Slide 7-1
Principles of Taxation:
Advanced Strategies
Chapter 7
 Distributions to Business Owners

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-2
C Corporations
Subject to double taxation
 Distributions out of earnings and profits
taxable to shareholders as dividends

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-3
Earnings and Profits
Two types:
 Current Earnings and profits
 Accumulated Earnings and profits
 Any payment out of either account will
result in a taxable dividend to the
shareholder

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-4
Current Earnings and Profits
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Any distribution not in excess of current
earnings and profits is a dividend
Negative accumulated earnings and profits
ignored if current earnings and profits
positive
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Slide 7-5
Accumulated Earnings and
Profits
Current earnings and profits reduced by
dividends added into accumulated earnings
and profits
 If current earnings and profits is negative, it
is netted from accumulated earnings and
profits to determine if a distribution is a
dividend

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Slide 7-6
Nondividend Distributions
Any distribution in excess of earnings and
profits
 Treated as a return of capital to extent of
stock basis
 Stock basis must be reduced by
nontaxable portion
 Any excess is capital gain

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-7
Property Distributions
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Distributions of appreciated property cause a corporation
to recognize gain
Current earnings and profits also increased as a result of
the gain recognized
 Earnings and profits reduced by fair market value of
appreciated property distributed
Losses not recognized on distributions of depreciated
property
 Earnings and profits decreased by adjusted basis of
depreciated property
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Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-8
Stock Dividends
Distributions of additional shares of stock
 Generally nontaxable to shareholder
 Will be treated as a taxable distribution if
shareholders can choose between stock and
cash

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-9
Constructive Dividends

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Payments or transfers for the benefit of the
shareholders
Treated as taxable dividends
Examples:
 Corporation pays personal expenses
 Use of corporate property for personal purposes
 Unreasonable compensation to
shareholder/employee
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Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-10
Penalty Taxes
Designed to prevent conversion of ordinary
income into capital gain by appreciation of
corporate stock
 Types:
 Accumulated earnings tax
 Personal holding company tax

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-11
Accumulated Earnings Tax
Tax imposed upon corporation if a
corporation accumulates funds beyond
reasonable need of the business
 Tax imposed at the highest individual
income tax rate in effect for the year

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Slide 7-12
Accumulated Earnings Tax Base

Tax imposed on after tax income reduced by
 Any dividends paid during the period
 Accumulated earnings tax credit
 Amount needed by corporation to meet
reasonable business needs
 Never less than $ 250,000 except for
personal service corporations
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Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-13
Personal Holding Company Tax
Imposed at the highest individual tax rate on
undistributed personal holding company
taxable income
 Corporation must be a personal holding
company

McGraw-Hill/Irwin
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Slide 7-14
Personal Holding Company
60% of ordinary gross income from
investment sources such as dividends,
interest, rent and royalties
 Five or fewer individuals own directly or
indirectly more than 50% of stock during
the last half of the year

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Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-15
Undistributed Personal Holding
Company Taxable Income
After-tax ordinary income less dividends
paid
 Deficiency dividends can be paid to
eliminate the tax

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-16
Partnership Distributions

Two types:
 Current distribution – reduces partner’s
capital account
 Liquidating distribution- extinguishes
partner’s interest in partnership
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Slide 7-17
Cash Distributions
Generally nontaxable
 Exception: cash distribution in excess of
partner’s outside basis
 Distributions reduce outside basis

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Slide 7-18
Property DistributionsAccounting Treatment
Gain or loss recognized on distribution to
extent property exceeds or is less than fair
market value.
 Gain or loss allocated to all partners
 Partner’s capital account reduced by fair
market value of distribution

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Slide 7-19
Property Distributions- Tax
Consequences
Generally nontaxable to partner
 No gain or loss recognized to partnership
 Partner’s basis in property is same as
partnership’s basis in property
 If basis of property is greater than
recipient partner’s outside basis, basis of
property to partner is outside basis of
partnership. Outside basis become zero

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 7-20
S Corporation Distributions
Generally nontaxable as long as does not
exceed shareholder’s basis in stock
 Cash distribution decreases shareholder’s
basis in S corporation stock

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Slide 7-21
Special Rules for S Corporations
with Earnings and Profits
Only applies to S corporations that were
formerly C corporations
 Special rules do not apply if C corporation
had no earnings and profits when S election
made or all earnings and profits distributed

McGraw-Hill/Irwin
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Slide 7-22
S Corporations with E and P
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Cash distributions nontaxable to extent do not
exceed accumulated adjustments account (AAA)
Any amount in excess of AAA treated as a taxable
dividend to extent of earnings and profits
Any amount in excess of earnings and profits is a
nontaxable return of capital up to shareholder’s
basis in stock
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Slide 7-23
Accumulated Adjustments Account
Represents undistributed S corporation
earnings
 Cash distributions reduce account but not
below zero
 Losses reduce AAA
 Any distribution during a loss year is
deemed made before account is decreased
for the loss
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McGraw-Hill/Irwin
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Slide 7-24
C Corporation Conversions

S corporations reverting to C corporations
have a favorable transition rule on
distributions
 Any distribution made within one year of
conversion is nontaxable as long as AAA
not exceeded
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Slide 7-25
Property Distributions
Generally C corporation rules apply to S
corporations making these distributions
 Gains but not losses recognized

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc