makes sense to pay out earnings as tax deductible payments to avoid double taxation.In a closely held corporation.

distribution is a return of capital) • Undistributed current E&P is added to accumulated E&P in the beginning of the next taxable year .What is a dividend? • A distribution out of the Earnings & Profits (E&P) account (economic earnings available to be distributed to shareholders. if no profit. While E&P can have a negative balance ( a loss) dividends cannot be distributed if there is a negative E&P (dividends are returns of profit to shareholders. excess distribution comes out of Accumulated E&P – therefore distributions reduce E&P. in contrast to retained earnings which includes accounting income) • E&P is an indicator of a corporation’s economic ability to pay dividends • Current E&P – current year earnings and profits • Accumulated E&P – Prior periods accumulated E&P • Dividends are distributed up to the balance in the Current E&P account.

Distributions paid out of E&P = Ending accumulated E&P .E&P adjustments = Current E&P • Accumulated E&P Calculation: Beginning accumulated E&P + Current period E&P .Current & Accumulated E&P Recap • Current E&P Calculation: Regular taxable income (loss) +/.

000 dividend + $25.Example • Alpha is a 50% shareholder of Beta Corporation.000 distribution only $20.Now the next portion of the distribution is a reduction of capital and can reduce Alpha’s basis in Beta stock down to 0 (cannot go below 0) .Out of the $60. Beta makes a distribution of $55. Beta has a balance in its Current E&P account of $12.Dividend = $20.Total distribution = $10.000 * 50% share of Beta’s E&P = $10.000 to Alpha.000 is a return of capital.000 .$20.000 and its balance in the Accumulated E&P account is $8.000 capital gain .The remainder of the distribution will be treated as a capital gain (deemed a sale) .000 return of capital + $20.000 is treated as a capital gain . a non-taxable reduction of stock basis . Alpha’s tax basis in Beta’s stock is $25. What is the tax treatment of the distribution? .Alpha’s basis in Beta stock is reduced to $0 .000 (the balance of current E&P + Accumulated E&P) can be treated as a dividend .000.$25.000.

How to compute Current E&P • Start with taxable income and make adjustments to arrive at current E&P • Since E&P is supposed to represent economic income. a separate accounting system must be maintained to compute it • 4 categories of adjustments: 1) Income that is excluded from taxable income 2)Disallowed deductions that do not require an economic outflow but are deducted in computing taxable income 3)Deduction of expenses that require an economic outflow but are not deducted for computing taxable income 4) Adjustment of timing for deductions or income because of accounting methods required for E&P computation .

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000 = $26. Beta Corp also received life insurance proceeds of $2.000 $4.000 . Assuming Beta distributes all of its current E&P. tax – exempt life insurance proceeds • Example – Balance in current E&P account = $20. Therefore it is added back to taxable income to arrive at E&P – interest income from municipal bonds. the total taxable dividend amount to its shareholders will be $20.000 and municipal bond interest income of $4.000.000 + $2.1) Income that is excluded from taxable income • Income that is exempt from taxes still has economic value since it is distributed to shareholders in the form of dividends.000.

NOL carryovers. Domestic Production Activities Deduction. • Dividends Received Deduction. net capital loss carryovers.2)Disallowed deductions that do not require an economic outflow but are deducted in computing taxable income • Some deductions or tax carryovers from other years are deducted to reduce taxable income but require no current cash flows and therefore are disregarded in calculating E&P – meaning these items reduce taxable income but do not reduce E&P. charitable contribution carryovers .

3)Deduction of expenses that require an economic outflow but are not deducted for computing taxable income • Items that require a cash flow but are not deducted for tax purposes are subtracted from current E&P – these items reduce E&P but not taxable income • Examples include: Federal income taxes. full amount of meals and entertainment expense. expenses incurred to earn tax exempt income. penalties. charitable contributions made in the current year over 10% of taxable income. lobbying costs . fines. current year net capital loss.

4) Adjustment of timing for deductions or income because of accounting methods required for E&P computation • Same accounting method must be used to compute taxable income and E&P • Some income or deduction items deferred for tax purposes must be included in computing E&P in the year the transaction occurs if the items result in economic outflow/inflow of cash .

positive accumulated E&P 4) Negative current E&P. negative accumulated E&P 3) Negative current E&P.Ordering of E&P Distributions • Whether a distribution will be considered a dividend depends on the balances in the Current and Accumulated E&P accounts – positive or negative • Four possibilities: 1) Positive Current E&P and Positive Accumulated E&P 2) Positive current E&P. negative accumulated E&P .

Ordering of Distributions • First. regardless of when distributions are actually made during the year • Distributions of property made during the year that exceed current E&P are next deemed to be paid out of accumulated E&P in chronological order . distributions out of Current E&P allocated pro rata to all distributions made that year (Distribution / total distributions). distributions are paid out of Current E&P – calculated on last day of the year before any distributions • If distributions exceed the balance in current E&P.

000 = 29.$16.000. 12/31 – $14.000.5% * 50.4% * 50.765 9/30: $20000/$68.000 $16. The following distributions were made during the year: 3/31 – $18.000.000 $14.000 = $11.000 = $14.6% * 50.000 or a total of $68. 9/30 – $20.000 = 20.Current E&P is prorated to each distribution: • • • • $18.5% * 50. 6/30 .235 6/30: $16000/$68.000 = $13.000 on on on on 3/31: $18000/$68. What is the order of the distributions and how much dividend income will be reported? .000 = 23.000 $20.000 and the balance in accumulated E&P is 3.706 12/31: $14000/$68.000.000 for the year.000 = 26.293 .000 = $10.1) Positive Current E&P and Positive Accumulated E&P • Assume the balance in Current E&P is 50.

000) will be a return of capital (nontaxable reduction of basis) .000 will all go toward the distribution on 3/31 – distributions from accumulated E&P are made in chronological order • Therefore the taxable dividend will be $53.000 – $53.000 = $15.000 and the remainder of the distribution ($68.1) Positive Current E&P and Positive Accumulated E&P • Accumulated E&P balance of $3.

2) Positive current E&P.000).000 .000 will be a nontaxable reduction of basis so Alpha’s basis in Beta’s stock becomes $20.000.000.000 and accumulated E&P ($15. any excess distribution will be a reduction of basis and any excess over basis will be treated as a capital gain -Assume current E&P is $50. Alpha’s basis in Beta stock is $30. Beta makes a distribution to Alpha of $60. -$50.000 will be a taxable dividend and the remaining $10. negative accumulated E&P • Distributions out of current E&P will be taxable dividends.

000 .000) = ($14.3) Negative current E&P.000 • Prorated current period E&P deficit: -Days from 1/1 to 4/1 = 90 -90/365 x ($60.795 = $135. positive accumulated E&P • Negative current E&P is prorated to the distribution date (excluding the distribution date itself) and subtracted from beginning accumulated E&P • Distribution is deemed to be paid out of E&P (a dividend) to the extent that the number above is positive – any excess is a reduction of tax basis and excess over basis is a capital gain • Assume beginning accumulated E&P is $150.205 dividend.795) -Accumulated E&P on 4/1 = $150. $6.000.795 return of capital . Current E&P is ($60.205 -$135.$14.000) And a distribution was made on April 1st of $142.

000 was made to a shareholder who had a basis in the stock of $40. .000). negative accumulated E&P • Distribution will not be considered a dividend • Distributions up to the shareholder’s tax basis in the stock will be nontaxable returns of capital and any excess distribution over basis will be treated as a capital gain • Assume current E&P is ($20.000.000.4) Negative current E&P. • Therefore the basis will be reduced to $0 and the shareholder will have a capital gain of $10.000) and accumulated E&P had a beginning balance of ($35. A distribution of $50.

Distributions of Noncash Property to Shareholders .

000 and the fair market value on distribution date was $100. Therefore.Distributions of Noncash Property to Shareholders • Shareholder’s tax basis in noncash property received is the property’s fair market value at distribution date • Tax Consequences: A corporation recognizes taxable gains on distributions of noncash property as dividends but does not deduct losses on such distributions .000 dividend.000. Beta pays tax on a $20. .000 gain and Alpha pays tax on a $100. Beta’s tax basis in the building was $80.Gain is recognized to the extent of fair market value in excess of tax basis in the property Example: Beta corporation distributed a building to its shareholder Alpha as a dividend.

Example: Beta corporation distributed a building to its shareholder Alpha as a dividend. The building had a fair market value of $100.Distributions of Noncash Property to Shareholders • Liabilities .000 – $40. the fair market value is deemed to be the liability assumed by the shareholder .000.000 and a mortgage of $120.000 gain .If the property’s fair market value is less than liabilities assumed by the shareholder. or $120. Beta’s basis in the building is $40. Thus. the gain Beta will realize on the dividend is the liability assumed less basis.000 = $80.000 that Alpha will assume.

Effect of noncash property distributions on E&P .

Effect of noncash property distributions on E&P • Gain recognized on a dividend distribution of appreciated property increases current E&P – it is taxable income • E&P then reduced by fair market value of property distributed less liabilities assumed by shareholder on property received • -Example: Beta corporation distributes a building with a FMV of $120.000 and an adjusted basis of $105.000 to Alpha.000 mortgage on the land. Beta’s E&P before considering this distribution is $110. . Alpha assumes a $25.000 and tax rate is 35%.

000 (FMV) less $25.100 tax on gain (15.000 (liability assumed)] -E&P balance is = $110.$15.000 recognized gain ($120.000 (basis))on the distribution .000 gain recognized -Decreases by $5.000 (FMV) less $25.000 dividend distribution [$120.000 * 34%) .000 = $24.000 (liability assumed) -Basis in land is $120.000 (FMV) .000($120.Effect of noncash property distributions on E&P • What are the tax consequences to shareholder and corporation? -Alpha: -Dividend is $95.Beta: .900 .Decreases by $95.000 (FMV) less $105.E&P effects: -Increases by $15.000 + $15.000 – $5100 -$95.

Stock Dividends • A stock dividend increases the number of shares outstanding and reduces the price per share (ex: own 100 shares with basis of $1000. so $10/ share. • Stock dividends are nontaxable to shareholders (since no increase in value) if two conditions are met: • Made with respect to common stock and • Pro rata (proportionate interests maintained by all shareholders) . After a 5% stock dividend own 105 shares with basis of $1000 or $9.52/share) • Stock dividends can also take the form of a stock split (ex: 2-for-1 stock split).

000 basis.Stock Dividends • Example: Corporation ABC has 100 shares outstanding. Alpha’s basis is $20. Alpha owns 60 shares and Beta owns 40 shares.000 basis and Beta has 80 shares with an $8. . This is non taxable since the stock dividend was made equally to the shareholders and the ownership value did not change (like breaking a $20 bill into 2 $10 bills) .000 and Beta’s basis is $8000. Corporation ABC declares a 2 for 1 stock dividend.Now Alpha has 120 shares with a $20.

shareholder’s ownership percentage increased so can be taxed on the increase in value .Taxable Stock Dividends • Non-pro rata stock dividends usually are taxable as dividends to the extent of distributing corporation’s E&P – now.

000.Stock Redemption • A stock redemption occurs when a corporation buys back its stock from a shareholder in exchange for property (done to increase stock value and Earnings per Share) • Shareholder’s gain or loss on the exchange is amount realized (cash plus noncash property received) less tax basis of stock • Form of Redemption: A redemption results in either a dividend or a sale of the redeemed shares • Individuals prefer exchange treatment because of the preferential tax rates for capital gains – if a distribution is in the form of an exchange (stock redemption) then shareholder will pay less tax: Example – Corporation redeems stock for $10. Shareholder’s basis in the stock is $7.000.000 instead of paying tax on a $10.000 dividend • Corporate shareholders prefer dividend treatment because of the dividends received deduction. So now the shareholder will be taxed on a capital gain of $3. .

a dividend? • Three types of redemptions are treated as exchanges: 1) Redemptions that are Substantially Disproportionate with respect to the shareholder are treated as sales 2) Redemptions in Complete Redemption of all of the Stock of the Corporation Owned by the Shareholder 3) Redemptions that are not Essentially Equivalent to a Dividend .When is a stock redemption treated as an exchange vs.

So the 40 percent ownership must drop to less than 32% (80% x 40% = 32%). .Example: Shareholder owns 40 of the corporation’s 100 shares of voting common stock. To treat the redemption as an exchange: 1) After the redemption the shareholder must own less than 50% of the outstanding shares 2) Percentage ownership after the redemption must be less than 80 percent of the percentage ownership before the redemption.1) Redemptions that are Substantially Disproportionate with respect to the shareholder • Stock ownership tests (bright line tests)are required for treatment as substantially disproportionate: • Shareholder does not control the corporation after the exchange (less than 50 percent of voting power) • Shareholder’s percentage of voting stock and aggregate value is less than 80 percent of the percentage before the redemption .

The shareholder is deemed to own (100+ (75% * 200)) or 250 shares. For example: A shareholder owns 100 shares of ABC corporation stock and is a 75% partner in a partnership that owns 200 shares of ABC stock. • Option attribution – anyone having an option to buy stock is considered to own those shares that the option entitles the person to buy . • Family attribution. children.a shareholder is considered to own any stock owned by their spouse. Shareholders own a pro rata share of corporation’s stock holdings if they own at least 50% of the corporation’s stock. • Attribution from owners or beneficiaries to entities – Entities own stock owned by their owners or beneficiaries – partnership owns 100% of shares owned by its partners and corporations own 100% of shares owned by its shareholders if the shareholder owns at least 50% of the corporate stock. parents and grandparents • Attribution from entities to owners or beneficiaries –owners or beneficiaries are considered to own any stock the entity itself owns (if a partnership owns stock. This prevents shareholders from giving shares of their stock to family members or related entities in order to meet the 50% and 80% tests and avoid having stock redemptions recharacterized as dividends.Constructive Ownership • Constructive ownership rules must be considered when determining if the 50% and 80% ownership tests are met. a 50% partner would own 50% of the stock).