Assignment 8 controllership

ACC624-Module-8-TaxRules-Distributions.pdf

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Corporations, Partnerships, Estates & Trusts

Tax Rules: Distributions Corporations: Earnings & Profits and Dividend Distributions

The Big Picture (slide 1 of 3)

• Lime Corporation, an ice cream manufacturer, has had a very profitable year. – To share its profits with its two shareholders, it

distributes the following: • Cash of $200,000 to Orange Corporation, and • Real estate worth $300,000 (adjusted basis of $20,000)

to Gustavo. – The real estate is subject to a mortgage of $100,000, which

Gustavo assumes.

• The distribution is made on December 31, Lime’s year-end.

The Big Picture (slide 2 of 3)

• Lime Corporation has had both good and bad years in the past. – More often than not, however, it has lost money. – Despite this year’s banner profits, the GAAP-

based balance sheet for Lime indicates a year-end deficit in retained earnings.

• Consequently, the distribution of cash and land is treated as a liquidating distribution for financial reporting purposes, resulting in a reduction of Lime’s paid-in capital account.

The Big Picture (slide 3 of 3)

• The tax consequences of the distributions to the corporation and its shareholders depend on a variety of factors. – Identify these factors.

• Explain the tax effects of the distributions to both Lime Corporation and its 2 shareholders.

• Read the chapter and formulate your response.

Taxable Dividends

• Distributions from corporate earnings and profits (E & P) – Treated as a dividend distribution

• Taxed as ordinary income or as preferentially taxed dividend income

• Distributions in excess of E & P – Nontaxable to extent of shareholder’s basis (i.e., a

return of capital) • Excess distribution over basis is capital gain

Presenter

Presentation Notes

CORPORATE DISTRIBUTIONS—OVERVIEW Distributions by a corporation to its shareholders are presumed to be dividends unless the parties can prove otherwise. Section 316 makes such distributions dividend income to the shareholder to the extent of the distributing corporation’s earning and profits (E & P). [§§ 301(c)(1), 316, and 1(h)(11)] 2. Distributions not taxed as dividends (because of insufficient E & P) are nontaxable to the extent of the shareholder’s stock basis and will reduce that basis accordingly. Any excess of the distribution over the shareholder’s basis is treated as a gain from the sale of the stock. [§§ 301(c)(2) and (3)]

Earnings & Profits (slide 1 of 2)

• No definition of E & P in Code • Similar to Retained Earnings (financial

reporting), but often not the same

Presenter

Presentation Notes

EARNINGS AND PROFITS (E & P)—§ 312 3. E & P, though similar in concept to “retained earnings,” is computed differently. Retained earnings is based on financial accounting rules, while E & P is determined using tax law. Both are measures of the firm’s accumulated capital. 4. E & P fixes the upper limit on the amount of dividend income a shareholder must recognize as a result of a distribution by the corporation. It represents the corporation’s economic ability to pay a dividend without impairing its capital.

Earnings & Profits (slide 2 of 2)

• E & P represents: – Upper limit on amount of dividend income

recognized on corporate distributions – Corporation's economic ability to pay dividend

without impairing capital

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Presentation Notes

5. E & P can often be determined by assessing whether the transaction increases or decreases the corporation’s capacity to pay a dividend.

Calculating Earnings & Profits (slide 1 of 4)

• Calculation generally begins with taxable income, plus or minus certain adjustments – Add previously excluded income items and certain

deductions to taxable income including: • Muni bond interest • Excluded life insurance proceeds • Federal income tax refunds • Dividends received deduction • Domestic production activities deduction

Presenter

Presentation Notes

Computation of E & P 6. E & P is not defined in the IRC. Rather, a set of adjustments to taxable income to arrive at E & P is identified. 7. Additions to taxable income to compute E & P include the following (Example 2): All tax-exempt income items such as municipal bond interest. Excluded life insurance proceeds (in excess of cash surrender value). Dividends not taxed due to the dividends received deduction. Federal income tax refunds for taxes paid in prior years. Domestic production activity deduction (DPAD).

Calculating Earnings & Profits (slide 2 of 4)

• Calculation generally begins with taxable income, plus or minus certain adjustments (cont’d) – Subtract certain nondeductible items:

• Nondeductible portion of meal and entertainment expenses • Related-party losses • Expenses incurred to produce tax-exempt income • Federal income taxes paid • Key employee life insurance premiums (net of increase in cash

surrender value) • Fines, penalties, and lobbying expenses

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Presentation Notes

8. Subtractions from taxable income to compute E & P include the following: Nondeductible related-party losses. Nondeductible portion of meals and entertainment. Excess capital losses. Federal income taxes paid. Nondeductible fines and penalties. Lobbying expenses. Expenses incurred to produce tax-exempt income. Key employee life insurance premiums in excess of the increases in the cash surrender value of the policy.

Calculating Earnings & Profits (slide 3 of 4)

• Certain E & P adjustments shift effect of transaction from the year of inclusion in or deduction from taxable income to year of economic effect, such as: – Charitable contribution carryovers – NOL carryovers – Capital loss carryovers

• Gains and losses from property transactions – Generally affect E & P only to extent recognized for tax

purposes – Thus, gains and losses deferred under the like-kind

exchange provision and deferred involuntary conversion gains do not affect E & P until recognized

Presenter

Presentation Notes

9. Timing adjustments shift a transaction’s impact from the year it is included in taxable income to the year it has an economic effect on a corporation. These adjustments include the following (Example 5): Excess capital losses. Excess charitable contributions. Net operating loss (NOL) carryovers. Gains and losses from property transactions only to the extent they are recognized for tax purposes. Gains and losses deferred under the like-kind exchange provision and deferred involuntary conversion gains do not affect E & P until recognized. These items require no timing adjustments.

Calculating Earnings & Profits (slide 4 of 4)

• Other adjustments – Accounting methods for E & P are generally more

conservative than for taxable income, for example: • Installment method is not permitted • Alternative depreciation system required • § 179 expense must be deducted over 5 years • Percentage of completion must be used (no completed

contract method)

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Presentation Notes

10. Accounting method adjustments are the differences in accounting methods required for taxable income and E & P. Methods used for E & P are generally more conservative than those allowed for calculating taxable income. These adjustments include the following: Installment sales. The installment method is not allowed for E & P purposes. [§ 312(n)(5)] Taxable income must be increased by the amount of any deferred gain in the year in which property is sold on the installment basis. (Example 6) Cost recovery. (Example 7) The alternative depreciation system (ADS) must be used for E & P. [§ 312(k)(3)(A)] ADS uses straight-line depreciation over a recovery period equal to the Asset Depreciation Range (ADR) midpoint life (Rev. Proc. 87-56, 1987-d CB 674). The ADR life is five years for autos and light trucks, 10 or 12 years for most machinery and equipment, and 40 years for real property. A positive or negative adjustment must be made each year if MACRS is used for income tax purposes. When an asset is later sold, the gain/loss recognized must be calculated based on the adjusted basis for E & P purposes. [§ 312(f)(1)] Section 179 expense is recognized over five years. [§ 312(k)(3)(B)] In the year § 179 is elected, 80% of the resulting expense is added back to taxable income for E & P purposes. In each of the following four years, a subtraction from taxable income equal to 20% of the § 179 expense is made.

Calculating Earnings & Profits (slide 4 of 4)

• Other adjustments – Accounting methods for E & P are generally more

contract method)

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Presentation Notes

Additional first year depreciation is not allowed. Only cost depletion, not percentage depletion, may be used for E & P. [Reg. §1.316-2(e)] Accounting for construction contracts must use percentage of completion. [§ 312(n)(6)] Since the amortization of organizational expenditures is not allowed for E & P purposes, this expense is added back to taxable income when determining E & P. [§ 312(n)(3)] LIFO recapture. Any increase in the LIFO recapture amount (excess of FIFO over LIFO inventory value) during the year is added to taxable income to determine current E & P. Decreases in the LIFO recapture amount are subtracted from taxable income. For E & P, intangible drilling costs and mine exploration and development costs are to be amortized over a period of 60 months and 120 months, respectively. [§ 312(n)(2)] For tax purposes, they are deducted in the current year.

Examples of E & P Adjustments (slide 1 of 2)

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Presentation Notes

Summary of E & P Adjustments 11. Concept Summary 5.1 lists the adjustments that are made to a corporation’s taxable income in arriving at E & P. 12. Note: Problem 27 in the text is an effective In-Class Exercise for teams of two or three students to complete after discussing the rules for computing E & P. Complete the problem and then discuss the solution.

Examples of E & P Adjustments (slide 2 of 2)

Current vs Accumulated E & P (slide 1 of 3)

• Current E & P – Taxable income as adjusted

Presenter

Presentation Notes

Current versus Accumulated E & P 13. Accumulated E & P is the total of all previous years’ current E & P (since February 28, 1913) reduced by any distributions made from E & P in previous years. Current E & P is that generated in the current year, determined by adjusting current taxable income as described above. The allocation of a corporate distribution between current and accumulated E & P plays an important part in determining the taxability of corporate distributions.

Current vs. Accumulated E & P (slide 2 of 3)

• Accumulated E & P – Total of all prior years’ current E & P (since

February 28, 1913) reduced by distributions from E & P

Current vs. Accumulated E & P (slide 3 of 3)

• Distinguishing between current and accumulated E & P is important – Taxability of corporate distributions depends

on how current and accumulated E & P are allocated to each distribution made during year

Allocating E & P to Distributions (slide 1 of 4)

• If positive balance in both current and accumulated E & P – Distributions are deemed made first from current E

& P, then accumulated E & P – If distributions exceed current E & P, must allocate

current and accumulated E & P to each distribution • Allocate current E & P pro rata (using dollar amounts)

to each distribution • Apply accumulated E & P in chronological order

Presenter

Presentation Notes

Allocating E & P to Distributions Concept Summary 5.2 lists the steps in allocating E & P to distributions. It is an excellent reference for students when they are working through the exercises and problems. When current and accumulated E & P are positive, corporate distributions are first made from current and then from accumulated E & P. a. When distributions exceed current E & P, determined as of the end of the year, the allocations of current and accumulated are as follows: (1) Current E & P is is applied first on a pro rata basis to each distribution (using the distribution dollar amounts). (2) Accumulated E & P is allocated to distributions in chronological order during the year, starting with the first distribution. b. This allocation is important if any shareholder sells stock during the year. (Example 8)

Allocating E & P to Distributions (slide 2 of 4)

• When the tax years of the corporation and its shareholders are not the same – May be impossible to determine the amount of

current E & P on a timely basis – Allocation rules presume that current E & P is

sufficient to cover every distribution made during the year until the parties can show otherwise

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Presentation Notes

18. When current E & P is unknown at the shareholder’s tax year-end (e.g., corporation uses a fiscal year and the shareholder uses a calendar year). a. Current E & P is assumed sufficient to cover all distributions made during the year. b. If current E & P is determined to be insufficient after the corporation’s year-end, then the shareholder may file an amended return to claim a refund for taxes paid. (Example 9)

Allocating E & P to Distributions (slide 3 of 4)

• If current E & P is positive and accumulated E & P has a deficit – Accumulated E & P IS NOT netted against current

E & P • Distribution is deemed to be taxable dividend to extent

of positive current E & P balance

Presenter

Presentation Notes

19. Allocations when either current or accumulated E & P has a deficit. If a deficit exists in accumulated and a positive balance exists in current, the two accounts are not netted. Instead, distributions are taxed as dividends to the extent of the positive balance in current E & P. (Example 10) If a deficit exists in current and a positive balance exists in accumulated, the two accounts are netted as of the date of the distribution. (1) If the resulting balance is zero or negative, the distribution is a return of capital. (2) Distributions are treated as dividends to the extent of a positive net balance. (3) A deficit in current E & P is allocated ratably throughout the year, unless the parties can show otherwise. (Example 11)

The Big Picture – Example 10 Positive Current E & P,

Deficit In Accumulated E & P • Return to the facts of The Big Picture on p. 5–1. • Lime Corp. had a deficit in GAAP-based retained earnings at

the start of the year and banner profits during the year. – Assume that this translates into an $800,000 deficit in accumulated E

& P at the start of the year and current E & P of $600,000. • In this case, current E & P would exceed the total cash and

property distributed to the shareholders. – The distributions are treated as taxable dividends. – They are deemed to be paid from current E & P even though Lime still

has a deficit in accumulated E & P at the end of the year.

Allocating E & P to Distributions (slide 4 of 4)

• If accumulated E & P is positive and current E&P is a deficit, net both at date of distribution – If balance is zero or a deficit, distribution is a

return of capital – If balance is positive, distribution is a dividend to

the extent of the balance – Any current E & P is allocated ratably during the

year unless the parties can show otherwise

Cash Distribution Example

A $20,000 cash distribution is made at year end in each independent situation:

1 2 3* . Accumulated E & P, beginning of year 100,000 (100,000) 15,000 Current E & P 50,000 50,000 (10,000) Dividend: 20,000 20,000 5,000 *Since there is a current deficit, current and accumulated E & P are netted before determining treatment of

distribution.

Presenter

Presentation Notes

ETHICS & EQUITY Shifting E & P. Ethical decisions can sometimes be reached via stakeholder analysis. Ideally, all stakeholders will be better off as a result of the solution; costs and benefits should be fairly distributed; and stakeholders’ rights should be preserved. To move toward an ethical solution, the instructor should encourage a discussion of what each stakeholder stands to gain or lose as a result of Spencer’s decision. Spencer: Assuming his tax rates will not change over the two-year period at issue, it is in Spencer’s self-interest to defer the income until next year because of the time value of money. Spencer’s benefit from deferral is equal to the return he can earn on the tax liability for one year. Robert: If Spencer defers the income until next year, Robert’s distribution will be tax-free to the extent of his stock basis and taxed as a capital gain if the distribution exceeds basis. If Robert’s stock basis is reduced, he will recognize a larger capital gain on the sale of his stock to Heidi at the beginning of next year. In contrast, acceleration of the income into this year will trigger dividend treatment on the distribution with no basis reduction. Thus, for Robert, the decision trades off dividend income this year with a similarly taxed capital gain next year.

Cash Distribution Example

A $20,000 cash distribution is made at year end in each independent situation:

distribution.

Presenter

Presentation Notes

ETHICS & EQUITY Shifting E & P. Heidi: If Spencer defers the income, the distribution to Heidi next year will be taxed as a dividend and her stock basis will be preserved. The present value of savings generated by preserving her stock basis will be small relative to the tax cost of the dividend because she will probably hold her stock for several years. Alternatively, if Spencer accelerates the income into the current year, Heidi’s distribution will be tax-free and reduce the basis in her stock. The basis reduction will create gain potential at some later date, but the present value of the tax cost is probably low, because any stock sale by Heidi is likely to be far into the future. Heidi trades off a tax on dividends next year with a heavily discounted capital gain tax. Comparing the costs and benefits faced by Heidi and Robert requires some assumption about relative tax rates. If we assume that Heidi and Robert have similar marginal rates, then Heidi stands to gain more than Robert will lose if Spencer accelerates the income into the current year. The benefit to Heidi probably also outweighs the small deferral benefit accruing to Spencer. Consequently, to minimize the overall tax cost for all parties involved, Spencer’s best decision is to accelerate the income into the current year.

Cash Distribution Example

A $20,000 cash distribution is made at year end in each independent situation:

distribution.

Presenter

Presentation Notes

ETHICS & EQUITY Shifting E & P. The proposed solution still falls short of the criteria established for an ethical decision. In particular, one might question whether the resulting distribution of costs and benefits is fair and whether stakeholder rights are preserved. Both Spencer and Robert are made worse off by this decision. To improve the solution, Spencer should search for a way for both himself and Robert to share in Heidi’s benefits. Robert might be able to offset the costs of accelerating the income by negotiating a higher stock price with Heidi in return for the income acceleration. Spencer might participate in the negotiations and attempt to capture a portion of the benefits as well (assuming the monetary benefits he receives outweigh any good feelings arising from transferring some wealth to his sister). Government (The Public). The role of the government as a stakeholder should also be addressed. If one considers the government’s position to be improved with larger amounts of taxes collected, the proposed solution appears to be at loggerheads with the government’s interests and the criteria for an ethical solution are not met. However, this view can be called into question by discussing the role of government and the role of tax law. In particular, the instructor should lead a discussion regarding whether or not the public’s interest is served or harmed by careful tax planning.

Qualified Dividends (slide 1 of 3)

• For individual taxpayers, qualified dividends are subject to a max 20% tax rate – Qualified dividends are exempt from tax for taxpayers in

the 10% or 15% rate brackets – The 20% rate applies to taxpayers in the 39.6% tax bracket – The lower rates on dividend income apply to both the

regular income tax and the alternative minimum tax • Corporations treat dividends as ordinary income and

are permitted a dividends received deduction

Presenter

Presentation Notes

DIVIDENDS 20. The tax treatment of dividends is determined in part by whether the shareholder is an individual, a corporation, or another type of taxpaying entity. a. Corporations receiving dividends are taxed at ordinary rates on amount remaining after subtracting the dividends received deduction. Individual taxpayers receive a reduced rate of tax on qualifying dividends, while nonqualifying dividends are taxed as ordinary income.

Qualified Dividends (slide 1 of 3)

• For individual taxpayers, qualified dividends are subject to a max 20% tax rate – Qualified dividends are exempt from tax for taxpayers in

the 10% or 15% rate brackets – The 20% rate applies to taxpayers in the 39.6% tax bracket – The lower rates on dividend income apply to both the

regular income tax and the alternative minimum tax • Corporations treat dividends as ordinary income and

are permitted a dividends received deduction

Presenter

Presentation Notes

Rational for Reduced Tax Rates on Dividends 21. Double taxation of dividends has been argued to distort the economy in the following ways: a. It encourages investment in noncorporate rather than corporate businesses. b. It encourages corporations to finance operations with debt rather than new equity because interest is deductible. c. It encourages retention of earnings to avoid double taxation. 22. Reasons for reducing the tax rate on dividends paid to individuals include the following: a. It will reduce the distortions to the economy discussed in 21 above. b. It will stimulate the economy. c. It will make the United States more competitive in international markets. Double taxation of dividends is not the norm. Most countries have corporate integration. d. The reduced rate on qualified dividends reflects a compromise between the complete elimination of tax on dividends and the treatment of dividends as ordinary income.

Qualified Dividends (slide 2 of 3)

• To qualify for lower rates, dividends must be: – Paid by domestic or certain qualified foreign corps

• Qualified foreign corps include those traded on a U.S. stock exchange or any corp. located in a country that:

– Has a comprehensive income tax treaty with the U.S. – Has an information-sharing agreement with the U.S. and – Is approved by the Treasury

– Paid on stock held > 60 days during the 121-day period beginning 60 days before the ex-dividend date

– Dividends paid to shareholders who hold both long and short positions in the stock do not qualify

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Presentation Notes

Qualified Dividends 23. Qualified dividends are eligible for the reduced tax rates applicable to capital gains. The lower capital gains rates are 0% for individuals in the 10% or 15% rate brackets, 20% for taxpayers in the 39.6% tax bracket, and 15% for all other taxpayers. 24. To qualify for the capital gains rates, dividends must meet three requirements. a. Dividends must be paid by qualifying corporations, which include the following: Domestic corporations. Foreign corporations whose stock is traded on U.S. markets. Corporations located in countries that meet the following requirements: Have comprehensive income tax treaties with the United States. Have information-sharing agreements with the United States. Are approved by the Treasury. b. Dividends paid to shareholders who hold both long and short positions in the same stock do not qualify. c. Stock must be held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.

Qualified Dividends (slide 3 of 3)

• Qualified dividends are not considered investment income for purposes of determining the investment interest expense deduction – An election is available to treat qualified dividends as

ordinary income (taxed at regular rates) and include them in investment interest income

– Thus, taxpayers subject to an investment interest expense limitation must compare relative benefits of low tax on qualifying dividends vs. increased amount of deductible investment interest expense

Property Dividends (slide 1 of 4)

• Effect on shareholder: – Amount distributed equals FMV of property

• Taxable as dividend to extent of E & P • Excess is treated as return of capital to extent of basis in

stock • Any remaining amount is capital gain

Presenter

Presentation Notes

Property Dividends 25. Property dividends have the same impact as cash distributions for the shareholder. For the corporation, there is the additional consideration of the “sale” of the property to the shareholder. Property dividends—effect on the shareholder (Examples 13 and 14): a. The shareholder’s dividend is measured as the property’s fair market value on the distribution date. This amount is reduced by any liabilities assumed by the shareholder due to the distribution. (1) As with a cash distribution, the portion of the property distribution covered by existing E & P is a dividend, and any excess is treated as a return of capital to the extent of the shareholder’s basis. Any remaining amount is treated as a capital gain. b. The shareholder’s basis in the distributed property is fair market value on the distribution date. c. If property distributed is subject to a liability, the fair market value of the property is considered to be at least equal to the amount of the liability.

Property Dividends (slide 2 of 4)

• Effect on shareholder (cont’d): – Reduce amount distributed by liabilities assumed

by shareholder – Basis of distributed property = fair market value

Property Dividends (slide 3 of 4)

• Effect on corporation: – Corp. is treated as if it sold the property for fair

market value • Corp. recognizes gain, but not loss

– If distributed property is subject to a liability in excess of basis

• Fair market value is treated as not being less than the amount of the liability

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Presentation Notes

27. Property dividends—effect on the corporation. a. Under § 311(b), gain but not loss is recognized by the corporation on a property dividend distribution. Gain is computed as if the appreciated property was sold to the shareholder at its fair market value. (Example 15) (1) Distributing property that has depreciated in value may reflect poor planning. b. If the property distributed is subject to a liability, the fair market value of the property is considered to be at least equal to the amount of the liability. [§ 311(b)(2)] (Example 17)

Property Dividends (slide 4 of 4)

• Effect on corporation’s E & P: – Increases E & P for excess of FMV over basis of

property distributed (i.e., gain recognized) – Reduces E & P by FMV of property distributed (or

basis, if greater) less liabilities on the property – Distributions of cash or property cannot generate

or add to a deficit in E & P • Deficits in E & P can arise only through corporate

losses

Presenter

Presentation Notes

28. Adjustments to E & P for property distributions. (Examples 18–21) a. The noncash property distribution rules are summarized in Concept Summary 5.3. b. E & P is reduced by the amount of money distributed, or by the greater of the fair market value or the adjusted basis of the property distributed, less the amount of any liability on the property. [§ 312(a), (b), and (c)] c. E & P is increased by any gain recognized on appreciated property distributed. d. Note that distributions cannot generate or add to a deficit in E & P. Only corporate losses generate or add to a deficit in E & P.

The Big Picture – Example 13 Property Dividends - Effect on the Shareholder

• Return to the facts of The Big Picture on p. 5–1. • Lime Corporation distributed property to Gustavo,

one of its shareholders. – Fair market value $300,000. – Adjusted basis $20,000. – Subject to a $100,000 mortgage, which Gustavo assumed.

• As a result, Gustavo has a taxable dividend of $200,000 – $300,000 (fair market value) – $100,000 (liability). – The basis of the property to Gustavo is $300,000.

The Big Picture – Example 16 Property Dividends - Effect on the Corporation

• Return to the facts of The Big Picture on p. 5–1. • Lime Corporation distributed property to Gustavo,

one of its shareholders. – Fair market value of $300,000 – Adjusted basis of $20,000

• As a result, Lime recognizes a $280,000 gain on the distribution.

Property Distribution Example

Property is distributed (corporation’s basis = $20,000) in each of the following independent situations. Assume Current and Accumulated E & P are both $100,000 in each case:

1 2 3 . Fair market value of distributed property 60,000 10,000 40,000 Liability on property -0- -0- 15,000 Gain(loss) recognized 40,000 -0- 20,000 E&P increased by gain 40,000 -0- 20,000 E & P decrease on dist. 60,000 20,000 25,000

Constructive Dividend (slide 1 of 2)

• Any economic benefit conveyed to a shareholder may be treated as a dividend for tax purposes, even though not formally declared – Need not be pro rata

Presenter

Presentation Notes

Constructive Dividends 29. Constructive dividends usually arise with closely held corporations. They need not be formally declared or issued pro rata. a. Treated the same as actual distributions. [Simon v. Comm., 57-2 USTC § 9989, 52 AFTR 698, 248 F.2d 869(CA-8, 1957)] (1) Corporate shareholders are entitled to the DRD. (2) Other shareholders receive a preferential tax rate on dividends. (3) Taxable as a dividend only to extent of E & P.

Constructive Dividend (slide 2 of 2)

• Usually arises with closely held corporations • Payment may be in lieu of actual dividend and

is presumed to take form for tax avoidance purposes

• Benefit conveyed is recharacterized as a dividend for all tax purposes – Corporate shareholders are entitled to the

dividends received deduction – Other shareholders receive preferential tax rates

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Presentation Notes

b. With constructive dividends, the shareholders may be attempting to distribute corporate profits in a form deductible to the corporation, or the shareholders may be seeking benefits for themselves while avoiding the recognition of income. Not all constructive dividends are deliberate attempts to avoid actual and formal dividends; many are inadvertent.

Examples of Constructive Dividends (slide 1 of 3)

• Shareholder use of corporate property at reduced cost or no cost (e.g., company car to non-employee shareholder)

• Bargain sale of property to shareholder (e.g., sale for $1,000 of property worth $10,000)

• Bargain rental of corporate property

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Presentation Notes

30. Constructive dividends include the following: a. Personal use by a shareholder of corporate-owned property (e.g., company-owned automobiles, airplanes, yachts, hunting lodges). The measure of the dividend usually is the fair rental value of the property for the period of its personal use. (See Daniel L. Reeves, 94 TCM 287, T.C.Memo. 2007–273.) Bargain sale of corporate property to the shareholders. The dividend is the difference between the amount paid for the property and its FMV. [Reg. 1.301-1(m)] c. Bargain rental of corporate property to its shareholders. The dividend is the amount of the property’s fair rental value that exceeds the rent actually paid. d. Payments for the benefit of shareholders. (1) Satisfaction by corporation of shareholder’s personal obligation to third party. (2) Forgiveness of a shareholder debt to the corporation. (3) Excessive rentals paid by a corporation for the use of shareholder property.

Examples of Constructive Dividends (slide 2 of 3)

• Payments on behalf of shareholder (e.g., corporation makes payments to satisfy obligation of shareholder)

• Unreasonable compensation

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Presentation Notes

ETHICS & EQUITY A Contribution to Alma Mater. In general, if Kristin has Eagle make a charitable contribution, a constructive dividend does not result even though such a payment might clearly benefit Kristin (see Henry J. Knott, 67 T.C. 681 (1977). And, Eagle can take a charitable contribution deduction for the payment. However, if Kristin had previously made a pledge to Southern State—as is the case here—and then has Eagle satisfy the pledge by paying the $150,000 to Southern State, Kristin will not have to include this amount in her income [see Schalk Chemical Co. v. Comm., 62-1 USTC¶9496 9 AFTR 2d 1579, 304 F.2d 48 (CA-9, 1962)]. e. Compensation to shareholder/employee that is unreasonable. (1) Numerous factors are considered in determining whether compensation is reasonable, including: The employee’s qualifications. A comparison of salaries with dividend distributions. The prevailing rates of compensation for comparable positions in comparable business concerns. The nature and scope of the employee’s work. The size and complexity of the business. A comparison of salaries paid with both gross and net income. The taxpayer’s salary policy toward all employees. For small corporations with a limited number of officers, the amount of compensation paid to the employee in question in the previous year. Whether a reasonable shareholder would have agreed to the level of compensation paid (reasonable investor test). Reasonable investor test is relatively new development in reasonable compensation. (3) Refer to the Tax in the News item titled “Win Some—Lose Some” for a discussion of reasonable compensation. Also refer to the Additional Lecture Resource in the Instructor’s Guide.

Examples of Constructive Dividends (slide 3 of 3)

• Below market interest rate loans to shareholders

• High rate interest on loans from shareholder to corporation

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Presentation Notes

f. Advances by a corporation to a shareholder that are not bona fide loans. Factors to consider include if the instrument is written or oral, if collateral was furnished, how long the advance has been outstanding, if repayments have been made, if the shareholder has the ability to repay, the regularity of the advances, and the dividend-paying history of the corporation. [Fin Hay Realty Co. v. U.S., 68–2 USTC ¶9438, 22 AFTR 2d 5004, 398 F.2d 694 (CA-3, 1968)]. g. Imputed interest element on interest-free (or below-market) loans by a corporation to a shareholder. (1) Shareholder is deemed to make an interest payment to the corporation to the extent of the forgone interest. (2) Corporation is then deemed to make a dividend distribution to the shareholder for the same amount. (3) Although the shareholder may be permitted to deduct the deemed interest payment, the corporation has interest income. (4) No corresponding corporate interest deduction is allowed because the imputed interest element is a constructive dividend. Interest and principal payments made by a corporation where debt owed to its shareholders is reclassified as equity (i.e., the corporation is thinly capitalized). See the In-Class Exercise on constructive dividends at the end of these Lecture Notes. This can be used as a take-home or classroom project.

Avoiding Unreasonable Compensation

• Documentation of the following attributes will help support payments made to an employee- shareholder: – Employee’s qualifications – Comparison of salaries with dividends made in past – Comparable salaries for similar positions in same

industry – Nature and scope of employee’s work – Size and complexity of business – Corporation’s salary policy for other employees

Presenter

Presentation Notes

ADDITIONAL LECTURE RESOURCE Court cases concerning reasonable compensation in closely held corporations have received inconsistent treatment. When deciding these cases, the courts rely on two different types of tests. The 13 Federal circuits differ in the use of these tests based in part on earlier precedent in their respective jurisdictions. Multiple Factor Approach. The first type of test uses multiple factors to assess the reasonableness of compensation, such as the company’s financial condition, its dividend history, and the size and complexity of its business. The approach also compares compensation to similarly situated employees of comparable companies and considers the employee’s contribution to corporate profits and the relationship between compensation and level of stock holdings. This type of analysis originated in the 6th Circuit [Mayson Manufacturing Co. v. Comm., 49-2 USTC ¶9467, 38 AFTR 1028, 178 F.2d 115 (CA-6, 1949)] and is followed in the 10th Circuit [Eberl’s Claim Service v. Comm., 87 AFTR2d 2001-2075, 249 F.3d 994 (CA-10, 2001)]. Independent Investor Approach. To examine reasonableness of compensation to the shareholder-employee, other courts are beginning to use a new approach, involving a hypothetical independent investor. The question asked by the judge is: “How much would an independent investor be willing to pay the employee, given the profits that are generated?” The 7th Circuit Court is the principal advocate for this standard. Other courts (including the 2nd, 6th, and 9th Circuit Courts) have started to use a hybrid approach, considering both the multiple factors suggested in Mayson Manufacturing and the new independent investor test. In many of the cases adopting either a hybrid approach or the independent investor test, opinions have often been critical of the Tax Court’s use of the multiple factor approach.

Stock Dividends (slide 1 of 2)

• Excluded from income if pro rata distribution of stock, or stock rights, paid on common stock – Five exceptions to nontaxable treatment deal with

various disproportionate distribution situations • Effect on E & P

– If nontaxable, E & P is not reduced – If taxable, treat as any other taxable property

distribution

Presenter

Presentation Notes

31. Stock dividends are not taxable if they are pro rata distributions of stock, or stock rights, on common stock. Stock dividends are considered disproportionate and, therefore, taxable under § 305 in the following situations. (Note: See Concept Summary 5.4 for a flowchart analysis of § 305.) If any shareholder can elect payment either in cash or in stock. Distributions of property to some shareholders with a corresponding increase in the proportionate interest of other shareholders in either assets or E & P of the distributing corporation. Common stock is distributed to some common shareholders and preferred stock to other common shareholders. Distributions of either common or preferred stock to preferred shareholders. However, changes in the conversion ratio of convertible preferred stock to account for a stock dividend or split are not taxable in some circumstances. Distributions of convertible preferred stock unless it can be shown that the distribution will not result in a disproportionate distribution. 32. If stock dividends are not taxable, there is no reduction in E & P. [§ 312(d)(1)] If they are taxable, the distribution is treated as any other property dividend. 33. If the stock dividend is not taxable, § 307 applies and the basis of the stock on which the dividend is paid is reallocated between the original stock and the new stock based on their relative fair market values. If the stock dividend is taxable, the basis of the stock received is its fair market value. (Examples 23 and 24)

Stock Dividends (slide 2 of 2)

• Basis of stock received – If nontaxable

• If shares received are identical to shares previously owned, basis = (cost of old shares/total number of shares)

• If shares received are not identical, allocate basis of old stock between old and new shares based on relative fair market value

• Holding period includes holding period of formerly held stock

– If taxable, basis of new shares received is fair market value • Holding period starts on date of receipt

Presenter

Presentation Notes

ADDITIONAL LECTURE RESOURCE The following examples illustrate the applicability of § 305. A corporation has a dividend reinvestment plan that allows shareholders to choose either a stock dividend or a cash dividend. The stock dividend is of greater fair market value than the cash dividend. In addition, for those electing to take the stock dividend and thereby reinvest in the corporation, an optional plan to purchase additional common stock of the company at a price equal to 95% of the fair market value of the stock is available. Those choosing the stock dividend would have a taxable dividend under § 305 to the extent of the fair market value of the stock received initially. In addition, for shareholders electing the optional plan, income will be recognized to the extent that the fair market value of the stock purchased at the 5% discount exceeds the purchase price of the stock (Rev. Rul. 78-375, 1978-2 CB 130). A corporation has an annual redemption plan whereby shareholders can redeem 1% of their stock annually. While those who tender their stock for redemption have dividend income under § 301 (because the provisions of § 302 are not met), those who do not tender their stock also have dividend income under § 305 because their proportionate share of E & P and assets of the corporation increases. While a distribution of property incident to an isolated redemption does not cause § 305(b)(2) to apply (even though the redemption is treated as a § 301 distribution), it does apply to an ongoing plan of annual stock redemptions (Rev. Rul. 78-60, 1978-1 CB 81).

Stock Rights (slide 1 of 2)

• Tax treatment of stock rights is same as for stock dividends – If stock rights are taxable

• Income recognized = fair market value of stock rights received

• Basis = fair market value of stock rights • If exercised, holding period begins on date rights are

exercised • Basis of new stock = basis of rights plus any other

consideration given

Presenter

Presentation Notes

ADDITIONAL LECTURE RESOURCE (continued) Under § 305(b)(1), a distribution to common shareholders of preferred stock, which is immediately redeemable, is taxable as offering a choice of stock or cash (Rev. Rul. 76-258, 1976-2 CB 95). A corporation has two classes of common, Class A and Class B. It makes a distribution of Class A stock to the current Class A shareholders, and a distribution of newly issued preferred stock to the Class B shareholders. Reg. § 1.305-4(b) holds that both distributions are taxable. A corporation, having one class of common stock, distributes to its common shareholders a new issue of convertible preferred having a six-month conversion period and a conversion price near the market value of the common stock. Reg. § 1.305-4(b) indicates that because early conversion by common shareholders is probable and this results in some common shareholders holding common stock while others hold preferred, the distribution of preferred is taxed under § 305(b)(3). An interest payment to a convertible debenture holder will cause the distribution of a stock dividend to the common shareholders to be taxed under § 305(b)(2). The holders of the convertible debentures are deemed to be shareholders; thus, some shareholders have received cash [Reg. § 1.305-3(b)(3)].

Stock Rights (slide 2 of 2)

• If stock rights are nontaxable – If value of rights received < 15% of value of old

stock, basis in rights = 0 • Election is available which allows allocation of some of

basis of formerly held stock to rights – If value of rights is 15% or more of value of old

stock, and rights are exercised or sold, must allocate some of basis in formerly held stock to rights

Presenter

Presentation Notes

34. The rules for determining taxability of stock rights are identical to those for determining the taxability of stock dividends. If the rights are taxable, income equals the fair market value of the rights. If the rights are exercised, the holding period for the new stock begins on the date the rights (whether taxable or nontaxable) are exercised. The basis of the new stock is the basis of the rights plus the amount of any other consideration given. a. If the stock rights are not taxable and the value of the rights is less than 15% of the value of the old stock, the basis of the rights is zero. The shareholder may elect to have some basis in the old stock allocated to the rights. [§ 307(b)(1)] b. If the FMV of the rights is 15% or more of the value of the old stock and the rights are sold or exercised, the shareholder must allocate some of the basis in the old stock to the rights. (Example 25)

Corporate Distribution Planning (slide 1 of 2)

• Maintain ongoing records of E & P: – Ensures return of capital is not taxed as dividend – No statute of limitations on E & P, so IRS can

redetermine at any time • Accurate records minimize this possibility

Corporate Distribution Planning (slide 2 of 2)

• Adjust timing of distribution to optimize tax treatment: – If accumulated E & P deficit and current E & P

loss, make distribution by end of tax year to achieve return of capital

– If current E & P is likely, make distribution at beginning of next year to defer taxation

Presenter

Presentation Notes

Corporate Distributions 35. When planning for corporate distributions, consider the following points (Examples 26 and 27): Since E & P represents the pool of funds from which dividends may be distributed, the amount of E & P should be determined periodically. (Example 26) Since there is no statute of limitations on the computation of E & P, the IRS can re-determine current E & P for a tax year long since passed. This impacts accumulated E & P, and therefore has a direct impact on the taxability of current shareholder distributions. Distributions should be planned to avoid or minimize dividend exposure.

Avoiding Constructive Dividends (slide 1 of 2)

• Structure transactions on “arms’ length” basis: – Reasonable rent, compensation, interest rates, etc...

Avoiding Constructive Dividends (slide 2 of 2)

• Use mix of techniques to “bail out” corporate earnings such as: – Shareholder loans to corporation – Salaries to shareholder-employee – Rent property to corporation – Pay some dividends

• Overdoing any one technique may attract attention of IRS

Presenter

Presentation Notes

Constructive Dividends 36. To avoid constructive dividend situations, shareholders should try to structure their dealings with the corporation on an arm’s length basis. If shareholders want to take out corporate profits in a form deductible to the corporation, a balanced mix of alternatives lessens the risk of constructive dividend treatment. Many things can be done to protect against the disallowance of unreasonable compensation. (Example 30) Consider paying some dividends to the shareholders and provide indirect compensation to shareholders by paying expenses that benefit them personally but are still deductible by the corporation (such as medical or travel). Indirect compensation is a “gray area” with no single set of standards to be applied.

Refocus On The Big Picture (slide 1 of 4)

• A number of factors affect the tax treatment of Lime Corporation’s distributions.

• The amount of current and accumulated E & P (which differ from retained earnings) partially determines the tax effect on the shareholders. – Given that Lime Corporation has had a highly profitable year, it is

likely that there is sufficient current E & P to cover the distributions. • If so, they are dividends to the shareholders rather than a return of capital.

• Orange Corporation receives $200,000 of dividend income that is mostly offset by the dividends received deduction. – The amount of the offsetting deduction depends on the ownership

percentage that Orange has in Lime.

Presenter

Presentation Notes

IN-CLASS EXERCISES Determine whether the following constitute constructive dividends: Q1. Sam and Leo are the sole shareholders of Brown Corporation. Sam is divorced from his wife, Wanda. In the current year, Sam dies and leaves all his property to Leo, stating that he wants Wanda to receive nothing from his estate. However, Leo feels he has a moral obligation to provide for Wanda, who is destitute. Consequently, at the end of the current year, Leo has Brown Corporation pay Wanda $60,000 in recognition of past services rendered by Sam [see Montgomery Engineering Co. v. U.S., 64-2 USTC ¶9618, 13 AFTR2d 1747, 230 F.Supp. 838 (D.Ct.N.J., 1964)]. Solution: The Court in Montgomery Engineering held that Leo had a taxable dividend. Payment was made to satisfy the surviving shareholder’s personal desire to right the moral wrong he thought had been done to Wanda. This result was reached even though it was found that Leo had no legal obligation to make the payment. Keep in mind that the dividend income treatment to Leo is not the only unfavorable tax consequence that can come about from this situation. First, redesignating the payment as a dividend will cost the payor corporation the deduction it probably claimed for additional compensation. Second, since the bonus is treated as having passed through Leo, the IRS can argue that Leo has made a gift to Wanda. This could, of course, generate the imposition of the Federal gift tax.

Refocus On The Big Picture (slide 2 of 4)

• Gustavo has $200,000 of dividend income (i.e., $300,000 value of the land less the $100,000 mortgage). – Assuming that Lime is a domestic corporation and that

Gustavo has held his stock for the entire year, the land is a qualified dividend.

• As a result, the dividend is either tax-free (if Gustavo has a marginal rate of 10% or 15%) or subject to a 15% (or 20%) tax rate (depending on Gustavo’s marginal tax rate).

– Gustavo’s basis in the land is its fair market value at distribution, or $300,000.

Presenter

Presentation Notes

Q2. Black Corporation pays a salary of $50,000 plus a bonus of 10% of profits to Olaf, the father of Ivan, who is the sole shareholder of Black Corporation. For the past two years, Olaf’s salary has been almost $200,000 because of the substantial profits of the corporation [see Harold’s Club v. Comm., 65-1 USTC ¶9198, 15 AFTR2d 241, 340 F.2d 861 (CA-9, 1965)]. Solution: Ivan would have a constructive dividend to the extent that Olaf’s salary is deemed to be unreasonable. Courts have held that unreasonable salaries paid by a corporation to a relative of a controlling shareholder may be treated as a dividend to the shareholder. Q3. White Corporation, a newly formed corporation, acquired the assets of Gray Corporation. As part of the consideration, White issued debentures in the amount of $1,000,000 to the sellers of Gray Corporation. The debentures were guaranteed by White’s major shareholder, Susan. In 2006, White had substantial profits and paid interest of $150,000 on the debentures plus a principal payment of $100,000. The IRS contends that the interest is not deductible by White Corporation and the entire payment of $250,000 is a constructive dividend to Susan [see Plantation Patterns, Inc. v. Comm., 72-2 USTC ¶9494, 29 AFTR2d 72-1408, 462 F.2d 712 (CA-5, 1972)]. Solution: If the corporation has a high debt-to-equity ratio as a result of the guaranteed debentures and a substantial portion of the purchase of the assets was with the debentures, courts will undoubtedly hold the debentures to be equity. If that is the case, payments of both interest and principal will be constructive dividends to Susan.

Refocus On The Big Picture (slide 3 of 4)

• From Lime Corporation’s perspective, the distribution of appreciated property creates a deemed gain of $280,000. – $300,000 fair market value of the land less its $20,000

adjusted basis. – While the gain increases Lime’s E & P, the distributions to

the shareholders reduce it by $200,000 for the cash and $200,000 for the land ($300,000 fair market value reduced by the $100,000 mortgage).

Presenter

Presentation Notes

Q4. Lee is the major shareholder of Brown Corporation. Brown bought a life insurance policy on Lee’s life and named Lee’s wife, Kim, as beneficiary. Kim owns no stock in Brown Corporation. Upon Lee’s death, Kim is paid the proceeds of the policy [see Ducros v. Comm., 59-2 USTC ¶9785, 4 AFTR2d 5856, 272 F.2d 49 (CA-6, 1959)]. Solution: The Ducros case held that the proceeds were not taxable when paid to other shareholders of the corporation. While the IRS has stated it will not follow Ducros (Rev. Rul. 61-134, 1961-2 CB 250), it probably would not contend the payments were dividends because the proceeds were paid to a nonshareholder (see Ltr. Rul. 8144010). Q5. Bonnie is the principal shareholder of Brown Corporation. During the year, Bonnie incurred legal expenses in a suit filed to contest her acquisition of additional shares in the corporation. The corporation paid her legal expenses in her successful defense of the suit. The corporation also paid the down payment on a house purchased by Bonnie’s son, Matt. Matt is not a shareholder of Brown Corporation [see Hagaman v. Comm., 92-1 USTC ¶50,141, 69 AFTR2d 906, 958 F.2d 684 (CA-6, 1992)]. Solution: The court in Hagaman held that a corporation’s payment of a shareholder’s legal fees is a constructive dividend. The court also held that corporate expenditures on a residence owned by children of the shareholder would be a constructive dividend to the shareholder. The court stated that when a corporation confers an economic benefit upon a shareholder without expectation of reimbursement, the economic benefit becomes a constructive dividend to the shareholder.

Refocus On The Big Picture (slide 4 of 4)

What If? • What if current E & P is less than the cash and land distributed

to the shareholders? • Current E & P is applied pro rata to the cash and the land.

– Since the amounts received by the two shareholders are equal ($200,000 each), the current E & P applied is taxed as a dividend

– To the extent that the distributions are not covered by current E & P, accumulated E & P is then applied in a pro rata fashion.

• However, Lime probably has a deficit in accumulated E & P. • As a result, the remaining amounts distributed to the two

shareholders are: – First a tax-free recovery of stock basis, and – Any excess is taxed as a sale of the stock (probably classified as capital

gain).

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA

[email protected] SUNY Oneonta

Tax Rules: Distributions
The Big Picture (slide 1 of 3)
The Big Picture (slide 2 of 3)
The Big Picture (slide 3 of 3)
Taxable Dividends
Earnings & Profits�(slide 1 of 2)
Earnings & Profits�(slide 2 of 2)
Calculating Earnings & Profits�(slide 1 of 4)
Calculating Earnings & Profits�(slide 2 of 4)
Calculating Earnings & Profits�(slide 3 of 4)
Calculating Earnings & Profits�(slide 4 of 4)
Calculating Earnings & Profits�(slide 4 of 4)
Examples of E & P Adjustments (slide 1 of 2)
Examples of E & P Adjustments (slide 2 of 2)
Current vs Accumulated E & P�(slide 1 of 3)
Current vs. Accumulated E & P�(slide 2 of 3)
Current vs. Accumulated E & P�(slide 3 of 3)
Allocating E & P to Distributions �(slide 1 of 4)
Allocating E & P to Distributions �(slide 2 of 4)
Allocating E & P to Distributions �(slide 3 of 4)
The Big Picture – Example 10� Positive Current E & P, �Deficit In Accumulated E & P
Allocating E & P to Distributions �(slide 4 of 4)
Cash Distribution Example
Cash Distribution Example
Cash Distribution Example
Qualified Dividends �(slide 1 of 3)
Qualified Dividends �(slide 1 of 3)
Qualified Dividends �(slide 2 of 3)
Qualified Dividends �(slide 3 of 3)
Property Dividends�(slide 1 of 4)
Property Dividends�(slide 2 of 4)
Property Dividends�(slide 3 of 4)
Property Dividends�(slide 4 of 4)
The Big Picture – Example 13� Property Dividends - Effect on the Shareholder
The Big Picture – Example 16� Property Dividends - Effect on the Corporation
Property Distribution Example
Constructive Dividend�(slide 1 of 2)
Constructive Dividend�(slide 2 of 2)
Examples of Constructive Dividends�(slide 1 of 3)
Examples of Constructive Dividends�(slide 2 of 3)
Examples of Constructive Dividends (slide 3 of 3)
Avoiding Unreasonable Compensation
Stock Dividends �(slide 1 of 2)
Stock Dividends �(slide 2 of 2)
Stock Rights �(slide 1 of 2)
Stock Rights �(slide 2 of 2)
Corporate Distribution Planning�(slide 1 of 2)
Corporate Distribution Planning�(slide 2 of 2)
Avoiding Constructive Dividends �(slide 1 of 2)
Avoiding Constructive Dividends�(slide 2 of 2)
Refocus On The Big Picture (slide 1 of 4)
Refocus On The Big Picture (slide 2 of 4)
Refocus On The Big Picture (slide 3 of 4)
Refocus On The Big Picture (slide 4 of 4)
Slide Number 55