Chapter 4

Chapter 7Corporate DistributionsTypes of distributionsShareholders contribute cash to a corporation in exchange for ownership (in the form of stock) and the expectation of income distributionsDistributions to shareholders will be taxed as either:Dividends - taxed as part of shareholders gross incomeReturn of capital non dividend distribution that reduces the shareholders basis in corporate stockCapital gains non dividend distribution in excess of the shareholders basis in the corporate stock is treated as a capital gain as if the stock was sold

Tax Consequences of DistributionsIf 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 taxationIf 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 corporationWhat are examples of constructive dividends?Unreasonable compensation

Shareholder use of corporate assets without an arms-length payment

Interest paid to shareholder at excessive interest rates

Payments made by the corporation on behalf of a shareholder

- In a closely held corporation, sometimes makes sense to pay out earnings as tax deductible payments to avoid double taxation. But payroll taxes on compensation might make it less desirable.

What is a dividend?A distribution out of the Earnings & Profits (E&P) account (economic earnings available to be distributed to shareholders, in contrast to retained earnings which includes accounting income)E&P is an indicator of a corporations economic ability to pay dividendsCurrent E&P current year earnings and profitsAccumulated E&P Prior periods accumulated E&P Dividends are distributed up to the balance in the Current E&P account, excess distribution comes out of Accumulated E&P therefore distributions reduce E&P. 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, if no profit, distribution is a return of capital)Undistributed current E&P is added to accumulated E&P in the beginning of the next taxable year

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

ExampleAlpha is a 50% shareholder of Beta Corporation. Alphas tax basis in Betas stock is $25,000. Beta has a balance in its Current E&P account of $12,000 and its balance in the Accumulated E&P account is $8,000. Beta makes a distribution of $55,000 to Alpha. What is the tax treatment of the distribution?Out of the $60,000 distribution only $20,000 (the balance of current E&P + Accumulated E&P) can be treated as a dividendDividend = $20,000 * 50% share of Betas E&P = $10,000Now the next portion of the distribution is a reduction of capital and can reduce Alphas basis in Beta stock down to 0 (cannot go below 0)$25,000 is a return of capital, a non-taxable reduction of stock basisThe remainder of the distribution will be treated as a capital gain (deemed a sale)$20,000 is treated as a capital gainTotal distribution = $10,000 dividend + $25,000 return of capital + $20,000 capital gainAlphas basis in Beta stock is reduced to $0How to compute Current E&PStart with taxable income and make adjustments to arrive at current E&PSince E&P is supposed to represent economic income, a separate accounting system must be maintained to compute it4 categories of adjustments:1) Income that is excluded from taxable income2)Disallowed deductions that do not require an economic outflow but are deducted in computing taxable income3)Deduction of expenses that require an economic outflow but are not deducted for computing taxable income4) Adjustment of timing for deductions or income because of accounting methods required for E&P computation

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. Therefore it is added back to taxable income to arrive at E&P interest income from municipal bonds, tax exempt life insurance proceedsExample Balance in current E&P account = $20,000. Beta Corp also received life insurance proceeds of $2,000 and municipal bond interest income of $4,000. Assuming Beta distributes all of its current E&P, the total taxable dividend amount to its shareholders will be $20,000 + $2,000 $4,000 = $26,000

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.Dividends Received Deduction, Domestic Production Activities Deduction, NOL carryovers, net capital loss carryovers, charitable contribution carryovers3)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 incomeExamples include: Federal income taxes, expenses incurred to earn tax exempt income, charitable contributions made in the current year over 10% of taxable income, current year net capital loss, full amount of meals and entertainment expense, penalties, fines, lobbying costs4) 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&PSome 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

Ordering of E&P DistributionsWhether a distribution will be considered a dividend depends on the balances in the Current and Accumulated E&P accounts positive or negativeFour possibilities:1) Positive Current E&P and Positive Accumulated E&P

2) Positive current E&P, negative accumulated E&P

3) Negative current E&P, positive accumulated E&P

4) Negative current E&P, negative accumulated E&POrdering of DistributionsFirst, distributions are paid out of Current E&P calculated on last day of the year before any distributionsIf distributions exceed the balance in current E&P, distributions out of Current E&P allocated pro rata to all distributions made that year (Distribution / total distributions), regardless of when distributions are actually made during the yearDistributions 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 1) Positive Current E&P and Positive Accumulated E&PAssume the balance in Current E&P is 50,000 and the balance in accumulated E&P is 3,000. The following distributions were made during the year: 3/31 $18,000, 6/30 - $16,000, 9/30 $20,000, 12/31 $14,000 or a total of $68,000 for the year. What is the order of the distributions and how much dividend income will be reported?- Current E&P is prorated to each distribution:$18,000 on 3/31: $18000/$68,000 = 26.5% * 50,000 = $13,235$16,000 on 6/30: $16000/$68,000 = 23.5% * 50,000 = $11,765$20,000 on 9/30: $20000/$68,000 = 29.4% * 50,000 = $14,706 $14,000 on 12/31: $14000/$68,000 = 20.6% * 50,000 = $10,2931) Positive Current E&P and Positive Accumulated E&PAccumulated E&P balance of $3,000 will all go toward the distribution on 3/31 distributions from accumulated E&P are made in chronological orderTherefore the taxable dividend will be $53,000 and the remainder of the distribution ($68,000 $53,000 = $15,000) will be a return of capital (nontaxable reduction of basis)2) Positive current E&P, negative accumulated E&P

Distributions out of current E&P will be taxable dividends, 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 $50,000 and accumulated E&P ($15,000). Alphas basis in Beta stock is $30,000. Beta makes a distribution to Alpha of $60,000. -$50,000 will be a taxable dividend and the remaining $10,000 will be a nontaxable reduction of basis so Alphas basis in Betas stock becomes $20,0003) Negative current E&P, 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&PDistribution 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 gainAssume beginning accumulated E&P is $150,000, Current E&P is ($60,000)And a distribution was made on April 1st of $142,000Prorated current period E&P deficit:-Days from 1/1 to 4/1 = 90-90/365 x ($60,000) = ($14,795)-Accumulated E&P on 4/1 = $150,000 - $14,795 = $135,205-$135,205 dividend, $6,795 return of capital

4) Negative current E&P, negative accumulated E&P

Distribution will not be considered a dividendDistributions up to the shareholders tax basis in the stock will be nontaxable returns of capital and any excess distribution over basis will be treated as a capital gainAssume current E&P is ($20,000) and accumulated E&P had a beginning balance of ($35,000). A distribution of $50,000 was made to a shareholder who had a basis in the stock of $40,000.Therefore the basis will be reduced to $0 and the shareholder will have a capital gain of $10,000.Distributions of Noncash Property to Shareholders

Distributions of Noncash Property to Shareholders

Shareholders tax basis in noncash property received is the propertys fair market value at distribution dateTax Consequences: A corporation recognizes taxable gains on distributions of noncash property as dividends but does not deduct losses on such distributionsGain is recognized to the extent of fair market value in excess of tax basis in the propertyExample: Beta corporation distributed a building to its shareholder Alpha as a dividend. Betas tax basis in the building was $80,000 and the fair market value on distribution date was $100,000. Therefore, Beta pays tax on a $20,000 gain and Alpha pays tax on a $100,000 dividend.

Distributions of Noncash Property to Shareholders

Liabilities - If the propertys fair market value is less than liabilities assumed by the shareholder, the fair market value is deemed to be the liability assumed by the shareholder- Example: Beta corporation distributed a building to its shareholder Alpha as a dividend. The building had a fair market value of $100,000 and a mortgage of $120,000 that Alpha will assume. Betas basis in the building is $40,000. Thus, the gain Beta will realize on the dividend is the liability assumed less basis, or $120,000 $40,000 = $80,000 gain

Effect of noncash property distributions on E&P

Effect of noncash property distributions on E&PGain recognized on a dividend distribution of appreciated property increases current E&P it is taxable incomeE&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. Alpha assumes a $25,000 mortgage on the land. Betas E&P before considering this distribution is $110,000 and tax rate is 35%.

Effect of noncash property distributions on E&PWhat are the tax consequences to shareholder and corporation?-Alpha: -Dividend is $95,000($120,000 (FMV) less $25,000 (liability assumed)-Basis in land is $120,000 (FMV)Beta:$15,000 recognized gain ($120,000 (FMV) less $105,000 (basis))on the distributionE&P effects:-Increases by $15,000 gain recognized-Decreases by $5,100 tax on gain (15,000 * 34%) - Decreases by $95,000 dividend distribution[$120,000 (FMV) less $25,000 (liability assumed)] -E&P balance is = $110,000 + $15,000 $5100 -$95,000 = $24,900

Stock DividendsA 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. 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).Stock dividends are nontaxable to shareholders (since no increase in value) if two conditions are met:Made with respect to common stock andPro rata (proportionate interests maintained by all shareholders)

Stock DividendsExample: Corporation ABC has 100 shares outstanding. Alpha owns 60 shares and Beta owns 40 shares. Alphas basis is $20,000 and Betas basis is $8000. Corporation ABC declares a 2 for 1 stock dividend.- Now Alpha has 120 shares with a $20,000 basis and Beta has 80 shares with an $8,000 basis. 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)Taxable Stock DividendsNon-pro rata stock dividends usually are taxable as dividends to the extent of distributing corporations E&P now, shareholders ownership percentage increased so can be taxed on the increase in value

Stock RedemptionA 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)Shareholders gain or loss on the exchange is amount realized (cash plus noncash property received) less tax basis of stockForm of Redemption: A redemption results in either a dividend or a sale of the redeemed sharesIndividuals 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 $10,000. Shareholders basis in the stock is $7,000. So now the shareholder will be taxed on a capital gain of $3,000 instead of paying tax on a $10,000 dividendCorporate shareholders prefer dividend treatment because of the dividends received deduction.

When is a stock redemption treated as an exchange vs. a dividend?Three types of redemptions are treated as exchanges:1) Redemptions that are Substantially Disproportionate with respect to the shareholder are treated as sales2) Redemptions in Complete Redemption of all of the Stock of the Corporation Owned by the Shareholder3) Redemptions that are not Essentially Equivalent to a Dividend

1) Redemptions that are Substantially Disproportionate with respect to the shareholderStock 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)Shareholders percentage of voting stock and aggregate value is less than 80 percent of the percentage before the redemptionExample: Shareholder owns 40 of the corporations 100 shares of voting common stock. To treat the redemption as an exchange:After the redemption the shareholder must own less than 50% of the outstanding sharesPercentage ownership after the redemption must be less than 80 percent of the percentage ownership before the redemption. So the 40 percent ownership must drop to less than 32% (80% x 40% = 32%).

Constructive OwnershipConstructive ownership rules must be considered when determining if the 50% and 80% ownership tests are met. 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.Family attribution- a shareholder is considered to own any stock owned by their spouse, children, parents and grandparentsAttribution from entities to owners or beneficiaries owners or beneficiaries are considered to own any stock the entity itself owns (if a partnership owns stock, a 50% partner would own 50% of the stock). Shareholders own a pro rata share of corporations stock holdings if they own at least 50% of the corporations stock. 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. The shareholder is deemed to own (100+ (75% * 200)) or 250 shares.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.Option attribution anyone having an option to buy stock is considered to own those shares that the option entitles the person to buy