CHAPTER 5: ANSWERS TO HOMEWORK
SPRING 2013
QUESTIONS
3.
a.
Taxable income for 2013 is increased by the amount of the capital loss
carryover because the loss reduced E & P in 2012.
b.
Taxable income is reduced by the nondeductible meal expenses.
c.
To determine current E & P for 2012, taxable income is increased by the
interest received on municipal bonds.
d.
Taxable income is reduced by the nondeductible lobbying expenses.
e.
Taxable income is reduced by the loss on sale between related parties.
f.
Taxable income is increased by the Federal income tax refund when
computing E & P for 2012.
6. a. If a distributing corporation has a deficit in accumulated E & P and a positive
amount in current E & P, a distribution during the year is a taxable dividend to the
extent of current E & P.
b. If the corporation has a positive amount in accumulated E & P and a deficit in current
E & P, a distribution either is a taxable dividend or a return of capital, depending on
the resulting balance in E & P when current and accumulated E & P are netted. The
accounts are netted at the date of distribution. If the resulting balance is zero or a
deficit, the distribution results in a tax-free recovery of basis or capital gain. If a
positive balance results, the distribution represents a dividend to that extent. For
netting purposes, current E & P is determined as of the date of the distribution by
ratably allocating the loss over the entire year, unless the loss can be shown to
have otherwise occurred.
c. If there is a deficit in both current and accumulated E & P, a corporate distribution is
treated as a return of capital to the extent of the shareholder’s basis in his or her
stock. Any excess is a capital gain.
d. If there is a positive amount in both current and accumulated E & P, to the extent of
the positive balance in both amounts, the distribution is a taxable dividend.
LECTURE. To qualify for the reduced 15%/0% tax rates, a dividend must be paid to
an individual shareholder by a qualifying corporation (U.S. corporations and certain
eligible foreign corporations). In addition, the shareholder cannot hold both long and
short positions in the stock at the time the dividend is paid. Finally, the shareholder must
hold the stock for 60 days during the 121-day period beginning 60 days before the exdividend date.
LECTURE. A corporation may distribute a property dividend for various reasons. The
shareholders could want a particular property that is held by the corporation. The
corporation may be strapped for cash but does not want to forgo distributing a dividend to
its shareholders.
12.
Distributing machine C triggers taxable gain of $8,000 for Seagull Corporation,
while distributing A produces a nondeductible loss of $7,000. To preserve the loss on A
and avoid recognizing gain on C, Seagull should consider selling A and then distributing
cash to the second shareholder. Seagull should also distribute machine B because there
will be no gain on the distribution and no nondeductible loss.
15.
A distribution 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 shareholders. Nor must the
distribution satisfy the legal requirements of a dividend as set forth by applicable state
law. The key factor determining dividend status is a measurable economic benefit
conveyed to the shareholder. This benefit, when described as a constructive dividend, is
distinguishable from actual corporate distributions of cash and property in form only.
Remember there still must be E & P.
16.
Because of Mike’s relationship with Judy, the IRS may argue that any excessive
compensation paid to Mike or Judy is a constructive dividend. Imputed interest on
the loan to Judy may also be a dividend. The following questions are relevant:

Are the salary payments to Judy and Mike reasonable?

What are Judy’s and Mike’s qualifications?

What are the nature and scope of Judy’s and Mike’s work?

How does the overall salary paid to Judy and Mike compare with the
company’s gross and net income?

What is the corporation’s salary policy towards all employees?

Regarding the advance to Judy, was it a bona fide loan?

Was the loan evidenced by a written instrument?

Was collateral or other security provided?

What is Judy’s financial capacity to repay the loan?

What is Parakeet’s dividend-paying history?

What is the amount of imputed interest on the loan to Judy?
18.
OPTIONAL. Danielle would prefer a dividend because she would have $42,500
after tax [$50,000 dividend – ($50,000 × 15% tax rate)]. If paid a bonus, only $36,000
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after tax [$50,000 bonus – ($50,000 × 28% tax rate)] results. However, this ignores the
effect of the payments on Orange Corporation. If Orange paid Danielle a deductible
bonus, it would save $17,000 ($50,000 deduction for bonus payment x 34% tax rate) in
taxes. (There is no deduction for a dividend payment.) Since Danielle is $6,500 better off
with a dividend ($42,500 after tax from a dividend – $36,000 after tax with a bonus) and
Orange is $17,000 better off with a bonus, overall the two parties are $10,500 better off
with a bonus ($17,000 benefit from bonus for Orange – $6,500 benefit from a dividend
for Danielle). As Danielle is the sole shareholder of the corporation, she is in a position to
choose the bonus alternative.
PROBLEMS
24.
Sarah and Mason each have dividend income of $200,000 {[$240,000
(accumulated E & P) + $160,000 (current E & P)] ÷ 2}. The dividend income will be
subject to the reduced tax rate on dividends available to individuals. The remaining
$40,000 of the $440,000 distribution reduces the basis ($20,000 each) in the
shareholders’ stock with any excess treated as a capital gain. Thus, Sarah reduces her
$8,000 stock basis to zero and has a capital gain of $12,000, while Mason reduces his
stock basis from $32,000 to $12,000 and has no income tax consequences.
30.
Dividend income is $100,000, tax-free recovery of basis is $40,000, and capital
gain is $60,000. To determine the amount of dividend income, the balances of both
accumulated and current E & P as of June 30 must be netted because of the deficit in
current E & P. As one-half of the loss (or $230,000) is deemed to have occurred on June
30, the $330,000 in accumulated E & P is reduced by $230,000. The $100,000 balance in
E & P triggers dividend income. The remaining $100,000 of the distribution is recovery
of capital, reducing basis to zero and then triggering capital gain.
32.
Cardinal Corporation has no accumulated E & P at the time of the distribution.
The shareholder has a taxable dividend equal to the current E & P determined at yearend, which was $80,000. The balance of the distribution, $40,000, reduces the
shareholder’s basis in the stock, and any excess over basis results in capital gain.
34.
Dividend Income
Return of Capital
a.
$ 70,000
$60,000
Taxed to the extent of current E & P.
b.
$ 30,000
$180,000
Accumulated E & P and current E &
P netted on the date of distribution.
c.
$150,000
$ –0–
Taxed to the extent of current and
accumulated E & P.
d.
$ 60,000
$70,000
Accumulated E & P and current E &
P are netted on the date of
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distribution. There is a dividend to
the extent of any positive balance.
e.
$90,000
$40,000
When the result in current E & P is a
deficit for the year, the deficit is
allocated on a pro rata basis
to distributions made during the year.
On June 30, E & P is $90,000
[current E & P is a deficit of $30,000
(i.e., 1/2 of $60,000) netted with
accumulated E & P of $120,000].
39.
a.
Peach has a gain of $150,000 on the distribution, computed as follows:
$400,000 (liability on the property exceeds fair market value) – $250,000
(basis of the property). Peach’s E & P is increased by the $150,000 gain.
In addition, E & P is decreased by $400,000 (representing the deemed fair
market value of the property), reduced by the $400,000 liability of the
property, or zero. Thus, E & P is $800,000, computed as follows:
$650,000 (beginning E & P balance) + $150,000 (gain on distribution).
b.
Karla has dividend income of zero, computed as follows: $400,000 (value
of the property based on liability) – $400,000 (liability on the property).
Karla has a basis of $400,000 in the property.
41.
To arrive at the taxability of the $40,000 distribution, the balance of both
accumulated and current E & P as of October 1 must be determined and netted. This is
necessary because of the deficit in current E & P. Three-fourths of the $36,000 loss, or
$27,000, reduces accumulated E & P to $28,000 as of October 1 ($55,000 – $27,000).
Thus, of the $40,000 distribution, $28,000 is taxed as a dividend and $12,000 represents a
return of capital.
47.
a.
The result of this transaction is a realized loss of $50,000 (the difference
between basis of $350,000 and fair market value of $300,000) and a
constructive dividend of $25,000 (the difference between the $300,000
fair market value and the $275,000 paid for the office building). Due to
the application of § 267, Parrot cannot recognize the realized loss but it
does reduce E & P. The constructive dividend also reduces E & P. Thus,
E & P is reduced by $75,000 (the sum of the $50,000 disallowed loss and
the $25,000 constructive dividend).
b.
The loan to Jerry generates imputed interest since no interest was charged.
The amount of imputed interest is $13,125 ($250,000 × 7% × 3/4 year)
and that amount is deemed paid as interest to the corporation. The
deductibility of the interest by Jerry depends on how the loan proceeds are
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used. Parrot has taxable interest income of $13,125 and is deemed to pay a
dividend to Jerry equal to the amount of interest. Parrot’s E & P is
increased by the amount of interest income and reduced by the amount of
deemed dividend payment.
c.
Bargain rentals create constructive dividends to shareholders. In the
present case, the amount of constructive dividends to both Tom and Jerry
equals the fair rental value of the airplane. Thus, Tom has $42,000 (120
hours × $350 hourly rental rate) of dividend income and Jerry has
dividend income of $56,000 (160 hours × $350 hourly rental rate).
Parrot’s E & P is reduced by the same amounts.
d.
The $11,000 excess amount ($20,000 – $9,000) paid to Tom by Parrot
over the fair rental value of the equipment is treated as a constructive
dividend taxable to Tom and reduces Parrot’s E & P.
52.
Hoffman, Raabe, Smith, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
November 9, 2012
Heron Corporation
12 Nature Trail Way
Daytona Beach, FL 32114
Dear President of Heron Corporation:
This letter is in response to your question concerning the tax consequences on the
planned distribution of $600,000 to your shareholders over the next four years.
Our conclusion is based upon the facts as outlined in your April 1 letter and any
change in these facts may cause such conclusion to be inaccurate.
Heron Corporation has a deficit in accumulated E & P of $300,000 as of January
1, 2012. Starting this year, Heron Corporation expects to generate annual E & P
of $150,000 for the next four years and would like to distribute this amount to its
shareholders. The corporation’s objective is to make the distribution in a manner
that causes the least amount of dividend income to its shareholders.
Heron Corporation should not make a distribution in 2012 but distribute $300,000
on December 31, 2013. Again make no distribution in 2014 but distribute the
remaining $300,000 on December 31, 2015. By distributing $300,000 every other
year, only half of the distribution, or $150,000, is taxed to the shareholders as
dividend income. Because E & P for 2012 ($150,000) is netted with the deficit in
accumulated E & P ($300,000), at the end of 2012 there is a deficit in E & P
($150,000). When a distribution of $300,000 is made in 2013, only $150,000 is
taxed, as dividend income is limited to current E & P ($150,000). This is again the
case in 2014 and 2015. On the other hand, if $150,000 is distributed each year, the
shareholders are taxed on the entire distribution because it is covered by current
E & P. The deficit in accumulated E & P does not cause part of the distribution to
be nontaxable.
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LECTURE. At least six factors impact the tax treatment of corporate distributions.
These factors are:

The availability of earnings to be distributed.

The basis of the stock in the hands of the shareholder.

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 in character.

Whether the assets distributed are subject to any liabilities or whether the
shareholder assumes any liabilities in the distribution.
*
Whether the distribution is a “qualified dividend.”
LECTURE. ‘‘Earnings and profits’’ is the factor that fixes the upper limit on the amount
of dividend income shareholders recognize as a result of a distribution from the
corporation. It represents the corporation’s economic ability to pay a dividend without
impairing its capital. ‘‘Earnings and profits’’ is similar to the accounting concept of
‘‘retained earnings.’’ However, E & P and retained earnings differ because E & P is
computed using tax rules while retained earnings is computed using financial accounting
rules. For example, a stock dividend that decreases the retained earnings account
does not decrease E & P. E & P is increased for all items of income. It is decreased
for deductible and nondeductible items, such as capital losses, income taxes, and
expenses incurred to produce tax-exempt income.
OPTIONAL PROBLEMS
27.
Sparrow Corporation’s current E & P is computed as follows:
Taxable income
Federal income tax liability
Interest income from tax-exempts
Disallowed portion of meals and entertainment expenses
Life insurance premiums paid, net of increase in
cash surrender value ($3,500 – $700)
Proceeds from life insurance policy, net of cash
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$330,000
(112,000)
5,000
(1,500)
(2,800)
surrender value ($130,000 – $20,000)
Excess capital losses
Excess of MACRS depreciation over E & P
depreciation ($26,000 – $16,000)
Allowable portion of 2007 § 179
expenses (20%  $100,000)
Organizational expense amortization
Dividends received deduction (70%  $25,000)
LIFO recapture adjustment
Installment sale gain
Current E & P
110,000
(13,000)
10,000
(20,000)
933*
17,500
10,000
(3,000)**
$331,133
*[($14,000 organizational expenses/180 months)  12 months]
**{[($40,000 sales price – $32,000 adjusted basis)/$40,000 sales price]  $15,000}
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