South-Western Federal Taxation, 2009 Edition

Comprehensive Volume
ISBN: 0324660529

Chapter 19
Corporations: Distributions Not in Complete Liquidation
Accumulated earnings and profits. Net undistributed tax-basis earnings of a corporation aggregated from
March 1, 1913, to the end of the prior tax year. Used to determine the amount of dividend income associated
with a distribution to shareholders. 316 and Reg. 1.3162.
Attribution. Under certain circumstances, the tax law applies attribution (constructive ownership) rules to
assign to one taxpayer the ownership interest of another taxpayer. If, for example, the stock of Gold Corporation
is held 60 percent by Marsha and 40 percent by Sidney, Marsha may be deemed to own 100 percent of Gold
Corporation if Marsha and Sidney are mother and son. In that case, the stock owned by Sidney is attributed to
Marsha. Stated differently, Marsha has a 60 percent direct and a 40 percent indirect interest in Gold
Corporation. It can also be said that Marsha is the constructive owner of Sidneys interest.
Complete termination redemption. Sale or exchange treatment is available relative to this type of redemption.
The shareholder must retire all of his or her outstanding shares in the corporation (ignoring family attribution
rules), and cannot hold an interest, other than that of a creditor, for the 10 years following the redemption.
302(b)(3).
Constructive dividend. A taxable benefit derived by a shareholder from his or her corporation that is not
actually called a dividend. Examples include unreasonable compensation, excessive rent payments, bargain
purchases of corporate property, and shareholder use of corporate property. Constructive dividends generally are
found in closely held corporations.
Current earnings and profits. Net tax-basis earnings of a corporation aggregated during the current tax year. A
corporate distribution is deemed to be first from the entitys current earnings and profits and then from
accumulated earnings and profits. Shareholders recognize dividend income to the extent of the earnings and
profits of the corporation. A dividend results to the extent of current earnings and profits, even if there is a larger
negative balance in accumulated earnings and profits.
Disproportionate redemption. Sale or exchange treatment is available relative to this type of redemption.
After the exchange, the shareholder owns less than 80 percent of his or her preredemption interest in the
corporation, and only a minority interest in the entity. 302(b)(2).
Earnings and profits (E & P). Measures the economic capacity of a corporation to make a distribution to
shareholders that is not a return of capital. Such a distribution results in dividend income to the shareholders to
the extent of the corporations current and accumulated earnings and profits.
Meaningful reduction test. A decrease in the shareholders voting control. Used to determine whether a
redemption qualifies for sale or exchange treatment.
Not essentially equivalent redemption. Sale or exchange treatment is given to this type of redemption.
Although various safe-harbor tests are failed, the nature of the redemption is such that dividend treatment is
avoided, because it represents a meaningful reduction in the shareholders interest in the corporation. 302(b)
(1).

Property dividend. Generally treated in the same manner as a cash distribution, measured by the fair market
value of the property on the date of distribution. The portion of the distribution representing E & P is a
dividend; any excess is treated as a return of capital. Distribution of appreciated property causes the distributing
corporation to recognize gain. The distributing corporation does not recognize loss on property that has
depreciated in value.
Qualified dividends. Distributions made by domestic (and certain non-U.S.) corporations to noncorporate
shareholders that are subject to tax at the same rates as those applicable to net long-term capital gains (15
percent and 5 percent). The dividends must be paid out of earnings and profits, and the shareholders must meet
certain holding period requirements as to the stock. Qualified dividend treatment applies to distributions made
after 2002 and before 2011. 1(h)(1) and (11).
Redemption to pay death taxes. Sale or exchange treatment is available relative to this type of redemption, to
the extent of the proceeds up to the total amount paid by the estate or heir for death taxes and administration
expenses. The stock value must exceed 35 percent of the value of the decedents adjusted gross estate. In
meeting this test, one can combine shareholdings in corporations where the decedent held at least 20 percent of
the outstanding shares.
Stock dividend. Not taxable if pro rata distributions of stock or stock rights on common stock. Section 305
governs the taxability of stock dividends and sets out five exceptions to the general rule that stock dividends are
nontaxable.
Stock redemption. A corporation buys back its own stock from a specified shareholder. Typically, the
corporation recognizes any realized gain on the noncash assets that it uses to effect a redemption, and the
shareholder obtains a capital gain or loss upon receipt of the purchase price.
Stock rights. Assets that convey to the holder the power to purchase corporate stock at a specified price, often
for a limited period of time. Stock rights received may be taxed as a distribution of earnings and profits. After
the right is exercised, the basis of the acquired share includes the investors purchase price or gross income, if
any, to obtain the right. Disposition of the right also is a taxable event, with basis often assigned from the shares
held prior to the issuance of the right.
Unreasonable compensation. A deduction is allowed for reasonable salaries or other compensation for
personal services actually rendered. To the extent compensation is excessive (unreasonable), no deduction
is allowed. The problem of unreasonable compensation usually is limited to closely held corporations, where the
motivation is to pay out profits in some form that is deductible to the corporation. Deductible compensation
therefore becomes an attractive substitute for nondeductible dividends when the shareholders also are employed
by the corporation.