Assignment 8 controllership
Radina99
Module8Corporations-EarningsProfitsandDividendDist.pdf
Corporations: Earnings & Profits and Dividend Distributions
L E A R N I N G O B J E C T I V E S : After completing Chapter 5, you should be able to:
LO.1 Explain the role that earnings and profits play in determining the tax treatment of distributions.
LO.2 Compute a corporation’s earnings and profits (E & P).
LO.3 Determine taxable dividends paid during the year by correctly allocating current and accumulated E & P to corporate distributions.
LO.4 Describe the tax treatment of dividends for individual shareholders.
LO.5 Evaluate the tax impact of property dividends by computing the shareholder’s dividend income, basis
in the property received, and the effect on the distributing corporation’s E & P and taxable income.
LO.6 Recognize situations when constructive dividends exist and compute the tax resulting from such dividends.
LO.7 Compute the tax arising from receipt of stock dividends and stock rights and the shareholder’s basis in the stock and stock rights received.
LO.8 Structure corporate distributions in a manner that minimizes the tax consequences to the parties involved.
C H A P T E R O U T L I N E
5-1 Corporate Distributions—Overview, 5-2
5-2 Earnings and Profits (E & P)—§ 312, 5-2 5-2a Computation of E & P, 5-3 5-2b Summary of E & P Adjustments, 5-6 5-2c Current versus Accumulated E & P, 5-7 5-2d Allocating E & P to Distributions, 5-7
5-3 Dividends, 5-9 5-3a Rationale for Reduced Tax Rates on Dividends, 5-10 5-3b Qualified Dividends, 5-10
5-3c Property Dividends, 5-11 5-3d Constructive Dividends, 5-14 5-3e Stock Dividends and Stock Rights, 5-17
5-4 Tax Planning, 5-20 5-4a Corporate Distributions, 5-20 5-4b Planning for Qualified Dividends, 5-21 5-4c Constructive Dividends, 5-22
C H A P T E R
5
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
THE BI ICTUREG P
TAXING CORPORATE DISTRIBUTIONS
Lime Corporation, an ice cream manufacturer, has had a very profitable year. To share its profits with its
two shareholders, Orange Corporation and Gustavo, it distributes cash of $200,000 to Orange 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.
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 defi-
cit in retained earnings. Consequently, the distribution of cash and land is treated as a liquidating distribu-
tion for financial reporting purposes, resulting in a reduction of Lime’s paid-in capital account.
The tax consequences of the distributions to the corporation and its shareholders depend on a variety of
factors that are not directly related to the financial reporting treatment. Identify these factors and explain the
tax effects of the distributions to both Lime Corporation and its two shareholders.
Read the chapter and formulate your response.
ªALEXANDER RATHS/ SHUTTERSTOCK.COM
5-1
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
C hapter 4 examines the tax consequences of corporate formation. In Chapters 5and 6, the focus shifts to the tax treatment of corporate distributions, a topicthat plays a leading role in tax planning. The importance of corporate distri- butions derives from the variety of tax treatments that may apply. From the share- holder’s perspective, distributions received from the corporation may be treated as ordinary income, preferentially taxed dividend income, capital gain, or a nontaxable recovery of capital. From the corporation’s perspective, distributions made to share- holders are generally not deductible. However, a corporation may recognize losses in liquidating distributions (see Chapter 6), and gains may be recognized at the corpo- rate level on distributions of appreciated property. In the most common scenario, a distribution triggers dividend income to the shareholder and provides no deduction to the paying corporation, resulting in a double tax (at both the corporate and the share- holder level). This double tax may be mitigated by a variety of factors, including the corporate dividends received deduction and preferential tax rates on qualified divi- dends paid to individuals.
As will become apparent in the subsequent discussion, the tax treatment of corpo- rate distributions can be affected by a number of considerations:
• The availability of earnings to be distributed.
• The basis of the shareholder’s stock.
• The character of the property being distributed.
• Whether the shareholder gives up ownership in return for the distribution.
• Whether the distribution is liquidating or nonliquidating.
• Whether the distribution is a “qualified dividend.”
• Whether the shareholder is an individual or another kind of taxpaying entity.
This chapter discusses the tax rules related to nonliquidating distributions of cash and property. Distributions of stock and stock rights are also addressed. Chapter 6 extends the discussion to the tax treatment of stock redemptions and corporate liquidations.
5-1 CORPORATE DISTRIBUTIONS—OVERVIEW To the extent that a distribution is made from corporate earnings and profits (E & P), the shareholder is deemed to receive a dividend, which is taxed either as ordinary income or as preferentially taxed dividend income.1 Generally, corporate distributions are pre- sumed to be paid out of E & P (defined later in this chapter) and are treated as divi- dends unless the parties to the transaction can show otherwise. Distributions not treated as dividends (because of insufficient E & P) are nontaxable to the extent of the share- holder’s stock basis, which is reduced accordingly. The excess of the distribution over the shareholder’s basis is treated as a gain from sale or exchange of the stock.2
5-2 EARNINGS AND PROFITS (E & P)—§ 312 The notion of earnings and profits (E & P) is similar in many respects to the accounting concept of retained earnings. Both are measures of the firm’s accumulated capital (E & P
E X A M P L E
1
At the beginning of the year, Amber Corporation (a calendar year taxpayer) has E & P of $15,000. The corporation generates no additional E & P during the year. On July 1, the corporation distributes $20,000 to its sole shareholder, Bonnie, whose stock basis is $4,000. In this situation, Bonnie recognizes dividend income of $15,000 (the amount of E & P distributed). Of the remaining $5,000 distributed, $4,000 reduces her stock basis to zero, and Bonnie recognizes a taxable gain of $1,000.
LO.1
Explain the role that earnings and profits play in determining the tax treatment of distributions.
1§§ 301(c)(1), 316, and 1(h)(11). 2§§ 301(c)(2) and (3).
5-2 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
includes both the accumulated E & P of the corporation since the latter of its incorporation date or February 28, 1913, and the current year’s E & P). A difference exists, however, in the way these figures are calculated. The computation of retained earnings is based on financial accounting rules, while E & P is determined using rules specified in the tax law.
E & P fixes the upper limit on the amount of dividend income that shareholders must recognize as a result of a distribution by the corporation. In this sense, E & P represents the corporation’s economic ability to pay a dividend without impairing its capital. Thus, the effect of a specific transaction on E & P can often be determined by assessing whether the transaction increases or decreases the corporation’s capacity to pay a dividend.
5-2a Computation of E & P The Code does not explicitly define the term earnings and profits. Instead, a series of adjustments to taxable income are identified to provide a measure of the corporation’s economic income. Both cash basis and accrual basis corporations use the same approach when determining E & P.3
Additions to Taxable Income To determine current E & P, it is necessary to add all previously excluded income items back to taxable income. Included among these positive adjustments are interest on mu- nicipal bonds, excluded life insurance proceeds (in excess of cash surrender value), and Federal income tax refunds from tax paid in prior years.
In addition to excluded income items, the dividends received deduction and the domestic production activities deduction, which do not decrease the corporation’s assets, are added back to taxable income to determine E & P. Neither of these deduc- tions impairs a corporation’s ability to pay dividends. Instead, they are partial exclusions for specific types of income (dividend income and income from domestic production activities).
Subtractions from Taxable Income When calculating E & P, it is also necessary to subtract certain nondeductible expenses from taxable income. These negative adjustments include the nondeductible portion of meal and entertainment expenses, related-party losses, expenses incurred to produce tax-exempt income, Federal income taxes paid, nondeductible key employee life insur- ance premiums (net of increases in cash surrender value), nondeductible fines, penal- ties, and lobbying expenses.
E X A M P L E
2
Eagle Corporation collects $100,000 on a key employee life insurance policy (the corporation is the owner and beneficiary of the policy). At the time the policy matured on the death of the insured employee, it had a cash surrender value of $30,000. None of the $100,000 is included in Eagle’s taxable income, but $70,000 is added to its taxable income when computing current E & P. The distribution of the $30,000 cash surrender value does not increase E & P because it does not reflect an increase in its dividend-paying capacity. Instead, it represents a shift in Eagle’s assets from life insurance to cash.
E X A M P L E
3
Herron Corporation sells property with a basis of $10,000 to its sole shareholder for $8,000. Because of § 267 (disallowance of losses on sales between related parties), Herron cannot deduct the $2,000 loss when calculating its taxable income. However, because the overall economic effect of the transaction is a decrease in its assets by $2,000, the loss reduces the current E & P for the year of sale.
LO.2
Compute a corporation’s earnings and profits (E & P).
3Section 312 describes many of the adjustments to taxable income necessary to determine E & P. Regulation § 1.312–6 addresses the effect of accounting methods on E & P.
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-3
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
Timing Adjustments Some E & P adjustments shift the effect of a transaction from the year of its inclusion in or deduction from taxable income to the year in which it has an economic effect on the corporation. Charitable contributions, net operating losses, and capital losses all necessi- tate this kind of adjustment.
Gains and losses from property transactions generally affect the determination of E & P only to the extent they are 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. Accordingly, no timing adjustment is required for these items.
Accounting Method Adjustments In addition to the above adjustments, accounting methods used for determining E & P are generally more conservative than those allowed for calculating taxable income. For example, the installment method is not permitted for E & P purposes.4 Thus, an adjust- ment is required for the deferred gain from property sales made during the year under the installment method. All principal payments are treated as having been received in the year of sale.
The alternative depreciation system (ADS) must be used for purposes of computing E & P.5 This method requires straight-line depreciation with a half-year convention over a recovery period equal to the Asset Depreciation Range (ADR) midpoint life of an asset.6 Also, ADS prohibits additional first-year depreciation.7 If MACRS cost recovery is used for income tax purposes, a positive or negative adjustment equal to the difference between MACRS and ADS must be made each year. Likewise, when assets are disposed of, an additional adjustment to taxable income is required to allow for the difference in
E X A M P L E
4
Crane Corporation pays a $10,000 premium on a key employee life insurance policy covering the life of its president. As a result of the payment, the cash surrender value of the policy is increased by $7,000. Although none of the $10,000 premium is deductible for tax purposes, current E & P is reduced by $3,000. The $7,000 increase in cash surrender value is not subtracted because it does not represent a decrease in its ability to pay a dividend. Instead, it represents a shift in Crane’s assets from cash to life insurance.
E X A M P L E
5
During 2015, Hawk Corporation makes charitable contributions, $12,000 of which cannot be deducted when calculating its taxable income for the year because of the 10% taxable income limitation. Conse- quently, the $12,000 is carried forward to 2016 and fully deducted in that year. The excess charitable contribution reduces Hawk’s current E & P for 2015 by $12,000 and increases its current E & P for 2016 (when the deduction is allowed) by the same amount. The increase in E & P in 2016 is necessary because the charitable contribution carryover reduces the taxable income for that year (the starting point for computing E & P) but already has been taken into account in determining its E & P for 2015.
E X A M P L E
6
In 2015, Cardinal Corporation, a calendar year taxpayer, sells unimproved real estate with a basis of $20,000 for $100,000. Under the terms of the sale, Cardinal will receive two annual payments of $50,000 beginning in 2016, each with interest of 9%. Cardinal Corporation does not elect out of the installment method. Because Cardinal’s taxable income for 2015 will not reflect any of the gain from the sale, the corporation must make an $80,000 positive adjustment for 2015 (the deferred gain from the sale). Similarly, $40,000 negative adjustments will be required in 2016 and 2017 when the deferred gain is recognized under the installment method.
4§ 312(n)(5). 5§ 312(k)(3)(A). 6See § 168(g)(2). The ADR midpoint lives for most assets are set out in Rev.Proc. 87–56, 1987–2 C.B. 674. The recovery period is 5 years for auto- mobiles and light-duty trucks and 40 years for real property. For assets with no class life, the recovery period is 12 years.
7§ 168(k)(2). A special additional first-year cost recovery allowance was allowed for certain property placed in service prior to 2005. In addition, it was available for certain assets placed in service from 2008 through 2014. This provision may be extended by Congress in 2015.
5-4 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
gain or loss caused by the gap between income tax basis and E & P basis.8 The adjust- ments arising from depreciation are illustrated in the following example.
In addition to more conservative depreciation methods, the E & P rules impose limi- tations on the deductibility of § 179 expense. In particular, this expense must be deducted over a period of five years.9 Thus, in any year that § 179 is elected, 80 percent of the resulting expense must be added back to taxable income to determine current E & P. In each of the following four years, a subtraction from taxable income equal to 20 percent of the § 179 expense must be made.
The E & P rules also require specific accounting methods in various situations, mak- ing adjustments necessary when certain methods are used for income tax purposes. For example, E & P requires cost depletion rather than percentage depletion.10 When accounting for long-term contracts, E & P rules specify the percentage of completion method rather than the completed contract method.11 As the E & P determination does not allow for the amortization of organizational expenses, any such expense deducted when computing taxable income must be added back to determine E & P.12 To account for income deferral under the LIFO inventory method, the E & P computation requires an adjustment for changes in the LIFO recapture amount (the excess of FIFO over LIFO inventory value) during the year. Increases in LIFO recapture are added to taxable income, and decreases are subtracted.13 E & P rules also specify that intangible drilling costs and mine exploration and development costs be amortized over a period of
E X A M P L E
7
On January 2, 2013, White Corporation paid $30,000 to purchase equipment with an ADR midpoint life of 10 years and a MACRS class life of 7 years. The equipment was depreciated under MACRS. The asset was sold on July 2, 2015, for $27,000. For purposes of determining taxable income and E & P, cost recovery claimed on the equipment is summarized below. Assume that White elected not to claim § 179 expense or additional first-year depreciation on the property.
Year Cost Recovery Computation MACRS ADS Adjustment
Amount
2013 $30,000 � 14.29% $ 4,287 $30,000 � 10-year ADR recovery period �
½ (half-year for first year of service) $1,500 $2,787
2014 $30,000 � 24.49% 7,347 $30,000 � 10-year ADR recovery period 3,000 4,347
2015 $30,000 � 17.49% � ½ (half-year for year of disposal) 2,624
$30,000 � 10-year ADR recovery period � ½ (half-year for year of disposal) 1,500 1,124
Total cost recovery $14,258 $6,000 $8,258
Each year, White Corporation will increase taxable income by the adjustment amount indicated above to determine E & P. In addition, when computing E & P for 2015, White will reduce taxable income by $8,258 to account for the excess gain recognized for income tax purposes, as shown below.
Income Tax E & P
Amount realized $27,000 $ 27,000
Adjusted basis for income tax ($30,000 cost � $14,258 MACRS) (15,742)
Adjusted basis for E & P ($30,000 cost � $6,000 ADS) (24,000) Gain on sale $11,258 $ 3,000
Adjustment amount ($3,000 � $11,258) ($ 8,258)
8§ 312(f)(1). 9§ 312(k)(3)(B).
10Reg. § 1.316–2(e).
11§ 312(n)(6). 12§ 312(n)(3). 13§ 312(n)(4).
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-5
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
60 months and 120 months, respectively.14 For income tax purposes, however, these costs can be deducted in the current year.
5-2b Summary of E & P Adjustments E & P serves as a measure of a corporation’s earnings that are available for distribution as taxable dividends to the shareholders. Current E & P is determined by making a series of adjustments to the corporation’s taxable income that are outlined in Concept Summary 5.1. Other items that affect E & P, such as property dividends, are covered later in the chapter. The effect of stock redemptions on E & P is covered in Chapter 6.
Concept Summary 5.1 E & P Adjustments
Adjustment to Taxable Income to Determine Current E & P
Nature of the Transaction Addition Subtraction
Tax-exempt income X
Dividends received deduction X
Domestic production activities deduction X
Collection of proceeds from insurance policy on life of corporate officer (in excess of cash surrender value) X
Deferred gain on installment sale (all gain is added to E & P in year of sale) X
Future recognition of installment sale gross profit X
Excess charitable contribution (over 10% limitation) and excess capital loss in year incurred X
Deduction of charitable contribution, NOL, or capital loss carryovers in succeeding taxable year (increase E & P because deduction reduces taxable income while E & P was reduced in a prior year) X
Federal income taxes paid X
Federal income tax refund X
Loss on sale between related parties X
Nondeductible fines, penalties, and lobbying expenses X
Nondeductible meal and entertainment expenses X
Payment of premiums on insurance policy on life of corporate officer (in excess of increase in cash surrender value of policy) X
Realized gain (not recognized) on an involuntary conversion No effect
Realized gain or loss (not recognized) on a like-kind exchange No effect
Excess percentage depletion (only cost depletion can reduce E & P) X
Accelerated depreciation (E & P is reduced only by straight-line, units-of-production, or machine hours depreciation) X X
Additional first-year depreciation X
Section 179 expense in year elected (80%) X
Section 179 expense in four years following election (20% each year) X
Increase (decrease) in LIFO recapture amount X X
Intangible drilling costs deducted currently (reduce E & P in future years by amortizing costs over 60 months) X
Mine exploration and development costs (reduce E & P in future years by amortizing costs over 120 months) X
14§ 312(n)(2).
5-6 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
5-2c Current versus Accumulated E & P Accumulated E & P is the total of all previous years’ current E & P (since February 28, 1913) reduced by distributions made from E & P in previous years. It is important to dis- tinguish between current E & P and accumulated E & P because the taxability of corpo- rate distributions depends on how these two accounts are allocated to each distribution made during the year. A complex set of rules governs the allocation process.15 These rules are described in the following section and summarized in Concept Summary 5.2.
5-2d Allocating E & P to Distributions When a positive balance exists in both the current and accumulated E & P accounts, corporate distributions are deemed to be made first from current E & P and then from accumulated E & P. When distributions exceed the amount of current E & P, it becomes necessary to allocate current and accumulated E & P to each distribution made during the year. Current E & P is applied first on a pro rata basis to each distribution (using the distribution dollar amounts). Then accumulated E & P is applied in chronologi- cal order, beginning with the earliest distribution. As shown in the following example, this allocation is important if any shareholder sells stock during the year.
E X A M P L E
8
On January 1 of the current year, Black Corporation has accumulated E & P of $10,000. Current E & P for the year amounts to $30,000, earned evenly throughout the year. Megan and Matt are sole equal shareholders of Black from January 1 to July 31. On August 1, Megan sells all of her stock to Helen. Black makes two distributions to shareholders during the year: $40,000 to Megan and Matt ($20,000 to each) on July 1 and $40,000 to Matt and Helen ($20,000 to each) on December 1. Current and accumulated E & P are applied to the two distributions as follows:
Source of Distribution
Current E & P
Accumulated E & P
Return of Capital
July 1 distribution ($40,000) $15,000 $10,000 $15,000
December 1 distribution ($40,000) 15,000 — 25,000
Because 50% of the total distributions are made on July 1 and December 1, respectively, one-half of current E & P is applied to each of the two distributions. Accumulated E & P is applied in chro- nological order, so the entire amount attaches to the July 1 distribution. The tax consequences to the shareholders are presented below.
Concept Summary 5.2 Allocating E & P to Distributions
1. Current E & P is applied first to distributions on a pro rata basis; then accumulated E & P is applied (as necessary) in chronological order beginning with the earliest distribu- tion. See Example 8.
2. Until the parties can show otherwise, it is presumed that current E & P covers all distributions. See Example 9.
3. When a deficit exists in accumulated E & P and a positive balance exists in current E & P, distributions are regarded as dividends to the extent of current E & P. See Example 10.
4. When a deficit exists in current E & P and a positive bal- ance exists in accumulated E & P, the two accounts are netted at the date of distribution. If the resulting balance is zero or a deficit, the distribution is treated as a return of capital, first reducing the basis of the stock to zero, then generating taxable gain. If a positive balance results, the distribution is a dividend to the extent of the balance. Any loss in current E & P is deemed to accrue ratably throughout the year unless the corporation can show otherwise. See Example 11.
15Regulations relating to the source of a distribution are at Reg. § 1.316–2.
LO.3
Determine taxable dividends paid during the year by correctly allocating current and accumulated E & P to corporate distributions.
continued
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-7
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
When the tax years of the corporation and its shareholders are not the same, it may be impossible to determine the amount of current E & P on a timely basis. For example, if shareholders use a calendar year and the corporation uses a fiscal year, then current E & P may not be ascertainable until after the shareholders’ returns have been filed. To address this timing issue, the allocation rules presume that current E & P is sufficient to cover every distribution made during the year until the parties can show otherwise.
Additional difficulties arise when either the current or the accumulated E & P account has a deficit balance. In particular, when current E & P is positive and accumulated E & P has a deficit balance, accumulated E & P is not netted against current E & P. Instead, the distribution is deemed to be a taxable dividend to the extent of the positive current E & P balance.
E X A M P L E
9
Green Corporation uses a June 30 fiscal year for tax purposes. Carol, Green’s only shareholder, uses a calendar year. On July 1, 2015, Green Corporation has a zero balance in its accumulated E & P account. For fiscal year 2015–2016, the corporation suffers a $5,000 deficit in current E & P. On August 1, 2015, Green distributed $10,000 to Carol. The distribution is dividend income to Carol and is reported when she files her income tax return for the 2015 calendar year on or before April 15, 2016. Because Carol cannot prove until June 30, 2016, that the corporation has a deficit for the 2015–2016 fiscal year, she must assume that the $10,000 distribution is fully covered by current E & P. When Carol learns of the deficit, she should file an amended return for 2015 showing the $10,000 as a return of capital.
Shareholder
Megan Matt Helen
July distribution ($40,000)
Dividend income—
From current E & P ($15,000) $ 7,500 $ 7,500 $ –0–
From accumulated E & P ($10,000) 5,000 5,000 –0–
Return of capital ($15,000) 7,500 7,500 –0–
December distribution ($40,000)
Dividend income—
From current E & P ($15,000) –0– 7,500 7,500
From accumulated E & P ($0) –0– –0– –0–
Return of capital ($25,000) –0– 12,500 12,500
Total distribution $20,000 $40,000 $20,000
Total dividend income $12,500 $20,000 $ 7,500
Nontaxable return of capital (assuming sufficient basis in the stock investment) $ 7,500 $20,000 $12,500
Because the balance in the accumulated E & P account is exhausted when it is applied to the July 1 distribution, Megan has more dividend income than Helen, even though both receive equal distri- butions during the year. In addition, each shareholder’s basis is reduced by the nontaxable return of capital; any excess over basis results in taxable gain.
E X A M P L E
The Big Picture
10
Return to the facts of The Big Picture on p. 5-1. Recall that Lime Corporation had a deficit in GAAP- based retained earnings at the start of the year and banner profits during the year. Assume that these financial results translate into an $800,000 deficit in accumulated E & P at the start of the year and cur- rent 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.
5-8 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
In contrast to the previous rule, when a deficit exists in current E & P and a positive balance exists in accumulated E & P, the accounts are netted at the date of distribution. If the resulting balance is zero or negative, the distribution is a return of capital. If a pos- itive balance results, the distribution is a dividend to the extent of the balance. Any loss in current E & P is deemed to accrue ratably throughout the year unless the parties can show otherwise.
5-3 DIVIDENDS As noted earlier, distributions by a corporation from its E & P are treated as dividends. The tax treatment of dividends varies, depending on whether the shareholder receiv- ing them is a corporation or another kind of taxpaying entity. All corporations treat dividends as ordinary income and are permitted a dividends received deduction (see Chapter 2). Qualified dividend income earned by individuals is taxed at reduced tax rates.
E T H I C S & E Q U I T Y Shifting E & P
Ten years ago, Spencer began a new business venture with Robert. Spencer owns 70 percent of the outstand- ing stock, and Robert owns 30 percent. The business has had some difficult times, but current prospects are favorable.
On November 15, Robert decides to quit the venture and plans to sell all of his stock to Spencer’s sister, Heidi, a longtime employee of the business. Robert will sell his stock to Heidi after the company pays out the current-year shareholder distribution of about $100,000. Spencer is looking forward to working with his sister, but he now faces a terrible dilemma.
The corporation has a $300,000 deficit in accumulated E & P and only about $20,000 of current E & P to date. Within
the next two months, however, Spencer expects to sign a major deal with a large client. If Spencer signs the contract before the end of the year, the corporation will have a large increase in current E & P, causing the upcoming distribution to be fully taxable to Robert as a dividend.
As a similar contract is not expected next year, most of next year’s distribution will be treated as a tax-free return of capital for Heidi. Alternatively, if Spencer waits until January, both he and Robert will receive a nontaxable distri- bution this year. However, next year’s annual distribution will be fully taxable to his sister as a dividend. What should Spencer do?
E X A M P L E
11
At the beginning of the current year, Gray Corporation (a calendar year taxpayer) has accumulated E & P of $10,000. During the year, the corporation incurs a $15,000 deficit in current E & P that accrues ratably. On July 1, Gray Corporation distributes $6,000 in cash to Hal, its sole shareholder. To determine how much of the $6,000 cash distribution represents dividend income to Hal, the balances of both accumulated and current E & P as of July 1 are determined and netted. This is necessary because of the deficit in current E & P.
Source of Distribution
Current E & P Accumulated E & P
January 1 $10,000
July 1 (½ of $15,000 net loss) ($7,500) 2,500
July 1 distribution of $6,000:
Dividend income: $2,500
Return of capital: $3,500
The balance in E & P just before the July 1 distribution is $2,500. Thus, of the $6,000 distribution, $2,500 is taxed as a dividend, and $3,500 represents a return of capital.
LO.4
Describe the tax treatment of dividends for individual shareholders.
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-9
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
5-3a Rationale for Reduced Tax Rates on Dividends The double tax on corporate income has always been controversial. Arguably, taxing dividends twice creates several undesirable economic distortions, including:
• An incentive to invest in noncorporate rather than corporate entities.
• An incentive for corporations to finance operations with debt rather than with equity because interest payments are deductible. Notably, this behavior increases the vulnerability of corporations in economic downturns because of higher leverage.
• An incentive for corporations to retain earnings and structure distributions of prof- its to avoid the double tax.
Collectively, these distortions raise the cost of capital for corporate investments. Esti- mates are that eliminating the double tax would increase capital stock in the corporate sector by as much as $500 billion.16 In addition, some argue that elimination of the dou- ble tax would make the United States more competitive globally. Bear in mind that a majority of our trading partners assess only one tax on corporate income.
While many support a reduced or no tax rate on dividends, others contend that the double tax should remain in place because of the concentration of economic power held by publicly traded corporations. Furthermore, many of the distortions noted above can be avoided through the use of deductible payments by C corporations and by utiliz- ing other forms of doing business (e.g., partnerships, limited liability companies, and Subchapter S corporations). Those favoring retention of the double tax also note that the benefits of reduced tax rates on dividends flow disproportionately to the wealthy.17
The United States continues to struggle to find the appropriate course to follow on the taxation of dividends. The reduced tax rate on qualified dividends for individuals reflects a compromise between the complete elimination of tax on dividends and the treatment of dividends as ordinary income.
5-3b Qualified Dividends
Qualified Dividends—Application and Effect Under current law, dividends that meet certain requirements are subject to a 15 percent tax rate for most individual taxpayers (a 20 percent rate applies to taxpayers in the 39.6 percent tax bracket). Dividends received by individuals in the 10 or 15 percent rate brackets are exempt from tax.18
Qualified Dividends—Requirements To be taxed at the lower rates, dividends must be paid by either domestic or certain qualified foreign corporations. Qualified foreign corporations include those traded on
G L O B A L T A X I S S U E S Corporate Integration
From an international perspective, the double taxation of dividends is unusual. Most countries have adopted a policy of corporate integration, which imposes a single tax on corporate profits. Corporate integration takes several forms. One popular approach is to impose a tax at the corporate level, but allow shareholders to claim a credit for corporate-level taxes paid when dividends are received.
A second alternative is to allow a corporate-level deduction for dividends paid to shareholders. A third approach is to allow shareholders to exclude corporate dividends from income. A fourth alternative suggested in the past by the U.S. Treasury is the “comprehensive business income tax,” which excludes both dividend and interest income while disallowing deductions for interest expense.
16Integration of Individual and Corporate Tax Systems, Report of the Depart- ment of the Treasury (January 1992).
17The Urban Institute–Brookings Institution Tax Policy Center estimates that more than one-half of the benefits from the reduced tax rate on dividends go to the .2% of households with incomes over $1 million.
18See §§ 1(h)(1) and (11).
5-10 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
a U.S. stock exchange or any corporation located in a country that (1) has a compre- hensive income tax treaty with the United States, (2) has an information-sharing agree- ment with the United States, and (3) is approved by the Treasury.19
Two other requirements must be met for dividends to qualify for the favorable rates. First, dividends paid to shareholders who hold both long and short positions in the stock do not qualify. Second, the stock on which the dividend is paid must be held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.20 To allow for settlement delays, the ex-dividend date is typically two days before the date of record on a dividend. This holding period rule parallels the rule applied to corporations that claim the dividends received deduction.21
Qualified dividends are not considered investment income for purposes of determin- ing the investment interest expense deduction. Taxpayers can, however, elect 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 evaluate the relative benefits of taxing qualified dividends at low rates versus using the dividends as investment income to increase the amount of deductible investment interest expense.
5-3c Property Dividends Although most corporate distributions are cash, a corporation may distribute a property dividend for various reasons. The shareholders could want a particular property that is held by the corporation. Similarly, a corporation with low cash reserves may still want to distribute a dividend to its shareholders.
Property distributions have the same impact as distributions of cash except for effects attributable to any difference between the basis and the fair market value of the distrib- uted property. In most situations, distributed property is appreciated, so its sale would result in a gain to the corporation. Distributions of property with a basis that differs from fair market value raise several tax questions.
• For the shareholder: • What is the amount of the distribution?
• What is the basis of the property in the shareholder’s hands?
• For the corporation: • Is a gain or loss recognized as a result of the distribution?
• What is the effect of the distribution on E & P?
E X A M P L E
12
In June of the current year, Green Corporation announces that a dividend of $1.50 will be paid on each share of its common stock to shareholders of record on July 15. Amy and Corey, two unre- lated shareholders, own 1,000 shares of the stock on the record date (July 15). Consequently, each receives $1,500 (1,000 shares � $1:50). Assume that Amy purchased her stock on January 15 of this year, while Corey purchased her stock on July 1. Both shareholders sell their stock on July 20. To qualify for the lower dividend rate, stock must be held for more than 60 days during the 121-day period beginning 60 days prior to July 13 (the ex-dividend date). In this case, the 121-day period runs from May 14 to September 11. The $1,500 Amy receives is subject to preferential tax treatment as she held the stock for more than 60 days during this 121-day period. The $1,500 Corey receives, however, is not. Corey did not meet the 60-day holding requirement, so her divi- dend will be taxed as ordinary income.
19In Notice 2011–64, 2011–37 I.R.B 231, the Treasury identified 57 qualifying countries (among those included in the list are the members of the Euro- pean Union, the Russian Federation, Canada, and Mexico). Nonqualifying countries not on the list include most of the former Soviet republics (except Kazakhstan), Bermuda, and the Netherlands Antilles.
20§ 1(h)(11)(B)(iii)(I). 21See § 246(c) and Chapter 2.
LO.5
Evaluate the tax impact of property dividends by computing the shareholder’s dividend income, basis in the property received, and the effect on the distributing corporation’s E & P and taxable income.
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-11
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
Property Dividends—Effect on the Shareholder When a corporation distributes property rather than cash to a shareholder, the amount distributed is measured by the fair market value of the property on the date of distribu- tion.22 As with a cash distribution, the portion of a property distribution covered by existing E & P is a dividend, and any excess is treated as a return of capital. If the fair market value of the property distributed exceeds the corporation’s E & P and the share- holder’s basis in the stock investment, a capital gain usually results.
The amount distributed is reduced by any liabilities to which the distributed property is subject immediately before and immediately after the distribution and by any liabil- ities of the corporation assumed by the shareholder. The basis of the distributed prop- erty for the shareholder is the fair market value of the property on the date of the distribution.
As discussed in the following section, distributing property that has depreciated in value as a property dividend may reflect poor planning.
Property Dividends—Effect on the Corporation All distributions of appreciated property generate gain to the distributing corporation.23
In effect, a corporation that distributes gain property is treated as if it had sold the prop- erty to the shareholder for its fair market value. However, the distributing corporation does not recognize loss on distributions of property.
E X A M P L E
The Big Picture
13
Return to the facts of The Big Picture on p. 5-1. Lime Corporation distributed property with a $300,000 fair market value and $20,000 adjusted basis to one of its shareholders, Gustavo. The prop- erty was subject to a $100,000 mortgage, which Gustavo assumed. As a result, Gustavo has a distri- bution of $200,000 [$300,000 (fair market value) – $100,000 (liability)] that is treated as a taxable dividend. The basis of the property to Gustavo is $300,000.
E X A M P L E
14
Red Corporation owns 10% of Tan Corporation. Tan has ample E & P to cover any distributions made during the year. One distribution made to Red Corporation consists of a vacant lot with an adjusted basis of $80,000 and a fair market value of $50,000. Red has a taxable dividend of $50,000 (before the dividends received deduction), and its basis in the lot becomes $50,000.
E X A M P L E
15
Refer back to the facts of Example 14. Tan Corporation is not allowed to recognize the $30,000 loss on the property distribution. The $30,000 basis disappears ($50,000 fair market value less $80,000 adjusted basis). As an alternative, Tan Corporation could sell the vacant lot and use the related $30,000 loss to reduce its taxes. Then, Tan could distribute the $50,000 of proceeds to its shareholders. Either way, the shareholders end up with property worth $50,000. But by selling the vacant lot and distributing the cash, Tan Corporation benefits by being able to use the $30,000 loss.
E X A M P L E
The Big Picture
16
Return to the facts of The Big Picture on p. 5-1. Lime Corporation distributed property with a fair market value of $300,000 and an adjusted basis of $20,000 to Gustavo, one of its shareholders. As a result, Lime recognizes a $280,000 gain on the distribution.
22Section 301 describes the tax treatment of corporate distributions to share- holders.
23Section 311 describes how corporations are taxed on distributions.
5-12 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
If the distributed property is subject to a liability in excess of basis or the shareholder assumes such a liability, a special rule applies. For purposes of determining gain on the distribution, the fair market value of the property is treated as not being less than the amount of the liability.24
Corporate distributions reduce E & P by the amount of money distributed or by the greater of the fair market value or the adjusted basis of property distributed, less the amount of any liability on the property.25 E & P is increased by gain recognized on appreciated property distributed as a property dividend.
Under no circumstances can a distribution, whether cash or property, either generate a deficit in E & P or add to a deficit in E & P. Deficits can arise only through corporate losses.
The non-cash property distribution rules are summarized in Concept Summary 5.3.
E X A M P L E
17
Assume that the land in Example 14 is subject to a liability of $85,000. Tan Corporation recognizes gain of $5,000 on the distribution [$85,000 ðliabilityÞ� $80,000 ðbasis of the landÞ]. Red Corpora- tion has no dividend income (the liability assumed exceeds the fair market value of the land), and its basis in the land is $85,000 (the land’s deemed fair market value based on the liability assumed).
E X A M P L E
19
Assume the same facts as in Example 18, except that the adjusted basis of the property in the hands of Crimson Corporation is $25,000. Because loss is not recognized and the adjusted basis is greater than fair market value, E & P is reduced by $25,000. Brenda reports dividend income of $20,000.
E X A M P L E
20
Assume the same facts as in Example 19, except that the property is subject to a liability of $6,000, which Brenda assumes. E & P is now reduced by $19,000 [$25,000 ðadjusted basisÞ� $6,000 ðliabilityÞ]. Brenda has a dividend of $14,000 [$20,000 ðamount of the distributionÞ�$6,000 ðliabilityÞ], and her basis in the property is $20,000.
E X A M P L E
21
Teal Corporation has accumulated E & P of $10,000 at the beginning of the current tax year. During the year, it has current E & P of $15,000. At the end of the year, it distributes cash of $30,000 to its sole shareholder, Walter. Teal’s E & P at the end of the year is zero. The accumulated E & P of $10,000 is increased by current E & P of $15,000 and reduced $25,000 by the dividend distribution. The remain- ing $5,000 of the distribution to Walter does not reduce E & P because a distribution cannot generate a deficit in E & P.
24§ 311(b)(2). 25§§ 312(a), (b), and (c).
E X A M P L E
18
Property Distributions—E & P Impacts
Crimson Corporation distributes property (basis of $10,000 and fair market value of $20,000) to Brenda, its shareholder. Crimson Corporation recognizes a gain of $10,000. Crimson’s E & P is increased by the $10,000 gain and decreased by the $20,000 fair market value of the distribution. Brenda has dividend income of $20,000 (presuming sufficient E & P).
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-13
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
5-3d Constructive Dividends Any measurable economic benefit conveyed by a corporation to its shareholders can be treated as a dividend for Federal income tax purposes even though it is not formally declared or designated as a dividend. Also, it need not be issued pro rata to all share- holders26 or satisfy the legal requirements of a dividend. Such a benefit, often described as a constructive dividend , is distinguishable from actual corporate distributions of cash and property in form only.
For tax purposes, constructive distributions are treated the same as actual distribu- tions.27 Thus, corporate shareholders are entitled to the dividends received deduction (see Chapter 2), and other shareholders receive preferential tax rates (0, 15, or 20 per- cent) on qualified constructive dividends. The constructive distribution is taxable as a div- idend only to the extent of the corporation’s current and accumulated E & P. The burden of proving that the distribution constitutes a return of capital because of inadequate E & P rests with the taxpayer.28
Constructive dividend situations usually arise in closely held corporations. Here, the dealings between the parties are less structured, and frequently, formalities are not pre- served. The constructive dividend serves as a substitute for actual distributions and is usually intended to accomplish some tax objective not available through the use of direct dividends. The shareholders may be attempting to distribute corporate profits in a form deductible to the corporation.29 Alternatively, the shareholders may be seeking benefits for themselves while avoiding the recognition of income. Although some con- structive dividends are disguised dividends, not all are deliberate attempts to avoid actual and formal dividends; many are inadvertent. Thus, an awareness of the various constructive dividend situations is essential to protect the parties from unanticipated, undesirable tax consequences. The most frequently encountered types of constructive dividends are summarized below.
Shareholder Use of Corporate-Owned Property A constructive dividend can occur when a shareholder uses corporation property for personal purposes at no cost. Personal use of corporate-owned automobiles, airplanes,
Concept Summary 5.3 Non-Cash Property Distributions
Appreciated Property Depreciated Property
1. Regular Tax: Increase regular taxable income by regular tax gain (difference between FMV and regular tax adjusted basis).
2. Current E & P: Increase current earnings and profits by E & P gain (difference between FMV and E & P adjusted basis).
3. Shareholder(s): Determine impact of distribution on the shareholder(s).
4. End of Year E & P: Decrease earnings and profits by the fair market value of property (net of liabilities assumed by the
shareholder). As with cash distributions, property distributions
cannot create an E & P deficit.
1. Regular Tax: No impact on regular taxable income (regular tax loss not recognized).
2. Current E & P: Generally, no change in current earnings and profits.
3. Shareholder(s): Determine impact of distribution on the shareholder(s).
4. End of Year E & P: Decrease earnings and profits by the E & P adjusted basis of property (net of liabilities assumed by the
shareholder). As with cash distributions, property distributions
cannot create an E & P deficit.
Note: The Internal Revenue Code puts the corporation in the same position as if it had sold the property and distributed the cash.
Note: Earnings and profits will reflect the “loss” on the distribution of depreciated property (via the adjusted basis decrease to E & P), but the regular tax loss vanishes.
LO.6
Recognize situations when constructive dividends exist and compute the tax resulting from such dividends.
26See Lengsfield v. Comm., 57–1 USTC {9437, 50 AFTR 1683, 241 F.2d 508 (CA–5, 1957).
27Simon v. Comm., 57–2 USTC {9989, 52 AFTR 698, 248 F.2d 869 (CA–8, 1957).
28DiZenzo v. Comm., 65–2 USTC {9518, 16 AFTR 2d 5107, 348 F.2d 122 (CA–2, 1965).
29Recall that dividend distributions do not provide the distributing corpora- tion with an income tax deduction, although they do reduce E & P.
5-14 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
yachts, fishing camps, hunting lodges, and other entertainment facilities is commonplace in some closely held corporations. In these situations, the shareholder has dividend income equal to the fair rental value of the property for the period of its personal use.30
Bargain Sale of Corporate Property to a Shareholder Shareholders often purchase property from a corporation at a cost below the fair market value. These bargain sales produce dividend income equal to the difference between the property’s fair market value on the date of sale and the amount the shareholder paid for the property.31 These situations might be avoided by appraising the property on or about the date of the sale. The appraised value should become the price paid by the shareholder.
Bargain Rental of Corporate Property A bargain rental of corporate property by a shareholder also produces dividend income. Here, the measure of the constructive dividend is the excess of the property’s fair rental value over the rent actually paid. Again, appraisal data should be used to avoid any questionable situations.
Payments for the Benefit of a Shareholder If a corporation pays an obligation of a shareholder, the payment is treated as a constructive dividend. The obligation in question need not be legally binding on the shareholder; it may, in fact, be a moral obligation.32 Forgiveness of shareholder indebtedness by the corporation creates an identical problem.33 Also, excessive rentals paid by a corporation for the use of shareholder property are treated as constructive dividends.
Unreasonable Compensation A salary payment to a shareholder-employee that is deemed to be unreasonable compensation is frequently treated as a constructive dividend. As a consequence, it is not deductible by the corporation. In determining the reasonableness of salary pay- ments, the following factors are considered:34
• 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.
E T H I C S & E Q U I T Y A Contribution to Alma Mater
Eagle Corporation pays its president and sole shareholder, Kristin, an annual salary of $400,000. As the sole shareholder, Kristin is always looking for ways to receive additional benefits from the corporation. However, Kristin wants to avoid dividends (because of the effects of double taxation) and has no desire to increase her compensation. Kristin recently made a pledge of $150,000 to her favorite
charity—Southern State College—her alma mater. The funds will be used to establish an endowed scholarship in Kristin’s name. Rather than fulfilling this pledge with her personal funds, she is thinking about having Eagle make the contribution on her behalf. How do you advise Kristin? Could this contribution be considered a constructive dividend? Why or why not?
30See Daniel L. Reeves, 94 TCM 287, T.C.Memo. 2007–273. 31Reg. § 1.301–1(j). 32Montgomery Engineering Co. v. U.S., 64–2 USTC {9618, 13 AFTR 2d 1747,
230 F.Supp. 838 (D.Ct. N.J., 1964), aff’d in 65–1 USTC {9368, 15 AFTR 2d 746, 344 F.2d 996 (CA–3, 1965).
33Reg. § 1.301–1(m). 34All but the final factor in this list are identified in Mayson Manufacturing
Co. v. Comm., 49–2 USTC {9467, 38 AFTR 1028, 178 F.2d 115 (CA–6, 1949).
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-15
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
• 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 compensa- tion paid to the employee in question in previous years.
• Whether a reasonable shareholder would have agreed to the level of compensa- tion paid.
The last factor above, known as the “reasonable investor test,” is a relatively new development in the law on reasonable compensation.35 Its use by the courts has been inconsistent. In some cases, the Seventh Circuit Court of Appeals has relied solely on the reasonable investor test in determining reasonableness, whereas the Tenth Circuit Court of Appeals has largely ignored this factor. Other Federal circuits have used an approach that considers all of the factors in the list.36
Loans to Shareholders Advances to shareholders that are not bona fide loans are constructive dividends. Whether an advance qualifies as a bona fide loan is a question of fact to be determined in light of the particular circumstances. Factors considered in determining whether the advance is a bona fide loan include the following:37
• Whether the advance is on open account or is evidenced by a written instrument.
• Whether the shareholder furnished collateral or other security for the advance.
• How long the advance has been outstanding.
T A X I N T H E N E W S Win Some—Lose Some
Compensation paid by an employer is deduct- ible as a business expense, provided the amount is reasona- ble. What is “reasonable” depends on the relevant facts and circumstances. In a recent case, the Tax Court determined that a portion of the amounts paid to a corporation’s owner and his wife was unreasonable.
Although the payments were largely intended to com- pensate the couple for prior years in which they received lit- tle to no salary, the payments essentially depleted the corporation’s assets. Compensation for prior years’ services can be deductible in the current year as long as the employee was actually undercompensated in prior years and the current payments are intended as compensation for past services.
In this case, the compensation—about $1.6 million over three years—included both salary and pension contributions to a defined benefit pension plan. On audit, the IRS deter- mined that all the compensation paid to the husband and wife was unreasonable, disallowed the deductions to the corporation, and treated the entire amount as a dividend to the husband and wife.
After reviewing a number of factors—including the low salary payments in prior years—the Tax Court held that most of the compensation (about $1.3 million) was reasona- ble. The balance (about $300,000) was deemed to be dividends.
However, there was another twist to this case. Remem- ber that the compensation payments included both salary and pension contributions. When the Tax Court found that a portion of the taxpayer’s compensation was unreasonable, it concluded that the taxpayers received a nondeductible pension contribution. Therefore, a 10% excise tax (§ 4975) on nondeductible contributions to qualified employer plans applied.
The Court did not impose a penalty for failure to file tax returns related to the § 4975 excise tax or a failure to pay a penalty on the tax that would have been due on those returns as it found that the taxpayers had reasonably relied on the advice of their CPA.
Source: Thousand Oaks Residential Care Home, Inc., 105 TCM 1056, T.C.Memo. 2013–10.
35For example, see Alpha Medical, Inc. v. Comm., 99–1 USTC {50,461, 83 AFTR 2d 99–697, 172 F.3d 942 (CA–6, 1999).
36See Vitamin Village, Inc., 94 TCM 277, T.C.Memo. 2007–272, for an example of a case that uses the reasonable investor test and other factors.
37Fin Hay Realty Co. v. U.S., 68–2 USTC {9438, 22 AFTR 2d 5004, 398 F.2d 694 (CA–3, 1968). But see Nariman Teymourian, 90 TCM 352, T.C.Memo. 2005–302, for an example of how good planning can avoid constructive dividends in the shareholder loan context.
5-16 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
• Whether any repayments have been made.
• The shareholder’s ability to repay the advance.
• The shareholder’s use of the funds (e.g., payment of routine bills versus nonrecur- ring, extraordinary expenses).
• The regularity of the advances.
• The dividend-paying history of the corporation.
Even when a corporation makes a bona fide loan to a shareholder, a constructive dividend may be triggered, equal to the amount of imputed (forgone) interest on the loan.38 Imputed interest equals the amount by which the interest paid by the Federal government on new borrowings, compounded semiannually, exceeds the interest charged on the loan. When the imputed interest provision applies, the shareholder is deemed to have made an interest payment to the corporation equal to the amount of imputed interest and the corporation is deemed to have repaid the imputed interest to the shareholder through a constructive dividend. As a result, the corporation receives interest income and makes a nondeductible dividend payment, and the shareholder has taxable dividend income that might be offset with an inter- est deduction.
Loans to a Corporation by Shareholders Shareholder loans to a corporation may be reclassified as equity because the debt has too many features of stock. Any interest and principal payments made by the corporation to the shareholder are then treated as constructive dividends. This topic was covered more thoroughly in the discussion of “thin capitalization” in Chapter 4.
5-3e Stock Dividends and Stock Rights
Stock Dividends—§ 305 Historically, stock dividends were excluded from income on the theory that the owner- ship interest of the shareholder was unchanged as a result of the distribution.39
Recognizing that some distributions of stock could affect ownership interests, the 1954 Code included a provision (§ 305) taxing stock dividends where (1) the stock- holder could elect to receive either stock or property or (2) the stock dividends were in discharge of preference dividends. However, because this provision applied to a narrow range of transactions, corporations were able to develop an assortment of alternative methods that circumvented taxation and still affected shareholders’ proportionate interests in the corporation.40 In response, the scope of § 305 was expanded.
In its current state, the provisions of § 305 are based on the proportionate interest concept. As a general rule, stock dividends are excluded from income if they are pro
E X A M P L E
22
Mallard Corporation lends its principal shareholder, Henry, $100,000 on January 2 of the current year. The loan is interest-free and payable on demand. On December 31, the imputed interest rules are applied. Assuming that the Federal rate is 6%, compounded semiannually, the amount of imputed interest is $6,090. This amount is deemed paid by Henry to Mallard in the form of interest. Mallard is then deemed to return the amount to Henry as a constructive dividend. Thus, Henry has dividend income of $6,090, which might be offset with a deduction for the interest paid to Mallard. Mallard has interest income of $6,090 for the interest received, with no offsetting deduc- tion for the dividend payment.
38See § 7872. 39See Eisner v. Macomber, 1 USTC {32, 3 AFTR 3020, 40 S.Ct. 189 (USSC, 1920).
40See “Stock Dividends,” Senate Report 91–552, 1969–3 C.B. 519.
LO.7
Compute the tax arising from receipt of stock dividends and stock rights and the shareholder’s basis in the stock and stock rights received.
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-17
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
rata distributions of stock or stock rights, paid on common stock. Listed below are five exceptions to this general rule. Each represents a disproportionate distribution situation in which the stock distribution may be taxed (see Concept Summary 5.4).
1. Distributions payable in either stock or property at the election of the shareholder. 2. 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.
3. Distributions of preferred stock to some common shareholders and of common stock to other common shareholders.
4. 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 stock split are not taxable in some circumstances.
5. Distributions of convertible preferred stock unless it can be shown that the distri- bution will not result in a disproportionate distribution.
Concept Summary 5.4 Section 305 Stock Dividends
YES
NO
YES
NO
YES
NO
YES
NO
YES
NO
Shareholder receives a stock dividend or rights to acquire stock
Do not include in the gross income of the shareholder.
Include in the gross income of the shareholder.
Was distribution payable in either stock or property at the option of the
shareholder?
Did it result in a receipt of property (cash) by some shareholders and an increase in assets or E & P to others (stock dividend)?
NO
Did some common shareholders receive common stock and others receive
preferred?
NO
Was it a distribution on preferred stock other than an increase in the conversion ratio of convertible preferred stock made
solely to take into account a stock dividend or split into which it is
convertible?
Did the distribution of convertible preferred stock result in a
disproportionate distribution?
5-18 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
Holders of convertible securities are considered shareholders. Thus, under the second exception above, when interest is paid on convertible debentures and stock dividends are paid on common stock, the stock dividends are taxable. This result is avoided if the con- version ratio or conversion price is adjusted to reflect the price of the stock dividend.41
If stock dividends are not taxable, the corporation’s E & P is not reduced.42 If the stock dividends are taxable, the distributing corporation treats the distribution in the same manner as any other taxable property dividend.
If a stock dividend is taxable, the shareholder’s basis for the newly received shares is fair market value and the holding period starts on the date of receipt. If a stock dividend is not taxable, the basis of the stock on which the dividend is distributed is reallocated.43
If the dividend shares are identical to these formerly held shares, basis for the old stock is reallocated by dividing the taxpayer’s cost in the old stock by the total number of shares. If the dividend stock is not identical to the underlying shares (e.g., a stock divi- dend of preferred on common), basis is determined by allocating the basis of the for- merly held shares between the old and new stock according to the fair market value of each. The holding period includes the holding period of the formerly held stock.44
Stock Rights The rules for determining taxability of stock rights are identical to those for determining taxability of stock dividends. If the rights are taxable, the recipient has income equal to the fair market value of the rights. The fair market value then becomes the shareholder- distributee’s basis in the rights.45 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 consid- eration given.
If stock rights are not taxable and the value of the rights is less than 15 percent of the value of the old stock, the basis of the rights is zero. However, the shareholder may elect to have some of the basis in the formerly held stock allocated to the rights.46 The election is made by attaching a statement to the shareholder’s return for the year in which the rights are received.47 If the fair market value of the rights is 15 percent or more of the value of the old stock and the rights are exercised or sold, the shareholder must allocate some of the basis in the formerly held stock to the rights.
E X A M P L E
23
Stock Dividends
Gail bought 1,000 shares of common stock two years ago for $10,000. In the current tax year, Gail receives 10 shares of common stock as a nontaxable stock dividend. Gail’s basis of $10,000 is divided by 1,010. Each share of stock has a basis of $9.90 instead of the pre-dividend $10 basis.
E X A M P L E
24
Assume that Gail received, instead, a nontaxable preferred stock dividend of 100 shares. The pre- ferred stock has a fair market value of $1,000, and the common stock, on which the preferred is distributed, has a fair market value of $19,000. After the receipt of the stock dividend, the basis of the common stock is $9,500, and the basis of the preferred is $500, computed as follows:
Fair market value of common $19,000
Fair market value of preferred 1,000
$20,000
Basis of common: 19=20 � $10,000 $ 9,500 Basis of preferred: 1=20 � $10,000 $ 500
41See Reg. § 1.305–3(d) for illustrations of how to compute required adjust- ments of conversion ratios or prices.
42§ 312(d)(1). 43§ 307(a). 44§ 1223(5).
45Reg. § 1.305–1(b). 46§ 307(b)(1). 47Reg. § 1.307–2.
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-19
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
5-4 TAX PLANNING
5-4a Corporate Distributions The following points are especially important when planning for corporate distributions.
• Because E & P is the pool of funds from which dividends may be distributed, its periodic determination is essential to corporate planning. Thus, an E & P account should be established and maintained, particularly if the possibility exists that a corporate distribution might be a return of capital.
• Accumulated E & P is the sum of all past years’ current E & P. Because there is no statute of limitations on the computation of E & P, the IRS can redetermine a cor- poration’s current E & P for a tax year long since passed. Such a change affects accumulated E & P and has a direct impact on the taxability of current distribu- tions to shareholders.
• Distributions can be planned to avoid or minimize dividend exposure.
E X A M P L E
25
A corporation with common stock outstanding declares a nontaxable dividend payable in rights to subscribe to common stock. Each right entitles the holder to purchase one share of stock for $90. One right is issued for every two shares of stock owned. Fred owns 400 shares of stock pur- chased two years ago for $15,000. At the time of the distribution of the rights, the market value of the common stock is $100 per share, and the market value of the rights is $8 per right. Fred receives 200 rights. He exercises 100 rights and sells the remaining 100 rights three months later for $9 per right.
Fred need not allocate the cost of the original stock to the rights because the value of the rights is less than 15% of the value of the stock ($1,600 � $40,000 ¼ 4%). If Fred does not allocate his original stock basis to the rights, the tax consequences are as follows:
• Basis of the new stock is $9,000 [$90 (exercise price) � 100 (shares)]. The holding period of the new stock begins on the date the stock was purchased.
• Sale of the rights produces long-term capital gain of $900 [$9 ðsales priceÞ� 100 ðrightsÞ]. The holding period of the rights starts with the date the original 400 shares of stock were acquired.
If Fred elects to allocate basis to the rights, the tax consequences are as follows:
• Basis of the stock is $14,423 [$40,000 (value of stock) � $41,600 (value of rights and stock) � $15,000 (cost of stock)].
• Basis of the rights is $577 [$1,600 (value of rights) � $41,600 (value of rights and stock) � $15,000 (cost of stock)].
• When Fred exercises the rights, his basis for the new stock will be $9,288.50 [$9,000 (cost) þ $288.50 (basis for 100 rights)].
• Sale of the rights would produce a long-term capital gain of $611.50 [$900 (sales price) � $288.50 (basis in the remaining 100 rights)].
E X A M P L E
26
Corporate Distributions—Tax Planning
Flicker Corporation has accumulated E & P of $100,000 as of January 1 of the current year. During the year, it expects to have earnings from operations of $80,000 and to sell an asset for a loss of $100,000. Thus, it anticipates a current E & P deficit of $20,000. Flicker Corporation also expects to make a cash distribution of $60,000. The best approach is to recognize the loss as soon as possible and, immediately thereafter, make the cash distribution to the shareholders. Suppose these two steps take place on January 1. Because the current E & P has a deficit, the accumulated E & P account must be updated (refer to Example 11 in this chapter). Thus, at the time of the distribution, the combined E & P balance is zero [$100,000 (beginning balance in accumulated E & P) � $100,000 (existing deficit in current E & P)], and the $60,000 distribution to the shareholders constitutes a return of capital. Current deficits are deemed to accrue pro rata throughout the year unless the parties can prove otherwise; here, they can.
LO.8
Structure corporate distributions in a manner that minimizes the tax consequences to the parties involved.
5-20 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
5-4b Planning for Qualified Dividends
Retirement Plans The reduced tax rates available to individual taxpayers on net capital gain and qualified dividend income are not available when stock is held in retirement accounts. Because income in § 401(k) plans and IRAs is not taxed when earned, the benefits of the lower tax rates on these forms of income are lost. Instead, distributions from these plans (other than Roth IRAs) are taxed at ordinary income tax rates.
Individual Alternative Minimum Tax The lower rates on dividends and long-term capital gains apply under both the regu- lar income tax and the alternative minimum tax. This increases the exposure of many individuals to the alternative minimum tax, particularly those with significant income from dividends or long-term capital gain. As a result, individual taxpayers who pay the alternative minimum tax should reconsider their investment strategies to manage the mix of ordinary income, dividend income, and capital gain.
E X A M P L E
27
Corporate Distributions—Tax Planning
After several unprofitable years, Darter Corporation has a deficit in accumulated E & P of $100,000 as of January 1, 2015. Starting in 2015, Darter expects to generate annual E & P of $50,000 for the next four years and would like to distribute this amount to its shareholders. The corporation’s cash position (for dividend purposes) will correspond to the current E & P generated. Consider the following two distribution schedules:
1. On December 31 of 2015, 2016, 2017, and 2018, Darter Corporation distributes cash of $50,000. 2. On December 31 of 2016 and 2018, Darter Corporation distributes cash of $100,000.
The two alternatives are illustrated below.
Year Accumulated E & P
(First of Year) Current E & P Distribution Amount of Dividend
Alternative 1
2015 ($100,000) $50,000 $ 50,000 $50,000
2016 (100,000) 50,000 50,000 50,000
2017 (100,000) 50,000 50,000 50,000
2018 (100,000) 50,000 50,000 50,000
Alternative 2
2015 ($100,000) $50,000 $ –0– $ –0–
2016 (50,000) 50,000 100,000 50,000
2017 (50,000) 50,000 –0– –0–
2018 –0– 50,000 100,000 50,000
Alternative 1 produces $200,000 of dividend income because each $50,000 distribution is fully cov- ered by current E & P. Alternative 2, however, produces only $100,000 of dividend income for the shareholders. The remaining $100,000 is a return of capital. Why? At the time Darter Corporation made its first distribution of $100,000 on December 31, 2016, it had a deficit of $50,000 in accumu- lated E & P (the original deficit of $100,000 is reduced by the $50,000 of current E & P from 2015). Consequently, the $100,000 distribution yields a $50,000 dividend (the current E & P for 2016), and $50,000 is treated as a return of capital. As of January 1, 2017, Darter’s accumulated E & P now has a deficit balance of $50,000 because a distribution cannot increase a deficit in E & P. After adding the remaining $50,000 of current E & P from 2017, the balance on January 1, 2018, is zero. Thus, the second distribution of $100,000, made on December 31, 2018, also yields $50,000 of dividends (the current E & P for 2018) and a $50,000 return of capital.
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-21
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
Closely Held Corporations Closely held corporations have considerable discretion regarding their dividend poli- cies. In the past, the double tax result provided strong motivation to avoid the payment of dividends. Instead, the incentive was to bail out corporate profits in a manner that provided tax benefits to the corporation. Hence, liberal use was made of compensa- tion, loan, and lease arrangements because salaries, interest, and rent are deductible. Under current law, however, shareholders prefer dividends because salaries, interest, and rent are fully taxed while dividends receive preferential treatment. Thus, the ques- tion becomes this: Should the corporation or the shareholders benefit? In general, the best strategy considers the tax consequences to both parties.
In Example 28, when the deductible payment is made, the shareholder bears an increased tax burden of $2,000 ($3,500 tax due from the deductible payment � $1,500 tax due from the dividend) while the corporation saves $3,400 ($3,400 tax saved because of the deductible payment � $0 tax saved because of the dividend). Both par- ties could actually benefit if the corporation transfers part of its benefit to the share- holder through a larger deductible payment.
Thus, if properly structured, deductible payments by the corporation to the share- holder still appear to be preferable to dividends in most situations (unless the corpora- tion faces a low tax rate). The benefit of this strategy will be even greater if the shareholder is paying alternative minimum tax.
5-4c Constructive Dividends Tax planning can be particularly effective in avoiding constructive dividend situations. Shareholders should try to structure their dealings with the corporation on an arm’s length basis. For example, reasonable rent should be paid for the use of corporate prop- erty, and a fair price should be paid for its purchase. The parties should make every effort to support the amount involved with appraisal data or market information obtained from reliable sources at or near the time of the transaction. Dealings between shareholders and a closely held corporation should be as formal as possible. In the case of loans to shareholders, for example, the parties should provide for an adequate rate of interest and written evidence of the debt. Shareholders also should establish and follow a realistic repayment schedule.
If shareholders want to bail out corporate profits in a form deductible to the corpora- tion, a balanced mix of the possible alternatives lessens the risk of constructive dividend
E X A M P L E
28
Consider a corporation paying tax at the 34% rate and an individual shareholder in the 35% tax bracket. A deductible $10,000 payment to the shareholder will save the corporation $3,400 in tax, resulting in an after-tax cost of $6,600. The shareholder will pay $3,500 in tax, resulting in after-tax income of $6,500. This creates a joint tax burden of $100 ($3,500 tax paid by the shareholder � $3,400 tax saved by the corporation). If, instead, the corporation paid a $10,000 qualified dividend (subject to a 15% tax rate) to the shareholder, no tax savings would be realized by the corporation, resulting in an after-tax cost of $10,000. The shareholder would owe $1,500 in taxes, leaving $8,500 of income. Considering both the corporation and the shareholder, a dividend creates $1,400 more tax liability than a deductible payment, so the deductible payment is more tax-efficient.
E X A M P L E
29
Assume the same facts as in Example 28, except that the corporation pays a $14,000 deductible payment. In this case, the corporation will save $4,760 ($14,000 � 34%) in tax, resulting in an after- tax cost of $9,240. From the corporation’s perspective, this is preferable to a $10,000 dividend because it costs $760 less after tax ($10,000 dividend cost � $9,240 after-tax cost of a $14,000 deductible payment). The shareholder will pay taxes of $4,900 on the deductible payment, resulting in after-tax income of $9,100. The shareholder will also prefer this payment to a $10,000 dividend because it generates $600 more after-tax income ($9,100 � $8,500 from a dividend).
5-22 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
treatment. Rent for the use of shareholder property, interest on amounts borrowed from shareholders, or salaries for services rendered by shareholders are all feasible substi- tutes for dividend distributions. Overdoing any one approach, however, may attract the attention of the IRS. Too much interest, for example, may mean that the corporation is thinly capitalized, and some of the debt may be reclassified as equity investment.
Much can be done to protect against the disallowance of unreasonable compensa- tion. Example 30 is an illustration, all too common in a family corporation, of what not to do.
What could have been done to improve the tax position of the parties in Example 30? Rebecca and Sam are not entitled to a salary as neither seems to be performing any ser- vices for the corporation. Paying them a salary simply aggravates the problem. The IRS is more apt to consider all the family members’ salaries excessive under the circumstances. Bob should probably reduce his compensation to correspond with that paid to Ed. He can then attempt to distribute corporate earnings to himself in some other form.
Paying some dividends to Bob would also help alleviate the problem raised in Example 30. The IRS has been successful in denying a deduction for salary paid to a shareholder-employee, even when the payment was reasonable, in a situation where the corporation had not distributed any dividends.49 Most courts, however, have not denied deductions for compensation solely because a dividend was not paid. A better approach is to compare an employee’s compensation with the level of compensation prevalent in the particular industry.
The corporation can provide indirect compensation to Bob by paying expenses that benefit him personally, but are nevertheless deductible to the corporation. For example, premiums paid by the corporation for sickness, accident, and hospitalization insurance for Bob are deductible to the corporation and nontaxable to him.50 Any payments under the policy are not taxable to Bob unless they exceed his medical expenses.51 The corpo- ration can also pay for travel and entertainment expenses incurred by Bob on behalf of the corporation. If these expenses are primarily for the benefit of the corporation, Bob will not recognize any taxable income and the corporation will receive a deduction.52
E X A M P L E
30
Bob Cole wholly owns Eagle Corporation. Corporate employees and annual salaries include Rebecca, Bob’s wife ($120,000), Sam, Bob’s son ($80,000), Bob ($640,000), and Ed, Bob’s long-time friend who is unrelated to the Cole family ($320,000). The operation of Eagle Corporation is shared about equally between Bob Cole and Ed. Rebecca performed significant services for Eagle during its formative years, but now merely attends the annual meeting of the board of directors. Sam Cole is a full-time student and occasionally signs papers for the corporation in his capacity as treas- urer. Eagle Corporation has not distributed a dividend for 10 years although it has accumulated substantial E & P. Rebecca, Sam, and Bob run the risk of a finding of unreasonable compensation, based on the following factors:
• Rebecca’s salary is vulnerable unless proof is available that some or all of her $120,000 annual salary is payment for services rendered to the corporation in prior years and that she was underpaid for those years.48
• Sam’s salary is also vulnerable; he does not appear to earn the $80,000 paid to him by the corporation. Neither Sam nor Rebecca is a shareholder, but each one’s relationship to Bob is enough of a tie-in to raise the unreasonable compensation issue.
• Bob’s salary appears susceptible to challenge. Why is he receiving $320,000 more than Ed when it appears that they share equally in the operation of the corporation?
• The fact that Eagle Corporation has not distributed dividends over the past 10 years, even though it is capable of doing so, increases the likelihood of a constructive dividend.
48See, for example, R.J. Nicoll Co., 59 T.C. 37 (1972). 49McCandless Tile Service v. U.S., 70–1 USTC {9284, 25 AFTR 2d 70–870,
422 F.2d 1336 (Ct.Cls., 1970). The court in McCandless concluded that a return on equity of 15% of net profits was reasonable.
50Reg. § 1.162–10.
51The medical reimbursement plan must meet certain nondiscrimination requirements of § 105(h)(2).
52Reg. § 1.62–2(c)(4).
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-23
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
When testing for reasonableness, the IRS looks at the total compensation package, including indirect compensation payments to a shareholder-employee. Thus, indirect payments must not be overlooked.
Indirect compensation can take many forms, including:
• Corporate payment of the shareholder’s personal expenses that are not related to the business (e.g., vacations, rent, medical bills, legal fees, country club dues, and/or other living expenses).
• Corporate reimbursements (e.g., excessive expense allowances and moving allowances).
• Shareholder use of company-owned property for personal purposes without fair payment by the shareholder (e.g., automobiles, boats, and office space).
• Purchase (or rental) of shareholder property in excess of fair market (rental) value.
• Shareholder purchase (or lease) of corporate property at a bargain price (rental).
• Corporate payment of a shareholder’s debt or obligation.
• Corporate loan to a shareholder where there is no expectation or demand for repayment (or with a below-market interest rate).
• Corporate loans to finance a shareholder’s purchase of personal items (e.g., a house, a vacation, and/or personal investments).
• Shareholder loans to the corporation at an interest rate in excess of market rate.
As with many things in life, indirect compensation is a “gray area” with no single set of standards to be applied. Certain activities can combine both business and personal dimensions (e.g., a business trip to Hawaii). A country club membership can generate both business and personal use. Disentangling the business and personal use of business assets can also be a challenge. In fact, many companies have policies that allow for the “limited personal use” of certain corporate assets (such as computers, telephones, mobile devices, fax machines, copy machines, conference rooms, and vehicles). This “limited personal use” exception is normally provided as long as the use is occasional, is not for outside employment, does not result in excessive costs, and does not interfere with work responsibilities. Ultimately, whether there is “indirect compensation” (and a constructive dividend) will depend on taxpayer policies and related documentation substantiating business justification for the usage.
REFOCUS ON THE BIG PICTURE
TAXING CORPORATE DISTRIBUTIONS
A number of factors affect the tax treatment of Lime Corporation’s distributions. The amount of current and accumulated E & P (which differ from the financial reporting concept of retained earnings) partially determines the tax effect on the shareholders. Given that Lime Corporation has had a highly profitable year (see Example 10), it is likely that there is sufficient current E & P to cover the distribu- tions. 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. 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
continued
ª AL
EX AN
DE R
RA TH
S/ SH
UT TE
RS TO
CK .C
OM 5-24 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
Key Terms
Accumulated E & P, 5-7
Constructive dividend, 5-14
Current E & P, 5-7
Earnings and profits (E & P), 5-2
Property dividend, 5-11
Qualified dividends, 5-10
Stock dividends, 5-17
Stock rights, 5-19
Unreasonable compensation, 5-15
Discussion Questions
1. LO.2 In determining Blue Corporation’s current E & P for 2015, how should taxable income be adjusted as a result of the following transactions?
a. A capital loss carryover from 2014, fully used in 2015.
b. Nondeductible meal expenses in 2015.
c. Interest on municipal bonds received in 2015.
d. Nondeductible lobbying expenses in 2015.
e. Loss on a sale between related parties in 2015.
f. Federal income tax refund received in 2015.
2. LO.5 Discuss the impact each of the following has on generating or adding to a deficit in E & P.
a. The distribution of a property dividend, where the basis of the property exceeds its fair market value.
b. An operating loss of the corporation.
held his stock for the entire year, the land is a qualified dividend. As a result, the divi- dend is tax-free (if Gustavo has a marginal rate of 10 or 15 percent) or subject to a 15 percent (or 20 percent) 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 (see Example 13).
From Lime Corporation’s perspective, the distribution of appreciated property cre- ates a deemed gain (see Example 16). Thus, a $280,000 gain results ($300,000 fair market value of the land less its adjusted basis of $20,000). 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).
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. Because the amounts received by the two shareholders are equal ($200,000 each), the current E & P applied is taxed as a dividend and is treated as described above. To the extent the distribu- tions are not covered by current E & P, accumulated E & P is then applied in a pro rata fashion (because both distributions were made on December 31). However, Lime probably has a deficit in accumulated E & P. As a result, the remaining amounts dis- tributed 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).
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-25
For the latest in changes to tax legislation, visit www.cengagebrain.com.
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
3. LO.3 Describe the effect of a distribution in a year when the distributing corporation has:
a. A deficit in accumulated E & P and a positive amount in current E & P.
b. A positive amount in accumulated E & P and a deficit in current E & P.
c. A deficit in both current and accumulated E & P.
d. A positive amount in both current and accumulated E & P.
4. LO.3 A calendar year corporation has substantial accumulated E & P, but it expects to incur a deficit in current E & P for the year due to significant losses in the
last half of the year. A cash distribution to its shareholders on January 1 should result in a return of capital. Comment on the validity of this statement.
5. LO.4 Discuss the rationale for the reduced tax rates on dividends paid to individuals.
6. LO.1, 2, 3, 4, 5 Orange Corporation distributes $200,000 in cash to each of its three shareholders: Sandy, Byron, and Fuchsia Corporation. What
factors must be considered when determining how the distribution is treated for tax purposes by the shareholders?
7. LO.5 Assume the same facts as in Question 6, except that property is distributed. What factors must be considered when determining how the distribution is
treated for tax purposes by Orange Corporation?
8. LO.5 Ochre Corporation’s board of directors decides to distribute property to its shareholders rather than pay a cash dividend. Why might Ochre’s board
make this decision?
9. LO.5 Raven Corporation owns three machines that it uses in its business. It no longer needs two of these machines and is considering distributing them to its two
shareholders as a property dividend. All three machines have a fair market value of $20,000 each. The basis of each machine is as follows: Machine A, $27,000; Machine B, $20,000; and Machine C, $12,000. The corporation has asked you for advice. What do you recommend?
10. LO.5 Tangerine Corporation is considering a property distribution to its shareholders. If appreciated property is to be used, does it matter to Tangerine whether the
property distributed is a long-term capital asset or depreciable property subject to recapture? Would your answer differ if the property distributed has a fair market value less than the adjusted basis? Explain.
11. LO.6 Samantha is the president and sole shareholder of Toucan Corporation. She is paid an annual salary of $500,000, while her son, Aaron, the company’s chief
financial officer, is paid a salary of $290,000. Aaron works for Toucan on a part-time basis and spends most of his time training for triathlons. Toucan advances $85,000 to Samantha as an interest-free loan. What are the tax issues?
12. LO.6 Whether compensation paid to a corporate employee is reasonable is a question of fact to be determined from the surrounding circumstances. How
would the resolution of this problem be affected by each of the following factors?
a. The employee owns no stock but is the mother-in-law of the sole shareholder.
b. The shareholder-employee does not have a college degree.
c. The shareholder-employee works 40 hours per week for another unrelated employer.
d. The shareholder-employee was underpaid for services during the formative period of the corporation.
e. The corporation has never paid a dividend.
f. Year-end bonuses are paid to all employees, but officer-shareholders receive disproportionately larger bonuses.
Issue ID
Issue ID
Decision Making
Issue ID
Issue ID
5-26 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
13. LO.6, 8 Pink Corporation has several employees. Their names and salaries are listed below.
Judy $470,000
Holly (Judy’s daughter) 100,000
Terry (Judy’s son) 100,000
John (an unrelated third party) 320,000
Holly and Terry are the only shareholders of Pink Corporation. Judy and John share equally in the management of the company’s operations. Holly and Terry are both full-time college students at a university 200 miles away. Pink has substantial E & P and has never distributed a dividend. Discuss any problems related to Pink’s salary arrangement.
14. LO.7 Your client, Raptor Corporation, declares a dividend permitting its common shareholders to elect to receive 9 shares of cumulative preferred stock or 3
additional shares of Raptor common stock for every 10 shares of common stock held. Raptor has only common stock outstanding (fair market value of $45 per share). One shareholder elects to receive preferred stock, while the remaining shareholders choose the common stock. Raptor asks you whether the shareholders have any taxable income on the receipt of the stock. Prepare a letter to Raptor and a memo for the file regarding this matter. Raptor’s address is 1812 S. Camino Seco, Tucson, AZ 85710.
Computational Exercises
15. LO.1 At the beginning of the year, Myrna Corporation (a calendar year taxpayer) has E & P of $32,000. The corporation generates no additional E & P during
the year. On December 31, the corporation distributes $50,000 to its sole share- holder, Abby, whose stock basis is $10,000. How is the distribution treated for tax purposes?
16. LO.3 On January 1 of the current year, Rhondell Corporation has accumulated E & P of $13,000. Current E & P for the year is $84,000, earned evenly
throughout the year. Elizabeth and Jonathan are sole equal shareholders of Rhondell from January 1 to April 30. On May 1, Elizabeth sells all of her stock to Marshall. Rhondell makes two distributions to shareholders during the year: A total of $42,000, ($21,000 to Elizabeth and $21,000 to Jonathan) on April 30 and a total of $58,000 ($29,000 to Jonathan and $29,000 to Marshall) on December 31.
Determine the allocation of the distributions by completing the table below. Assume the shareholders have sufficient basis in their stock for any amount that is treated as return of capital.
From Current E & P
From Accumulated E & P
Treated as Return of Capital
April 30 distribution of $42,000 $_________________ $_________________ $_________________
December 31 distribution of $58,000 $_________________ $_________________ $_________________
17. LO.4, 8 Robin Corporation would like to transfer excess cash to its sole share- holder, Adam, who is also an employee. Adam is in the 28% tax bracket,
and Robin is in the 34% bracket. Because Adam’s contribution to the business is sub- stantial, Robin believes that a $25,000 bonus in the current year is reasonable com- pensation and should be deductible by the corporation. However, Robin is considering paying Adam a $25,000 dividend because the tax rate on dividends is lower than the tax rate on compensation. Is Robin correct in believing that a divi- dend is the better choice? Why or why not?
Communications
Decision Making
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-27
For the latest in changes to tax legislation, visit www.cengagebrain.com.
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
18. LO.5 Global Corporation distributed property with an $850,000 fair market value and a $415,000 adjusted basis to one of its shareholders. The property was
subject to a $230,000 mortgage, which the shareholder assumed. Global has ample E & P to cover any distribution made during the year. What is the amount of the shareholder’s dividend income on the distribution? What is the shareholder’s basis in the property received?
19. LO.5 Quinlan has ample E & P to cover any distributions made during the year. One distribution made to a shareholder consists of property with an adjusted
basis of $150,000 and a fair market value of $90,000. What are the tax consequences of this distribution to Quinlan?
20. LO.5 Fargo Corporation distributes property (basis of $260,000 and fair market value of $310,000) to a shareholder. Fargo Corporation has sufficient E & P
for its distributions. What are the tax consequences of this distribution to Fargo?
21. LO.6 Deerwood Corporation lends its principal shareholder, Lafayette, $500,000 on July 1 of the current year. The loan is interest-free and payable on demand.
On December 31, the imputed interest rules are applied. Assume that the Federal rate is 6%, compounded semiannually. What are the tax consequences of this loan to Lafayette?
22. LO.7 What are the tax consequences to Euclid from the following independent events?
a. Euclid bought 500 shares of common stock five years ago for $50,000. This year, Euclid receives 20 shares of common stock as a nontaxable stock dividend. What is Euclid’s basis per share after this event?
b. Assume instead that Euclid received a nontaxable preferred stock dividend of 20 shares. The preferred stock has a fair market value of $5,000 and the common stock, on which the preferred is distributed, has a fair market value of $75,000.
23. LO.7 A corporation with common stock outstanding declares a nontaxable dividend payable in rights to subscribe to common stock on June 30 of the current year.
Each right entitles the holder to purchase one share of stock for $25. One right is issued for every share of stock owned. Thomas owns 100 shares of stock purchased ten years ago for $1,000. At the time of the distribution of the rights, the market value of the common stock is $40 per share, and the market value of the rights is $5 per right. Thomas receives 100 rights. On September 30, he exercises 75 of the rights and sells the remaining 25 rights for $6 per right.
a. Assuming Thomas does not allocate his original stock basis to the rights, what is his basis in the new stock?
b. When does his holding period begin?
c. What are the tax consequences of the sale of the rights?
Problems
24. LO.1, 4 At the start of the current year, Blue Corporation (a calendar year taxpayer) has accumulated E & P of $100,000. Blue’s current E & P is $60,000, and at
the end of the year, it distributes $200,000 ($100,000 each) to its equal shareholders, Pam and Jon. Pam’s stock basis is $11,000; Jon’s stock basis is $26,000. How is the distribution treated for tax purposes?
5-28 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
25. LO.1, 2 Cardinal Corporation, a calendar year taxpayer, receives dividend income of $250,000 from a corporation in which it holds a 10% interest. Cardinal
also receives interest income of $35,000 from municipal bonds. (The municipality used the proceeds from the bond issue to construct a library.) Cardinal borrowed funds to purchase the municipal bonds and pays $20,000 of interest on the loan. Excluding these items, Cardinal’s taxable income is $500,000.
a. What is Cardinal Corporation’s taxable income after these items are taken into account?
b. What is Cardinal Corporation’s accumulated E & P at the start of next year if its beginning balance this year is $150,000?
26. LO.1, 2, 3 On September 30, Silver Corporation, a calendar year taxpayer, sold a parcel of land (basis of $400,000) for a $1 million note. The note is
payable in five installments, with the first payment due next year. Because Silver did not elect out of the installment method, none of the $600,000 gain is taxed this year.
Silver Corporation had a $300,000 deficit in accumulated E & P at the beginning of the year. Before considering the effect of the land sale, Silver had a deficit in current E & P of $50,000.
Sam, the sole shareholder of Silver, has a basis of $200,000 in his stock. If Silver distributes $900,000 to Sam on December 31, how much income must he report for tax purposes?
27. LO.2 Sparrow Corporation (a calendar year, accrual basis taxpayer) had the following transactions in 2015, its second year of operation.
Taxable income $330,000
Federal income tax liability paid 112,000
Tax-exempt interest income 5,000
Meals and entertainment expenses (total) 3,000
Premiums paid on key employee life insurance 3,500
Increase in cash surrender value attributable to life insurance premiums 700
Proceeds from key employee life insurance policy 130,000
Cash surrender value of life insurance policy at distribution 20,000
Excess of capital losses over capital gains 13,000
MACRS deduction 26,000
Straight-line depreciation using ADS lives 16,000
Section 179 expense elected during 2014 25,000
Dividends received from domestic corporations (less than 20% owned) 25,000
Sparrow uses the LIFO inventory method, and its LIFO recapture amount increased by $10,000 during 2015. In addition, Sparrow sold property on installment during 2014. The property was sold for $40,000 and had an adjusted basis at sale of $32,000. During 2015, Sparrow received a $15,000 payment on the installment sale. Finally, assume that no additional first-year depreciation was claimed. Compute Sparrow’s current E & P.
28. LO.1, 2 In each of the following independent situations, indicate the effect on taxable income and E & P, stating the amount of any increase (or decrease)
in each as a result of the transaction. Assume that E & P has already been increased by taxable income.
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-29
For the latest in changes to tax legislation, visit www.cengagebrain.com.
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
Transaction Taxable Income
Increase (Decrease) E & P Increase
(Decrease)
a. Realized gain of $80,000 on involuntary conversion of building ($10,000 of gain is recognized). ______________ ______________
b. Mining exploration costs incurred on May 1 of current year; $24,000 is deductible from current-year taxable income. ______________ ______________
c. Sale of equipment to unrelated third party for $240,000; basis is $120,000 (no election out of installment method; no payments are received in current year). ______________ ______________
d. Dividends of $20,000 received from 5% owned corporation, together with dividends received deduction (assume that taxable income limit does not apply). ______________ ______________
e. Domestic production activities deduction of $45,000 claimed in current year. ______________ ______________
f. Section 179 expense deduction of $25,000 in current year. ______________ ______________
g. Impact of current-year § 179 expense deduction in succeeding year. ______________ ______________
h. MACRS depreciation of $80,000. ADS depreciation would have been $90,000. ______________ ______________
i. Federal income taxes of $80,000 paid in current year. ______________ ______________
29. LO.2 Yellow Corporation, a calendar year taxpayer, made estimated tax payments of $40,000 for 2015 ($10,000 per quarter). Yellow filed its Federal income tax
return for 2015 reflecting a tax liability of $15,000. Due to its overpayments, Yellow received a $25,000 refund in 2016. What is the impact on Yellow’s E & P of the payment of estimated taxes and the receipt of the Federal income tax refund?
30. LO.1, 3 Sparrow Corporation is a calendar year taxpayer. At the beginning of the current year, Sparrow has accumulated E & P of $33,000. The corporation
incurs a deficit in current E & P of $46,000 that accrues ratably throughout the year. On June 30, Sparrow distributes $20,000 to its sole shareholder, Libby. If Libby’s stock has a basis of $4,000, how is she taxed on the distribution?
31. LO.1, 3 At the beginning of the year, Teal Corporation had accumulated E & P of $225,000. On March 30, Teal sold an asset at a loss of $225,000. For the cal-
endar year, Teal incurred a deficit in current E & P of $305,000, which includes the $225,000 loss on the sale of the asset. If Teal made a distribution of $50,000 to its sole shareholder on April 1, how will the shareholder be taxed?
32. LO.1, 3 Green Corporation (a calendar year taxpayer) had a deficit in accumulated E & P of $250,000 at the beginning of the current year. Its net profit for the
period January 1 through July 30 was $300,000, but its E & P for the entire taxable year was only $40,000. If Green made a distribution of $60,000 to its sole share- holder on August 1, how will the shareholder be taxed?
33. LO.1, 3 Black Corporation and Tom each own 50% of Tan Corporation’s common stock. On January 1, Tan has a deficit in accumulated E & P of $200,000. Its
current E & P is $90,000. During the year, Tan makes cash distributions of $40,000 each to Black and Tom.
a. How are the two shareholders taxed on the distribution?
b. What is Tan Corporation’s accumulated E & P at the end of the year?
5-30 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
34. LO.1, 3 Complete the following schedule for each case. Unless otherwise indicated, assume that the shareholders have ample basis in the stock investment.
Accumulated E & P
Beginning of Year Current E & P
Cash Distributions (All on Last Day of
Year) Dividend Income
Return of Capital
a. ($200,000) $ 70,000 $130,000 $________ $________ b. 150,000 (120,000) 210,000 ________ ________ c. 90,000 70,000 150,000 ________ ________ d. 120,000 (60,000) 130,000 ________ ________ e. Same as (d), except that the distribution of $130,000 is
made on June 30 and the corporation uses the calendar year for tax purposes. ________ ________
35. LO.1, 3 Larry, the sole shareholder of Brown Corporation, sold his Brown stock to Ed on July 30 for $270,000. Larry’s basis in the stock was $200,000 at the
beginning of the year. Brown had accumulated E & P of $120,000 on January 1 and has current E & P of $240,000. During the year, Brown made the following distribu- tions: $450,000 cash to Larry on July 1 and $150,000 cash to Ed on December 30. How will Larry and Ed be taxed on the distributions? How much gain will Larry recognize on the sale of his stock to Ed?
36. LO.4 Sean, a shareholder of Crimson Corporation, is in the 35% tax bracket. This year, he receives a $7,000 qualified dividend from Crimson. Sean has
investment interest expense of $16,000 and net investment income of $9,000 (not including the qualified dividend). Assume that Sean does not expect to have any investment income in the foreseeable future. Should Sean treat the distribution as a qualified dividend (subject to a 15% tax rate) or classify it as net investment income?
37. LO.4 In November of the current year, Emerald Corporation declared a dividend of $2 per share (the shareholder record date is December 15). Assume that Emerald has
sufficient current E & P to cover the dividend payment. If Judy purchases 500 shares of Emerald stock on December 5 and sells the stock on December 25, how is she taxed on the $1,000 dividend?
38. LO.1, 5 Heather, an individual, owns all of the outstanding stock in Silver Corporation. Heather purchased her stock in Silver nine years ago, and
her basis is $56,000. At the beginning of this year, the corporation has $76,000 of accumulated E & P and no current E & P (before considering the effect of the distributions as noted below). What are the tax consequences to Heather (amount and type of income and basis in property received) and Silver Corporation (gain or loss and effect on E & P) in each of the following situations?
a. Silver distributes land to Heather. The land was held as an investment and has a fair market value of $54,000 and an adjusted basis of $42,000.
b. Assume that Silver Corporation has no current or accumulated E & P prior to the distribution. How would your answer to (a) change?
c. Assume that the land distributed in (a) is subject to a $46,000 mortgage (which Heather assumes). How would your answer change?
d. Assume that the land has a fair market value of $54,000 and an adjusted basis of $62,000 on the date of the distribution. How would your answer to (a) change?
e. Instead of distributing land in (a), assume that Silver decides to distribute equipment used in its business. The equipment has a $14,000 market value, a $1,200 adjusted basis for income tax purposes, and a $5,200 adjusted basis for E & P purposes. When the equipment was purchased four years ago, its original fair market value was $18,000.
Decision Making
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-31
For the latest in changes to tax legislation, visit www.cengagebrain.com.
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
39. LO.1, 5 Apricot Corporation distributes property ($125,000 basis and $150,000 fair market value) to its sole shareholder, Ellie. The property is subject to a
liability of $200,000, which Ellie assumes. Apricot has E & P of $325,000 prior to the distribution.
a. What gain, if any, does Apricot recognize on the distribution? What is Apricot’s accumulated E & P at the start of the following year?
b. What is the amount of Ellie’s dividend income on the distribution? What is her basis in the property received?
40. LO.1, 5 Lime Corporation, with E & P of $500,000, distributes land (worth $300,000, adjusted basis of $350,000) to Harry, its sole shareholder. The land is sub-
ject to a liability of $120,000, which Harry assumes. What are the tax consequences to Lime and to Harry?
41. LO.1, 3 At the beginning of the year, Penguin Corporation (a calendar year tax- payer) has accumulated E & P of $55,000. During the year, Penguin incurs
a $36,000 loss from operations that accrues ratably. On October 1, Penguin distrib- utes $40,000 in cash to Holly, its sole shareholder. How is Holly taxed on the distri- bution?
42. LO.1, 5 Cornflower Corporation distributes equipment (adjusted basis of $70,000, fair market value of $55,000) to its shareholder, Roy. Assume that
Cornflower has more than $100,000 of current E & P. What are the tax consequences to Cornflower Corporation and to Roy?
43. LO.1, 2, 3, 4, 5 Cerulean Corporation has two equal shareholders, Eloise and Olivia. Eloise acquired her Cerulean stock three years ago by transferring
property worth $700,000, basis of $300,000, for 70 shares of the stock. Olivia acquired 70 shares in Cerulean Corporation two years ago by transferring property worth $660,000, basis of $110,000. Cerulean Corporation’s accumulated E & P as of January 1 of the current year is $350,000. On March 1 of the current year, the corpo- ration distributed to Eloise property worth $120,000, basis to Cerulean of $50,000. It distributed cash of $220,000 to Olivia. On July 1 of the current year, Olivia sold her stock to Magnus for $820,000. On December 1 of the current year, Cerulean distrib- uted cash of $90,000 each to Magnus and Eloise. What are the tax issues?
44. LO.1, 2, 5 Petrel Corporation has accumulated E & P of $85,000 at the beginning of the year. Its current-year taxable income is $320,000. On December 31,
Petrel distributed business property (worth $140,000, adjusted basis of $290,000) to Juan, its sole shareholder. Juan assumes a $70,000 liability on the property. Included in the determination of Petrel’s current taxable income is $16,000 of income recog- nized from an installment sale in a previous year. In addition, the corporation incurred a Federal income tax liability of $112,000, paid life insurance premiums of $4,500, and received term life insurance proceeds of $150,000 on the death of an officer.
a. What is Juan’s gross income from the distribution?
b. What is the E & P of Petrel Corporation after the property distribution?
c. What is Juan’s tax basis in the property received?
d. How would your answers to (a) and (b) change if Petrel had sold the property at its fair market value, used $70,000 of the proceeds to pay off the liability, and distributed the remaining cash and any tax savings to Juan?
45. LO.5 Iris Corporation owns 30% of Fresia Corporation’s stock. On November 15, Fresia Corporation, with current E & P of $320,000, distributes land (fair
market value of $100,000; basis of $160,000) to Iris. The land is subject to a liability of $80,000, which Iris assumes.
a. How is Iris Corporation taxed on the distribution?
b. What is Fresia Corporation’s E & P after the distribution?
Issue ID
Decision Making
5-32 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
46. LO.6 Parrot Corporation is a closely held company with accumulated E & P of $300,000 and current E & P of $350,000. Tom and Jerry are brothers; each
owns a 50% share in Parrot, and they share management responsibilities equally. What are the tax consequences of each of the following independent transactions involving Parrot, Tom, and Jerry? How does each transaction affect Parrot’s E & P?
a. Parrot sells an office building (adjusted basis of $350,000; fair market value of $300,000) to Tom for $275,000.
b. Parrot lends Jerry $250,000 on March 31 of this year. The loan is evidenced by a note and is payable on demand. No interest is charged on the loan (the current applicable Federal interest rate is 7%).
c. Parrot owns an airplane that it leases to others for a specified rental rate. Tom and Jerry also use the airplane for personal use and pay no rent. During the year, Tom used the airplane for 120 hours, and Jerry used it for 160 hours. The rental value of the airplane is $350 per hour, and its maintenance costs average $80 per hour.
d. Tom leases equipment to Parrot for $20,000 per year. The same equipment can be leased from another company for $9,000 per year.
47. LO.7 Ken purchased 10,000 shares of Gold Corporation common stock six years ago for $160,000. In the current year, Ken received a preferred stock dividend
of 800 shares, while the other holders of common stock received a common stock dividend. The preferred stock Ken received has a fair market value of $80,000, and his common stock has a fair market value of $240,000. Assume that Gold has ample E & P to cover any distributions made during the year. What is Ken’s basis in the preferred and common stock after the dividend is received? When does his holding period commence for the preferred stock?
48. LO.7 Jacob Corcoran bought 10,000 shares of Grebe Corporation stock two years ago for $24,000. Last year, Jacob received a nontaxable stock dividend of
2,000 shares in Grebe Corporation. In the current tax year, Jacob sold all of the stock received as a dividend for $18,000. Prepare a letter to Jacob and a memo for the file describing the tax consequences of the stock sale. Jacob’s address is 925 Arapahoe Street, Boulder, CO 80304.
49. LO.7 Denim Corporation declares a nontaxable dividend payable in rights to sub- scribe to common stock. One right and $60 entitle the holder to subscribe to
one share of stock. One right is issued for every two shares of stock owned. At the date of distribution of the rights, the market value of the stock is $110 per share, and the market value of the rights is $55 per right. Lauren owns 300 shares of stock that she purchased two years ago for $9,000. Lauren receives 150 rights, of which she exercises 105 to purchase 105 additional shares. She sells the remaining 45 rights for $2,475. What are the tax consequences of this transaction to Lauren?
50. LO.4, 8 Kristen, the president and sole shareholder of Egret Corporation, has earned a salary bonus of $30,000 for the current year. Because of the lower tax rates
on qualifying dividends, Kristen is considering substituting a dividend for the bonus. Assume that the tax rates are 28% for Kristen and 34% for Egret Corporation.
a. How much better off would Kristen be if she were paid a dividend rather than salary?
b. How much better off would Egret Corporation be if it paid Kristen a salary rather than a dividend?
c. If Egret Corporation pays Kristen a salary bonus of $40,000 instead of a $30,000 dividend, how would your answers to (a) and (b) change?
d. What should Kristen do?
Communications
Decision Making
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-33
For the latest in changes to tax legislation, visit www.cengagebrain.com.
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
51. LO.1, 3, 8 Your client, Heron Corporation, has a deficit in accumulated E & P of $300,000. Starting this year, it expects to generate annual E & P of
$150,000 for the next four years and would like to distribute this amount to its share- holders. How should Heron Corporation distribute the $600,000 over the four-year period to provide the least amount of dividend income to its shareholders (all indi- viduals)? In a letter to your client, make appropriate suggestions on how this should be done. Also prepare a memo for your firm’s file. Heron Corporation’s address is 12 Nature Trail Way, Daytona Beach, FL 32114.
Research Problems
Student Edition
Note: Solutions to Research Problems can be prepared by using the Checkpoint�
Student Edition online research product, which is available to accompany this text. It is also possible to prepare solutions to the Research Problems by using tax research materials found in a standard tax library.
Research Problem 1. Kenny Merinoff and his son, John, own all outstanding stock of Flamingo Corporation. Both John and Kenny are officers in the corporation and, together with their uncle, Ira, comprise the entire board of directors. Flamingo uses the cash method of accounting and has a calendar year-end. In late 2008, the board of directors adopted the following legally enforceable resolution (agreed to in writing by each of the officers):
Salary payments made to an officer of the corporation that shall be disallowed in whole or in part as a deductible expense for Federal income tax purposes shall be reimbursed by such officer to the corporation to the full extent of the disallowance. It shall be the duty of the board of directors to enforce payment of each such amount.
In 2013, Flamingo paid Kenny $800,000 in compensation. John received $650,000. On an audit in late 2014, the IRS found the compensation of both officers to be excessive. It disallowed deductions for $400,000 of the payment to Kenny and $350,000 of the payment to John. The IRS recharacterized the disallowed payments as constructive dividends. Complying with the resolution by the board of directors, both Kenny and John repaid the disallowed compensation to Flamingo Corporation in 2015. John and Kenny have asked you to determine how their repayments should be treated for tax purposes. John is still working as a highly compensated executive for Flamingo, while Kenny is retired and living off his savings. Prepare a memo for your firm’s client files describing the results of your research.
Partial list of research aids: § 1341. Vincent E. Oswald, 49 T.C. 645 (1968).
Research Problem 2. Your client, White Corporation, has done well since its forma- tion 20 years ago. This year, it recognized a $50 million capital gain from the sale of a subsidiary. White’s CEO has contacted you to discuss a proposed transaction to reduce the tax on the capital gain. Under the proposal, White will purchase all of the common stock in Purple Corporation for $200 million. Purple is a profitable corpora- tion that has $63 million in cash and marketable securities, $137 million in operating assets, and approximately $280 million in E & P. After its acquisition, Purple will dis- tribute $50 million in cash and marketable securities to White. Due to the 100% divi- dends received deduction, no taxable income results to White from the dividend. White will then resell Purple for $150 million. The subsequent sale of Purple gener- ates a $50 million capital loss [$200 million (stock basis) – $150 million (sales price)]. The loss from the stock sale can then be used to offset the preexisting $50 million capital gain. Will the proposed plan work? Why or why not?
Partial list of research aids: § 1059.
Communications
Communications
5-34 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
Research Problem 3. Emerald Corporation is required to change its method of accounting for Federal income tax purposes. The change will require an adjustment to income to be made over three tax periods. Jonas, the sole shareholder of Emerald Corporation, wants to better understand the implications of this adjustment for E & P purposes, as he anticipates a distribution from Emerald in the current year. Prepare a memo for your firm’s client files describing the results of your research.
Partial list of research aids: § 481(a). Rev.Proc. 97–27, 1997–1 C.B. 680.
Research Problem 4. In July 2013, Windstream Corp. (Nasdaq: WIN), a Fortune 500 and S&P 500 company, made an announcement regarding the taxation of a recent dis- tribution. It also made a projection regarding the anticipated tax consequences of future distributions. Locate articles or press releases regarding Windstream’s announce- ment and related distribution. What might have led Windstream to make the announcement? What implications might the information contained in the announce- ment have for investors’ expectations regarding the company’s future earnings? On what might the predictions regarding the taxation of future distributions be based?
Research Problem 5. The applicability of the lower capital gains rates to qualified div- idends, enacted on a temporary basis in 2003, was made permanent in 2013. There was considerable debate surrounding the desirability of making the reduced rates permanent. Search the Internet for arguments for and against extending the reduced rates on dividends for individuals. Summarize the arguments made on both sides. Which side do you agree with? Why?
Roger CPA Review Questions
1. Candy Corp. is a C Corporation that began operations in Year 1. Candy Corp.’s Year 1 through Year 3 taxable earnings and profits are as follows:
Year E & P
1 ($25,000)
2 5,000
3 10,000
On the last day of Year 3, Candy Corp. makes a $12,500 cash shareholder distribu- tion, distributed equally among its two shareholders, Goode and Plenteau. How much of Goode’s distribution is a nontaxable return of capital? Assume sufficient basis in Goode’s stock investment.
a. $5,000
b. $0
c. $1,250
d. $6,250
2. As of December 31, 20X14, Eliot Corp. has net income per books of $100,000, which includes municipal bond interest of $4,000, a deduction for business meals of $5,000, a deduction for a net capital loss of $5,000, and a deduction for federal income taxes of $22,000. What is Eliot Corp.’s current earnings and profits (Current E & P) for 20X14?
a. $98,500
b. $107,500
c. $125,500
d. $102,500
Communications
CHAPTER 5 Corporations: Earnings & Profits and Dividend Distributions 5-35
For the latest in changes to tax legislation, visit www.cengagebrain.com.
Use the tax resources of the Internet to address the following questions. Do not restrict your search to the Web, but include a review of newsgroups and general reference materials, practitioner sites and resources, primary sources of the tax law, chat rooms and discussion groups, and other opportunities.
Internet Activity
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
3. As of December 31, 20X15, Hardy Corp. has net income per books of $120,000, which includes straight-line depreciation expense of $5,000. Hardy Corp. claimed accelerated depreciation of $15,000 for tax purposes. Also included in book income were lobbying expenses of $4,000 and a federal income tax refund of $5,000. What is Hardy Corp.’s current earnings and profits (Current E & P) for 20X15?
a. $119,000
b. $109,000
c. $124,000
d. $114,000
4. As of December 31, 20X15, Caledonia Corp. has taxable income of $150,000, which includes a $20,000 accelerated depreciation deduction; had straight-line deprecia- tion been used, the deduction would have been $6,000. Also included in taxable income is an operating loss carryforward from a prior year of $3,000. Additionally, Caledonia earned $4,000 in municipal bond interest during the year. What is Caledo- nia Corp.’s current earnings and profits (Current E & P) for 20X15?
a. $164,000
b. $171,000
c. $157,000
d. $168,000
5. At the beginning of the year, Crispin, a C corporation, had a deficit of $35,000 in accumulated earnings and profits (E & P). For the current year, Crispin reported E & P of $12,000. Crispin distributed $10,000 during the year. What was the amount of Crispin’s accumulated E & P deficit at year-end?
a. $23,000
b. $33,000
c. $27,000
d. $37,000
6. On January 1 of the current year, Quail Corp., an accrual-basis, calendar-year C cor- poration, had accumulated earnings and profits (E & P) of $20,000. On December 31 of the current year, Quail Corp. has current E & P of $24,000, earned evenly through- out the year. Ray and Devi were sole equal shareholders of Quail throughout the year. Quail made two distributions to shareholders during the year: $30,000 on July 1 and $30,000 on December 31. How much of the December 31 distribution is taxable dividend income for Devi?
a. $7,000
b. $11,000
c. $6,000
d. $1,000
7. Compendium Corp. distributed cash and personal property to its sole shareholder. Considering the following facts, what is the amount of gain that would be recog- nized by Compendium as the result of making this distribution to its shareholder?
Item Amount
Cash $25,000
Personal property
Fair market value 10,000
Adjusted basis 4,000
Liability on property assumed by shareholder 12,000
a. $4,000
b. $6,000
c. $8,000
d. $29,000
5-36 PART 2 Corporations
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
PR OP
ER TY
O F
CE NG
AG E
LE AR
NI NG
<< /ASCII85EncodePages false /AllowTransparency false /AutoPositionEPSFiles true /AutoRotatePages /None /Binding /Left /CalGrayProfile () /CalRGBProfile (sRGB IEC61966-2.1) /CalCMYKProfile (U.S. Web Coated \050SWOP\051 v2) /sRGBProfile (sRGB IEC61966-2.1) /CannotEmbedFontPolicy /Warning /CompatibilityLevel 1.7 /CompressObjects /Off /CompressPages true /ConvertImagesToIndexed true /PassThroughJPEGImages false /CreateJobTicket false /DefaultRenderingIntent /Default /DetectBlends true /DetectCurves 0.1000 /ColorConversionStrategy /LeaveColorUnchanged /DoThumbnails false /EmbedAllFonts true /EmbedOpenType false /ParseICCProfilesInComments true /EmbedJobOptions true /DSCReportingLevel 0 /EmitDSCWarnings false /EndPage -1 /ImageMemory 524288 /LockDistillerParams true /MaxSubsetPct 1 /Optimize false /OPM 1 /ParseDSCComments true /ParseDSCCommentsForDocInfo true /PreserveCopyPage true /PreserveDICMYKValues true /PreserveEPSInfo true /PreserveFlatness false /PreserveHalftoneInfo false /PreserveOPIComments false /PreserveOverprintSettings true /StartPage 1 /SubsetFonts false /TransferFunctionInfo /Preserve /UCRandBGInfo /Preserve /UsePrologue false /ColorSettingsFile () /AlwaysEmbed [ true ] /NeverEmbed [ true ] /AntiAliasColorImages false /CropColorImages false /ColorImageMinResolution 200 /ColorImageMinResolutionPolicy /OK /DownsampleColorImages true /ColorImageDownsampleType /Bicubic /ColorImageResolution 600 /ColorImageDepth -1 /ColorImageMinDownsampleDepth 1 /ColorImageDownsampleThreshold 1.00000 /EncodeColorImages true /ColorImageFilter /DCTEncode /AutoFilterColorImages false /ColorImageAutoFilterStrategy /JPEG /ColorACSImageDict << /QFactor 0.15 /HSamples [1 1 1 1] /VSamples [1 1 1 1] >> /ColorImageDict << /QFactor 0.15 /HSamples [1 1 1 1] /VSamples [1 1 1 1] >> /JPEG2000ColorACSImageDict << /TileWidth 256 /TileHeight 256 /Quality 30 >> /JPEG2000ColorImageDict << /TileWidth 256 /TileHeight 256 /Quality 30 >> /AntiAliasGrayImages false /CropGrayImages false /GrayImageMinResolution 200 /GrayImageMinResolutionPolicy /OK /DownsampleGrayImages true /GrayImageDownsampleType /Bicubic /GrayImageResolution 600 /GrayImageDepth -1 /GrayImageMinDownsampleDepth 2 /GrayImageDownsampleThreshold 1.00000 /EncodeGrayImages true /GrayImageFilter /DCTEncode /AutoFilterGrayImages false /GrayImageAutoFilterStrategy /JPEG /GrayACSImageDict << /QFactor 0.15 /HSamples [1 1 1 1] /VSamples [1 1 1 1] >> /GrayImageDict << /QFactor 0.15 /HSamples [1 1 1 1] /VSamples [1 1 1 1] >> /JPEG2000GrayACSImageDict << /TileWidth 256 /TileHeight 256 /Quality 30 >> /JPEG2000GrayImageDict << /TileWidth 256 /TileHeight 256 /Quality 30 >> /AntiAliasMonoImages false /CropMonoImages false /MonoImageMinResolution 595 /MonoImageMinResolutionPolicy /OK /DownsampleMonoImages false /MonoImageDownsampleType /Average /MonoImageResolution 1200 /MonoImageDepth -1 /MonoImageDownsampleThreshold 1.50000 /EncodeMonoImages true /MonoImageFilter /CCITTFaxEncode /MonoImageDict << /K -1 >> /AllowPSXObjects true /CheckCompliance [ /None ] /PDFX1aCheck false /PDFX3Check false /PDFXCompliantPDFOnly false /PDFXNoTrimBoxError true /PDFXTrimBoxToMediaBoxOffset [ 0.00000 0.00000 0.00000 0.00000 ] /PDFXSetBleedBoxToMediaBox true /PDFXBleedBoxToTrimBoxOffset [ 0.00000 0.00000 0.00000 0.00000 ] /PDFXOutputIntentProfile (U.S. Web Coated \050SWOP\051 v2) /PDFXOutputConditionIdentifier (CGATS TR 001) /PDFXOutputCondition () /PDFXRegistryName (http://www.color.org) /PDFXTrapped /False /CreateJDFFile false /Description << /ENU (Use these settings to create press-ready Adobe PDF documents for Cengage Learning books using Distiller 8.0.x. The resulting PDF will be compatible with Acrobat 8 \(PDF 1.7\) per CL File Preparation and Certification Task Force) >> /Namespace [ (Adobe) (Common) (1.0) ] /OtherNamespaces [ << /AsReaderSpreads false /CropImagesToFrames true /ErrorControl /WarnAndContinue /FlattenerIgnoreSpreadOverrides false /IncludeGuidesGrids false /IncludeNonPrinting false /IncludeSlug false /Namespace [ (Adobe) (InDesign) (4.0) ] /OmitPlacedBitmaps false /OmitPlacedEPS false /OmitPlacedPDF false /SimulateOverprint /Legacy >> << /AllowImageBreaks true /AllowTableBreaks true /ExpandPage false /HonorBaseURL true /HonorRolloverEffect false /IgnoreHTMLPageBreaks false /IncludeHeaderFooter false /MarginOffset [ 0 0 0 0 ] /MetadataAuthor () /MetadataKeywords () /MetadataSubject () /MetadataTitle () /MetricPageSize [ 0 0 ] /MetricUnit /inch /MobileCompatible 0 /Namespace [ (Adobe) (GoLive) (8.0) ] /OpenZoomToHTMLFontSize false /PageOrientation /Portrait /RemoveBackground false /ShrinkContent true /TreatColorsAs /MainMonitorColors /UseEmbeddedProfiles false /UseHTMLTitleAsMetadata true >> << /AddBleedMarks false /AddColorBars false /AddCropMarks true /AddPageInfo true /AddRegMarks false /BleedOffset [ 18 18 18 18 ] /ConvertColors /NoConversion /DestinationProfileName (U.S. Web Coated \(SWOP\) v2) /DestinationProfileSelector /UseName /Downsample16BitImages true /FlattenerPreset << /PresetSelector /MediumResolution >> /FormElements true /GenerateStructure false /IncludeBookmarks false /IncludeHyperlinks false /IncludeInteractive false /IncludeLayers false /IncludeProfiles false /MarksOffset 18 /MarksWeight 0.250000 /MultimediaHandling /UseObjectSettings /Namespace [ (Adobe) (CreativeSuite) (2.0) ] /PDFXOutputIntentProfileSelector /UseName /PageMarksFile /RomanDefault /PreserveEditing true /UntaggedCMYKHandling /LeaveUntagged /UntaggedRGBHandling /LeaveUntagged /UseDocumentBleed false >> ] /SyntheticBoldness 1.000000 >> setdistillerparams << /HWResolution [2400 2400] /PageSize [612.000 792.000] >> setpagedevice
