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

updated: August 8, 2011

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

25.

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 Corporations 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, Roberts stock basis is $0. pp. 5-4, 5-9, and Examples 1 and 6 Sparrow Corporations current E & P is computed as follows: Taxable income Federal income tax liability Interest income from tax-exempts Disallowed portion of meals and entertainment expenses Life insurance premiums paid, net of increase in cash surrender value ($3,500 $700) Proceeds from life insurance policy, net of cash surrender value ($130,000 $20,000) Excess capital losses Excess of MACRS depreciation over E & P depreciation ($26,000 $16,000) Allowable portion of 2010 179 expenses (20% $100,000) Organizational expense amortization Dividends received deduction (70% $25,000) LIFO recapture adjustment Installment sale gain Current E & P *($14,000 organizational expenses/180 months) 12 months **[($40,000 sales price $32,000 adjusted basis)/$40,000 sales price] $15,000 Concept Summary 5.1 $330,000 (112,000) 5,000 (1,500) (2,800) 110,000 (13,000) 10,000 (20,000) 933* 17,500 10,000 (3,000)** $331,133

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28. a. b. c. d. e. f. g. h. i.

Taxable Income Increase (Decrease) $20,000 ($36,000) No effect $9,000 ($60,000) ($60,000) No effect ($90,000) No effect

E & P Increase (Decrease) No effect $33,900* $140,000 $21,000** $60,000 $48,000*** ($12,000) ($10,000) ($50,000)

*Although mining exploration costs are deductible in full under the income tax, they are amortized over 120 months when computing E & P. Since $300 per month is amortizable ($36,000/120 months), $2,100 is currently deductible for E & P purposes ($300 7 months). Thus, of the $36,000 income tax deduction, $33,900 is added back to E & P ($36,000 $2,100 deduction allowed). **The receipt of a $30,000 dividend generates a dividends received deduction of $21,000 with a net effect on taxable income of a $9,000 increase. For E & P purposes, the dividends received deduction is added back. ***Only 20% of current-year 179 expense is allowed for E & P purposes. Thus, 80% of the amount deducted for income tax purposes is added back. In each of the four succeeding years, 20% of the 179 expense is allowed as a deduction for E & P purposes.

ADS straight-line depreciation is allowed for E & P purposes; thus, E & P is decreased by $10,000 (the excess of ADS depreciation over the amount allowed under MACRS).

Concept Summary 5.1 30. Dividend income is $100,000, tax-free recovery of basis is $40,000, and capital gain is $60,000. To determine the amount of dividend income, the balances of both accumulated and current E & P as of June 30 must be netted because of the deficit in current E & P. As one-half of the loss (or $230,000) is deemed to have occurred on June 30, the $330,000 in accumulated E & P is reduced by $230,000. The $100,000 balance in E & P triggers dividend income. The remaining $100,000 of the distribution is recovery of capital, reducing basis to zero and then triggering capital gain. Example 11 Cardinal Corporation has no accumulated E & P at the time of the distribution. The shareholder has a taxable dividend equal to the current E & P determined at year-end, which was $80,000. The balance of the distribution, $40,000, reduces the shareholders basis in the stock, and any excess over basis results in capital gain. pp. 5-8 to 5-10 a. Bunting Corporation and Jennifer each have a taxable dividend of $30,000. Sparrow Corporations current E & P is $65,000; thus, the entire distribution is a taxable dividend even though Sparrow has no accumulated E & P. Assuming the taxable income limitation does not apply, Bunting Corporation is entitled to a dividends received deduction of $24,000 (80% $30,000). Thus, Bunting is only taxed on $6,000 ($30,000 distribution $24,000 dividends received deduction). Because Jennifer is an individual, she pays tax on the entire dividend, subject to the preferential 15%/0% tax rates if the dividend is qualifying. To determine Sparrow Corporations accumulated E & P at the end of the year, its current E & P ($65,000) is reduced by the amount of the distributions ($60,000). The remaining $5,000 is then netted against the deficit in accumulated E & P of $150,000, leaving a net deficit of $145,000.

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pp. 5-8 to 5-11 34. a. b. Dividend Income $ 70,000 $140,000 Return of Capital $60,000 $70,000

Taxed to the extent of current E & P. Accumulated E & P and current E & P netted on the date of distribution. Taxed to the extent of current and accumulated E & P. Accumulated E & P and current E & P are netted on the date of distribution. There is a dividend to the extent of any positive balance. When the result in current E & P is a deficit for the year, the deficit is allocated on a pro rata basis to distributions made during the year. On June 30, E & P is $100,000 [current E & P is a deficit of $20,000 (i.e., 1/2 of $40,000) netted with accumulated E & P of $120,000].

c. d.

$150,000 $ 80,000

$50,000

e.

$100,000

$30,000

pp. 5-8 to 5-10 37. The $1,000 dividend will be taxed to Judy as ordinary income. 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, the dividend does not qualify for the preferential 15%/0% tax rates. Example 12 a. Silver recognizes a gain on the distribution of the land to Heather. The amount of the gain is $12,000 ($54,000 fair market value $42,000 adjusted basis). Since Silvers gain increases its E & P, it will have $12,000 of current E & P and $76,000 of accumulated E & P available to apply to the distribution. The entire value of the land ($54,000) is a dividend to Heather, leaving $34,000 of accumulated E & P ($88,000 total E & P at yearend $54,000 distribution) as the beginning balance for next year. Heathers basis in the land is its fair market value ($54,000). The distribution triggers $12,000 of gain to Silver and creates $12,000 of current E & P. Consequently, the distribution generates a $12,000 dividend to Heather (to the extent of current E & P). The remaining $42,000 of the value of the land decreases Heathers stock basis from $56,000 to $14,000 and is a tax-free recovery of capital. Heathers basis in the land is $54,000. Silver recognizes $12,000 of gain and increases current E & P by $12,000, as a result of the distribution of appreciated land. The amount deemed distributed is the fair market value of the land, net of the mortgage, or $8,000 ($54,000 fair market value $46,000 mortgage). Since there is $12,000 of current E & P and $76,000 of accumulated E & P, the entire $8,000 distribution is taxed as a dividend. Current E & P is reduced by the $8,000 distribution, leaving accumulated E & P with a beginning balance for the following year of $80,000 ($76,000 accumulated E & P + $12,000 current E & P $8,000 distribution). Heathers basis in the land is its fair market value ($54,000). While Silver realizes an $8,000 loss, none of the loss is recognized on the distribution. Heather receives a $54,000 dividend and she takes a basis of $54,000 in the land. Silver has accumulated E & P at the beginning of the following year of $14,000 [$76,000 accumulated E & P $62,000 (greater of $62,000 adjusted basis of the land or $54,000 fair market value)]. Silver recognizes gain on the distribution of $12,800 for income tax purposes ($14,000 fair market value $1,200 adjusted basis for income tax purposes). Current E & P is increased to $8,800 ($14,000 fair market value $5,200 adjusted basis for E & P). Heather receives a $14,000 dividend and takes a $14,000 basis in the furniture. Silvers E & P is reduced by $14,000, leaving $70,800 of accumulated E & P at the start of the

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following year ($76,000 accumulated E & P + $8,800 current E & P $14,000 distribution). pp. 5-13 to 5-15 40. Michael has a taxable dividend of $170,000 [$300,000 (fair market value of the land) $130,000 (liability assumed)]. Michaels basis in the land is $300,000. Green Corporation does not recognize a loss on the distribution, but the distribution reduces its E & P account by $210,000 [$340,000 (adjusted basis of the land) $130,000 (liability assumed by Michael)]. pp. 5-13 to 515 Holly has a $65,000 taxable dividend and a $65,000 basis in the land. Penguin Corporation does not recognize a loss on the distribution and its E & P is reduced by $80,000. pp. 5-13 to 5-15 a. The result of this transaction is a realized loss of $50,000 (the difference between basis of $350,000 and fair market value of $300,000) and a constructive dividend of $25,000 (the difference between the $300,000 fair market value and the $275,000 paid for the office building). Due to the application of 267, Parrot cannot recognize the realized loss but it does reduce E & P. The constructive dividend also reduces E & P. Thus, E & P is reduced by $75,000 (the sum of the $50,000 disallowed loss and the $25,000 constructive dividend). The loan to Jerry generates imputed interest since no interest was charged. The amount of imputed interest is $13,125 ($250,000 7% 3/4 year) and that amount is deemed paid as interest to the corporation. The deductibility of the interest by Jerry depends on how the loan proceeds are used. Parrot has taxable interest income of $13,125 and is deemed to pay a dividend to Jerry equal to the amount of interest. Parrots E & P is increased by the amount of interest income and reduced by the amount of deemed dividend payment. Bargain rentals create constructive dividends to shareholders. In the present case, the amount of constructive dividends to both Tom and Jerry equals the fair rental value of the airplane. Thus, Tom has $42,000 (120 hours $350 hourly rental rate) of dividend income and Jerry has dividend income of $56,000 (160 hours $350 hourly rental rate). Parrots E & P is reduced by the same amounts. The $11,000 excess amount ($20,000 $9,000) paid to Tom by Parrot over the fair rental value of the equipment is treated as a constructive dividend taxable to Tom and reduces Parrots E & P.

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47.

b.

c.

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pp. 5-15 to 5-18 48. Because the distribution of preferred stock is taxable to Katie, her basis in the newly acquired shares is equal to its fair market value of $40,000. The holding period of the preferred stock begins on the date of receipt. p. 5-19 a. If Ivana were paid a bonus, she would receive $10,800 after tax [$15,000 bonus ($15,000 28% tax rate)]. If she received a dividend, she would receive $12,750 after tax [$15,000 dividend ($15,000 15% tax rate)]. Thus, she would be $1,950 better off ($12,750 $10,800) with a dividend. If Robin Corporation paid Ivana a $15,000 bonus, it would receive a deduction for the payment. This would reduce Robins tax liability. The net after-tax cost of the bonus would be $9,900 [$15,000 bonus $5,100 tax savings (34% tax rate $15,000)]. In contrast, a dividend payment is not deductible, so no taxes would be saved by Robin. The cost of the dividend would be $15,000. Therefore, Robin would be $5,100 [$15,000 (cost of a dividend) $9,900 (cost of a bonus)] better off if it paid a bonus. If Robin paid Ivana a $20,000 bonus, she would receive $14,400 after tax [$20,000 bonus ($20,000 28% tax rate)]. This would be better than receiving a $15,000 dividend, which would provide $12,750 after tax. A $20,000 bonus would cost Robin Corporation

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$13,200 after tax [$20,000 bonus (34% tax rate $20,000)]. This is less expensive than a nondeductible $15,000 dividend. d. Since both Robin Corporation and Ivana are better off with a $20,000 bonus than they are with a $15,000 dividend, the corporation should pay a bonus.

Examples 28 and 29