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Chapter 18

Corporate Taxation: Nonliquidating


Distributions

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Learning Objectives

1.

Explain how distributions from a corporation are taxed


to a shareholder

2.

Compute earnings and profits to determine


shareholder dividend income and stock basis

3.

Describe constructive dividends

4.

Explain tax treatment of stock dividends

5.

Describe the tax treatment of stock redemptions

6.

Contrast partial liquidations with stock redemptions

18-2

How do companies distribute after-tax


earnings to shareholders?

The company can distribute its after-tax profits to


its shareholders in the form of

Dividends

Stock redemption

Partial liquidation

When distributions from corporations are taxed to


shareholders, this creates double taxation of
corporate income.
18-3

Taxes for Property Distributions

Some payments to shareholders are deductible by the


corporation

Examples are payments for services (salary), interest,


and rent

To be deductible, payments to shareholders must be


reasonable in amount

Unreasonable payments (e.g., excessive salary) are


taxed as constructive dividends to shareholders.

18-4

Dividend distribution

What constitutes dividends?

A dividend is any distribution of property made by a


corporation to its shareholders out of its earnings and
profits (E&P) account.

E&P

A measure of the corporation's economic earnings


available for distribution to its shareholders.
Not retained earnings in GAAP

18-5

Dividend distribution

How to calculate dividends (at corporation level)?

Distributions are dividends up to the balance of current E&P.


Dividends in excess of current E&P are dividends up to the balance
in accumulated E&P (on LIFO basis)
Distribution in excess of both current and accumulated E&P is
return of capital
3. Current E&P
(Dividend)

Shareholders

2. Accumulated
E&P(Dividend)
1.Shareholders basis
(return of capital)
18-6

Dividend distribution

How to characterize distribution at shareholder


level?
1.

2.

3.

The portion of the distribution that is a dividend is


included in the gross income of the shareholder.
The portion of the distribution in excess of total E&P
reduces the shareholder's tax basis in the corporation's
stock and is non-taxable (i.e., it is a return of capital).
The portion of the distribution that is in excess of the
shareholder's stock tax basis is treated as gain from
sale or exchange of the stock (capital gain).

18-7

Example 18-1
Jim has a tax basis in his Spartan Cycles and Repair (SCR)
stock of $24,000. Ginny's tax basis in her SCR stock is
$10,000. Assume SCR has current earnings and profits
(CE&P) of $30,000, and no accumulated earnings and
profits. At year-end, SCR makes a $48,000 distribution to
Jim and a $16,000 distribution to Ginny. Jim owns 75
percent of the SCR stock, while Ginny owns the remaining
25 percent.
What is the tax treatment of the distribution to Jim and
Ginny? What is Jim and Ginny's tax basis in their SCR
stock after the distribution?

18-8

Compute E&P

E&P represents a companys economic value, so it is


neither taxable income nor book income

Taxable income-the income that companies pay taxes on


Book income-the income that companies report in financial
statements
E&P-the economic income that decides the tax treatment for
shareholder distribution

Computing Earnings and Profits

Begins with taxable income and make adjustments according


to the law

18-9

18-10

18-11

Example
Oakland Corporation reported a net operating
loss of $500,000 in 2013 and elected to carry
the loss forward to 2014. Not included in the
computation was a disallowed meals and
entertainment expense of $20,000, tax-exempt
income of $10,000, and deferred gain on an
installment sale of $250,000. The corporation's
current earnings and profits for 2013 would be?
12

18-12

Determining the Dividend

Ordering of E&P Distributions

Positive Current E&P and Positive Accumulated E&P

Positive current E&P, negative accumulated E&P

Negative current E&P, positive accumulated E&P

Negative current E&P, negative accumulated E&P

18-13

Ordering of E&P Distributions

Positive Current E&P and Positive Accumulated


E&P

Distribution first comes out of current E&P, then comes


out of accumulated E&P (on a LIFO basis)
To the extent that distribution is less than total E&P,
distribution is characterized as dividends

When there are multiple shareholders, dividends are allocated


on a pro-rata basis

If distribution is more than total E&P, distribution is


characterized as return of capital

When there are multiple shareholders, dividends are allocated


on a pro-rata basis
18-14

Ordering of E&P Distributions

Positive Current E&P and Negative Accumulated


E&P

Distribution only comes out of current E&P. No


distribution comes out of accumulated E&P.
Distributions in excess of current E&P in this scenario
would first be treated as nontaxable reductions in the
shareholders' tax basis in their stock.
Any excess received over their stock basis would be
treated as a (capital) gain from sale of the stock.

18-15

Example 18-4/5
On December 31, SCR distributed $48,000 to Jim and
$16,000 to Ginny. Jim has a tax basis in his SCR
stock of $24,000. Ginny's tax basis in her SCR stock
is $10,000. Jim has 75% ownership and Ginny has
25% ownership.
Calculate dividend income and tax basis for each
shareholder when 1) When SCR reported current E&P of
$40,000. The balance in accumulated E&P at the beginning
of the year was $16,000; 2) When SCR reported current E&P
of $60,000. The balance in accumulated E&P at the
beginning of the year was negative $20,000;
18-16

Ordering of E&P Distributions

Negative Current E&P and Positive Accumulated


E&P

When current E&P is negative, the tax status of a


dividend is determined by total E&P on the date of the
distribution.
Prorate the negative current E&P to the distribution date
and add it to accumulated E&P at the beginning of the
year to determine total E&P at the distribution date.

E&P available for dividend at the time of distribution =


Accumulated E&P + Current E&P*(# of months until
distribution/12-month)
18-17

Ordering of E&P Distributions

Negative Current E&P and Negative Accumulated


E&P

No dividend recognized
Reduce shareholders tax basis in their stocks

18-18

Example 18-6/7
On June 30, SCR distributed $48,000 to Jim and $16,000
to Ginny. Jim has a tax basis in his SCR stock of $24,000.
Ginny's tax basis in her SCR stock is $10,000. Jim has
75% ownership and Ginny has 25% ownership.
Calculate dividend income and tax basis for each
shareholder when 1) SCR reported current E&P of negative
$20,000. The balance in accumulated E&P at the beginning
of the year was $60,000. 2) SCR reported current E&P of
negative $50,000. The balance in accumulated E&P at the
beginning of the year was negative $60,000.
18-19

Determining the Dividend for Shareholders

Distributions of Noncash Property to


Shareholders
Dividend income:

Tax basis = FMV of property

18-20

Example 18-10
Assume Jim elected to receive a parcel of land the
company had previously purchased for possible expansion
instead of cash. The land has a fair market value of
$60,000 and a remaining mortgage of $12,000 attached to
it. SCR has a tax basis in the land of $20,000. Jim will
assume the mortgage on the land. SCR has current E&P of
$100,000 and no accumulated E&P. How much dividend
income does Jim recognize on the distribution? What is
Jim's tax basis in the land he receives?

18-21

Determining the Dividend for Corporations

Tax Consequences to a Corporation Paying Noncash


Property as a Dividend
For corporations:
Step 1: recognize gains (but not losses) from property
distribution;
Step 2: as the property is distributed to shareholders,
reduce E&P of the corporation by:

If the property appreciates (FMV>taxable basis), E&P is


reduced by the propertys FMV and increased by the liability
assumed by shareholders;
If the property depreciates (FMV<taxable basis), E&P is
reduced by the propertys E&P basis and increased by the
liability assumed by shareholders.
18-22

Determining the Dividend

Liabilities assumed by shareholders


If the liability assumed is more than the property's fair
market value, the fair market value is equal to the
liability and gain recognized is the excess of the
propertys assume liability over its tax basis.
If the liability assumed is less than the property's fair
market value, the gain recognized on the distribution is
the excess of the property's fair market value over its
tax basis (i.e., the liability is ignored).

18-23

Example
Assume Bill Hotdog has current and accumulated E&P of
400,000 at December 1, 2013. On December 31, the
company made a distribution of office building to its sole
shareholder, Bill. Calculate the tax consequences for Bill
Hotdog (gain recognized and E&P)
1) The office building's fair market value was $150,000
and its tax and E&P basis was $100,000. 1a) Bill
assumed a liability of $25,000 attached to the office
building; 1b) What if Bill assumed the liability of
200,000;
2) The office building's fair market value was $50,000 and
its tax and E&P basis was $100,000. Bill assumed a
liability of $25,000 attached to the office building;
18-24

Constructive Dividends

Dividends are distributed from after-tax earnings. There is


a double taxation issue:

First level, corporate income tax


Second level, individual income tax

To avoid double taxation, corporations might make


payments to shareholders as tax deductible expenses
such as salary, bonus, interest or rents

18-25

Constructive Dividends

The IRS can recharacterize what the corporation calls a


deductible payment (e.g., compensation) into a
nondeductible constructive dividend distribution.

Unreasonable compensation paid to shareholder/employees.


Bargain sales of property by the corporation to shareholders.
Bargain lease or uncompensated use of corporate property by a
shareholder.
Excess purchase/lease price paid to a shareholder/lessor by the
corporation.
Payments to a shareholder/creditor where the loan has
unreasonable terms or below market rate of interest.
Corporate payments on a shareholders behalf (e.g., legal fees
paid to defend a shareholder of criminal charges).
18-26

Stock Dividends
Distribute

additional shares to shareholders


A stock dividend increases the number of shares
outstanding and reduces the price per share
Stock dividends can also take the form of a stock
split (e.g., 2-for-1 stock split).
Basis of stock after stock dividends

New basis per share =

18-27

Stock Dividends

Stock dividends are nontaxable to shareholders


if two conditions are met:

Made with respect to common stock, and


Pro rata with respect to all shareholders (the stock
dividends are proportional to shareholders equity
positions)
Non-pro rata stock dividends are included in the
shareholders gross income as taxable dividends
to the extent of the distributing companys E&P
E.g., a special stock dividend to certain stock
owners
18-28

Example
Sweetwater Corporation declared a stock dividend to all
common stock shareholders of record on December 31,
2013. Shareholders will receive 1 share of Sweetwater
common stock for each 5 shares of common stock they
already own. Pierre Dorgan owns 500 shares of
Sweetwater common stock with a tax basis of $150 per
share. The fair market value of the Sweetwater common
stock was $90 per share on December 31. What is Pierre's
income tax basis in his new and existing common stock in
Sweetwater, assuming the distribution is non-taxable?

18-29

Stock Redemptions (Stock buyback)

Form of a Stock Redemption

A redemption occurs when a corporation acquires its


stock from a shareholder in exchange for property (cash
or noncash property)

Pay cash or noncash


property

Shareholders

Corporation
Buy back stocks

18-30

Stock Redemptions (Stock buyback)

Compare tax treatment for stock redemption


(exchange) and dividend distribution

Exchange: shareholders compute gain or loss as


(Amount realized - Tax basis in the stock exchanged)

Dividend: shareholders recognize distribution as


dividend to the extent of E&P

The tax preference for individual and corporate


shareholders

Individuals prefer exchange (lower taxable amount)


Corporations prefer dividend (DRD deduction)

18-31

Stock Redemptions (substantially


disproportionate rule)

To qualify stock redemptions, shareholders need


to meet the following three requirements:
1.

2.

3.

Immediately after the exchange, the shareholder owns


less than 50 percent of the total combined voting power
of all classes of stock entitled to vote.
The shareholder's percentage ownership of voting
stock after the redemption is less than 80 percent of his
or her percentage ownership before the redemption.
The shareholder's percentage ownership of the
aggregate fair market value of the corporation's
common stock (voting and nonvoting) after the
redemption is less than 80 percent of his or her
percentage ownership before the redemption.
18-32

Stock Redemptions (substantially


disproportionate rule)
If

the substantial disproportionate rule is met,


the transaction is treated as a stock
redemption.

Shareholders recognize capital gains


Carryover old basis to determine capital gains

If

the substantial disproportionate rule test


fails, the transaction is treated as a dividend
distribution.

Shareholders recognize dividend


Shareholders basis in their redeemed shares is
transferred to their remaining shares
18-33

Example 18-17
Assume Walk owns 25 shares out of 125
shares that SCR issues. This year, SCR
redeemed five shares of his stock in
exchange for $25,000. Walt has a tax basis
in the five shares of SCR stock of $10,000
($2,000 per share). Is this qualified for stock
redemption? How much dividend or capital
gain should Walk recognize? If not, how
many shares does SCR need to redeem to
be qualified?
18-34

Stock Redemptions

Thus far, we have assumed shareholders acting


independently
But if shareholders are related and share similar
economic interests, the tax law treats them on an
aggregated basis.
Constructive ownership rules exist to prevent
shareholders from opportunistically dispersing
stock ownership to avoid dividend treatment

18-35

Stock Redemptions

Family attribution

Individuals are treated as owning the shares of stock


owned by their spouse, children, grandchildren, and
parents.
Not applicable to brothers and sisters
No double family attribution

Eg. Suppose that Josh and Jane are a couple. If the family
attribution applies to Josh, then Jane does not need to apply
the family rule again.

18-36

Example
Crystal, Inc. is owned equally by John and his wife Arlene,
each of whom own 500 shares in the company. Arlene
wants to reduce her ownership in the company, and it was
decided that the company will redeem 200 of her shares for
$5,000 per share on December 31, 2013. Arlene's income
tax basis in each share is $1,000. Crystal has current E&P
of $1,000,000 and accumulated E&P of $3,000,000. What
is the amount and character (capital gain or dividend)
recognized by Arlene as a result of the stock redemption,
assuming only the "substantially disproportionate with
respect to the shareholder" test is applied? What is her tax
basis in the remaining shares?
18-37

Stock Redemptions

Complete Redemptions

An exception to the family attribution rule when shareholders


completely redeem their shares
Requirements (Trip i agreements):

Shareholders cannot have an interest in the corporation immediately


after the exchange as a shareholder, employee, director, officer or
consultant (referred to as prohibited interests).
Shareholder cannot acquire a prohibited interest within 10 years after
redemption, unless by inheritance.
Shareholder must notify the IRS within 30 days if they acquire a
prohibited interest within 10 years after the redemption.

18-38

Tax Consequences to the


Distributing Corporation

How does the distributing corporation reduce its


E&P as a result of the distribution?

If the distribution is dividend, the company reduces its


E&P by cash distributed and FMV of property
If the distribution is exchange, the company reduces the
lesser of 1) total E&P*ownership%, or 2) FMV of
property or cash

18-39

Partial Liquidations

In the case of a sale, the corporation may


distribute the proceeds from the sale to its
shareholders in partial liquidation of their
ownership interests.
The tax treatment depends on the identify of the
shareholder receiving the distribution

Noncorporate shareholders receive exchange treatment.


Corporate shareholders determine their tax
consequences using the change-in-stock ownership
rules that apply to stock redemptions.

Usually dividend treatment

18-40

homework
34,

35, 36, 37, 39, 45 c), 48, 51 a), 53 a)

18-41