Taxation of Corporate Distributions to
Shareholders
Introduction
Corporations are treated as “persons” for U.S. tax purposes, separate and distinct from their
shareholders. Thus, the corporate taxpayer must file its own tax return as discussed
previously, and must pay income tax on its income just as any other taxpayer. When that
income is subsequently distributed to shareholders, the tax consequences, both to the
corporation and the shareholder(s) depend on the nature and structure of the distribution.
Compensatory payments to shareholders such as salaries, rent or lease payments for the
use of property, interest on amounts loaned to the corporation, etc. are generally
deductible by the corporation if reasonable in amount. Payments to shareholders to
purchase assets are capitalized by the corporation, and may be amortized or depreciated
depending on the nature of the asset sold. In contrast, the distribution of cash or property
to shareholders in connection with their stock ownership will generally be treated as a
distribution of corporate profits. The distribution of corporate profits is treated by the
shareholder as a dividend, taxable to the shareholder but not deductible by the
corporation.
Generally speaking, under Section 301(c)(1) distributions received by shareholders will be
taxable as dividends to the extent paid from current or accumulated corporate “earnings
and profits” (E&P). Distributions in excess of such E&P constitute a return of the
shareholders’ capital investment in the corporation. As such, they are nondeductible by the
corporation and will generally be nontaxable to the shareholder(s) to the extent of the
latter’s tax basis in stock owned in the issuing corporation. To the extent the distribution
exceeds both the corporation’s E&P and the shareholder’s tax basis in stock, it will be
taxable to the shareholder as a capital gain.
Example 1: Kyle is the sole shareholder of KPix, Inc. His tax basis in his KPix
stock is $25,000. Assume that KPix had current and accumulated E&P of
$50,000 at the end of the year. The company distributed $80,000 to Kyle. The
distribution was made in connection with Kyle’s stock ownership; he did not
provide any additional services, capital or other property in connection with
receipt of the payment. The distribution will be reported by Kyle for tax
purposes as follows:
Dividend income (to extent of E&P)
Nontaxable return of capital (to extent of stock basis)
Taxable capital gain (excess)
Total distribution
$50,000
25,000
5,000
$80,000
Under current law, the maximum tax rate on dividend and capital gain
income for an individual taxpayer is 15%. Thus, Kyle’s tax liability will
increase by $8,250 ($55,000 x 15%) as a result of the distribution (assuming
Kyle does not have other losses to offset the income).
The distinction between the tax treatment of these different types of payments from the
corporation to its shareholders is twofold. First, and most important, is the issue of
deductibility on the corporate return. Payments to a shareholder that are deductible by the
corporation essentially move the income from which such payments are paid off the
corporate tax return and onto the shareholder return. That is, if a payment is deductible,
the income from which it is financed will now be taxed to the shareholder rather than to
the corporation. In contrast, where a payment is not deductible by the corporation (i.e., a
dividend payment), the underlying income is now taxed on both the corporation’s and the
shareholder’s returns. By not allowing corporations to deduct dividend payments, the U.S.
income tax system is explicitly designed to subject corporate income to two levels of
taxation: the first when the corporation earns the income and the second when that income
is ultimately distributed to the shareholder. This is a common criticism of the U.S. taxation
of corporate income—critics suggest that this system of double taxation puts U.S.
corporations at a competitive disadvantage relative to their competitors from other
countries. Any such disadvantage has been lessened in recent years as a result of the
reduction of the dividend tax rate to 15 percent, but the system is still designed to impose
two layers of tax. It is very important for taxpayers and their advisors to understand this
characteristic of the corporate tax system in deciding how to structure their business
operations, especially with regard to decisions regarding the amount and types of incomeearning assets to transfer inside the corporate shell.
Example 2: Carlos is the sole shareholder of Rugged Corporation. Rugged
Corporation had income of $1,500,000 before accounting for a $400,000
payment to Carlos. Assume that Carlos is in the 35 percent tax bracket and
that the entire payment is taxable to him. If the payment is classified as a
dividend, the combined income tax liability of Carlos and Rugged will be
much higher than if the payment is classified as a compensatory payment, as
illustrated below:
Payment
Structured as:
Carlos’
Individual
Tax Liability
Rugged
Corp Tax
Liability
Total
Compensation
Dividend
Difference
$140,000
$ 60,000
($ 80,000)
$374,000
$510,000
$136,000
$514,000
$570,000
$56,000
The other distinction between deductible and nondeductible payments from corporations
to their shareholders, at least under current law, is the tax rate at which the distribution is
taxed on the shareholder’s tax return. Dividends, which are nondeductible to the
corporation, are taxed to the shareholder at a maximum rate of 15 percent. In contrast,
compensatory payments to the shareholder, which are deductible by the corporation, are
taxed to the shareholder at his or her (or its) marginal ordinary tax rate. For individuals,
the maximum marginal tax rate is 35 percent under current law. Thus, individual
shareholders potentially face much higher tax rates on compensatory payments received
from corporations than on dividend payments.
Example 3: Miriam is a shareholder in Taxomics, Inc. She is in the maximum
individual income tax bracket in the U.S. (currently 35%). This year, she
received a distribution from Taxomics in the amount of $200,000. If the
distribution is a dividend for income tax purposes, it will increase her
individual income tax liability by $30,000 (15% of $200,000). In contrast, if
the distribution is taxable to her as ordinary income, she will owe an
additional $70,000 income tax liability (35% of $200,000). This amount may
be further increased if the payment is subject to the Medicare or healthcare
tax. Thus, Miriam may prefer the payment to be classified as a dividend, even
though such classification will increase the corporation’s income tax liability
(because it will not be deductible in computing corporate taxable income).
Although corporate taxpayers do not receive beneficial tax rates for dividend or
capital gain income, they are subject to a lighter tax burden on dividend income as a
result of the dividends received deduction. As discussed previously, under Section
243 the dividends received deduction is equal to 70 percent of domestic dividends
received from other corporations in which the corporate recipient owns less than a
20 percent interest, 80 percent of dividends received from 20 percent or more
owned companies, and 100% of dividends received if they own at least 80 percent
of the dividend-paying company. Thus, the maximum corporate tax on eligible
dividends is 10.5 percent (maximum corporate tax rate of 35% times (1-70% DRD)).
Measuring E&P
As noted above, a distribution to shareholders is distinguished from compensatory
payments. Distributions are received by the shareholders in connection with their
investment in corporate stock. Distributions represent a return to the shareholders of their
capital investment in the corporation; the distribution can represent a return of either the
shareholder’s original capital investment in the corporation or of his or her share of
reinvested earnings (E&P). Only those distributions paid from the corporation's E&P are
taxable as dividends. For this purpose, Section 316 provides that distributions are
generally deemed to be paid first from corporate E&P to the extent thereof. Thus,
corporations are not free to determine the source of distributions paid to shareholders; if
the corporation has E&P, the distribution is deemed to be derived from that E&P until it is
fully distributed. Only if there is no remaining E&P will a distribution be deemed to come
from contributed capital. (There are no other sources from which a distribution can be
derived).
Earnings and profits are a federal tax concept intended to reflect the corporation’s
undistributed “economic” earnings available for distribution to shareholders. Over time,
E&P will closely mirror the GAAP measure “retained earnings” on the corporation’s balance
sheet, though in any particular year the two measures may not be comparable. Section 312
is the primary source of the rules governing the measurement of E&P. The statute provides
only limited guidance however and is not particularly useful for either taxpayers or their
advisors. The Treasury Regulations under §312 provide greater insight. The starting point
for computing the current year addition to E&P is taxable income. Adjustments are then
made to this figure to compute the corporation’s “economic” income available for
distribution to the shareholders. To compute E&P, the following types of adjustments are
made to taxable income:
1. Methodological adjustments. A number of provisions of the Internal Revenue Code
are designed to encourage in investment in business activity (e.g., accelerated and
bonus depreciation, the §179 deduction), or to more closely match the obligation to
pay taxes with the cash flows available to the corporation (e.g., deferral of income
from installment sales until cash is received under §453, deferral of income from
discharge of indebtedness under §108, etc.). These accounting methods are not
allowed in computing E&P. Thus, in computing E&P, a corporation must use
straight-line depreciation, it must increase E&P to reflect discharge of indebtedness
income in the taxable year that it is realized, it must recognize income from the sale
of assets in the year of the sale, etc. A number of other methodological adjustments
are necessary to adapt the amount reported as taxable income to a more
economically justified figure.
2. Inclusion of nontaxable income. Most items of nontaxable income must be added to
taxable income in computing E&P. For example, interest on state and local
government obligations excluded under §103 must be added to taxable income in
computing E&P, as must proceeds from life insurance on key officers excluded
under § 101. Although not subject to federal income taxes, these items constitute
economic income that is available to be distributed to shareholders.
3. Reduction for nondeductible expenditures. E&P is reduced by non-deductible
expenditures of the corporation. Thus, E&P are reduced for fines and penalties
disallowed under §162(f), excess executive compensation disallowed under
§162(m), half of the cost of business meals and entertainment disallowed under
§274(n), and any other non-deductible expenses. Similarly, charitable contributions
in excess of 10 percent of a corporation’s taxable income, capital losses in excess of
capital gains, and other expenses subject to similar limitations are fully deductible in
computing E&P.
4. Disallowance of “artificial” deductions. Earnings and profits are not reduced by the
dividends received deduction allowed under §243, the domestic production
activities deduction allowed under §199, or other such artificial deductions not
attributable to actual expenditures.
5. Disallowance of “carry forward” amounts. Because losses and expenses are deducted
in computing E&P in the year incurred, regardless of taxable income limitations,
carryforwards deducted in computing taxable income in the current year are
disregarded in computing E&P. For example, capital loss carryforwards, charitable
contributions carryforwards, and net operating loss carryforwards are disregarded
in computing E&P. These amounts will have previously been subtracted from E&P in
the years initially incurred; allowing a further reduction for carryforwards would
double count such expenditures in measuring E&P.
6. Reduction for income taxes paid or payable with Form 1120. Income taxes paid
reduce the accumulated earnings available for distribution to shareholders. Since
income taxes are not deductible in computing federal taxable income, they must be
subtracted from that figure in computing E&P.
Because the rules governing the computation of taxable income change frequently, the
rules governing the measurement of E&P are also frequently updated. The IRS frequently
publishes guidance, either publicly (e.g., through Revenue Rulings), or privately (e.g.
through letter rulings), explaining how new or unusual tax accounting rules are to be
treated for purposes of calculating the corporation’s E&P. For example, Revenue Ruling
2001-1 (2001-1 CB 726) explains that the deduction allowed under §83 upon the exercise
by an employee of a nonstatutory stock option is also allowed for purposes of computing
the corporation’s E&P. Taxpayers or their advisors unsure about how to apply a particular
accounting method should first review the regulations. If the answer is not evident in the
regs, additional research may identify a ruling or other published guidance on whether or
not such accounting method will be allowable for purposes of the E&P computation.
Example 4: Kinergy, Inc. reported taxable income this year of $4,350,000
and paid income taxes of $1,479,000. In computing taxable income, the
corporation claimed a dividends received deduction of $40,000 and a
domestic production activities deduction of $100,000. It had a net capital loss
of ($32,000) that was not deductible this year due to a lack of capital gain
income, and it deducted $48,000 in charitable contribution carryforwards
from a prior year. Kinergy’s current E&P (i.e., the current year addition to
E&P) will be $3,027,000, computed as follows:
Taxable income
Add back artificial deductions:
Dividends received deduction
Domestic production activities deduction
Add back charitable contribution carryforward
Less excess capital losses
Less income taxes paid
Current year E&P
$4,350,000
40,000
100,000
48,000
(
32,000)
(1,479,,000_
$ 3,027,000
Because E&P is not reported on the corporation’s income tax return, it may not be
computed on an annual basis. (Recall that E&P is not the same as retained earnings). Thus,
it must often be computed for prior years in addition to the current year. Earnings and
profits are not relevant to the corporation until it makes distributions to its shareholders
that are significant in comparison to its earnings (or until it is acquired by another
company, in which case the acquirer will generally want to know how much potential
dividend income its shareholders will face with respect to future distributions). It is not
difficult to retroactively compute E&P, however, as long as the corporation’s prior tax
returns are available.
Determining the Source of Corporate Distributions
As noted above, §316(a) provides that distributions are deemed to have been made from
E&P to the extent the company has E&P. The statute further provides that distributions are
presumed to come from the most recently accumulated E&P first. Under §316(a)(2) E&P
for the current year (current E&P) is measured as of the close of the year without reduction
for distributions made during the year. Thus a distribution will be taxable to the
shareholder as a dividend if the corporation has E&P at the end of the current tax year,
whether or not it had any E&P at the beginning of the year (generally referred to as
accumulated E&P), and even if it had no E&P as of the date the dividend was actually
distributed. Alternatively, a distribution may be deemed to come from accumulated E&P
even when the corporation had no current earnings in the year the distribution occurred.
Example 5: Jenkins Corporation had accumulated E&P (AE&P) as of January
1 of $300,000. For the current year, the company incurred a substantial loss.
Its current E&P (CE&P) was ($175,000). The company distributed $150,000
to its shareholders at year end. No part of the distribution can be derived
from CE&P because there was none. As of year end, the net balance in E&P
was $125,000 (beginning balance of $300,000 less current year deficit of
$175,000). Thus, $125,000 of the year-end distribution will be taxable to the
shareholders as a dividend. The balance in the company’s E&P account as of
January 1 of the next year will be zero.
Example 6: Washington Corporation had a deficit in accumulated E&P
(AE&P) as of January 1 of ($100,000). For the current year, the company
earned a profit. Its current E&P was $75,000. The company distributed
$150,000 to its shareholders at year end. The first $75,000 of this
distribution will be deemed to have come from CE&P, regardless of when the
distribution was made. It does not matter that the combined balance in the
company’s E&P account would have been negative. Because CE&P is
distributed before AE&P, the entire balance in CE&P can be distributed to
shareholders in the current year. Thus, the shareholders will recognize
$75,000 in dividend income in connection with the current year distribution.
No part of the remaining distribution can be derived from AE&P because
there was none. Note that in the above example, because no portion of the
distribution came from CE&P, the current year deficit in E&P was netted
against the company’s beginning balance in AE&P to determine the balance
in AE&P as of the date of the distribution.
Special rules apply when a company makes multiple distributions in a given year, and the
aggregate amount distributed exceeds the combined balances in current and accumulated
E&P. In such cases, E&P must be apportioned among the different distributions. The
apportionment rules, which differ for current vs. accumulated E&P, are described in the
Treasury Regulations under §316. The regs provide that current E&P is allocated pro rata
among all distributions made during the year, regardless of the actual date of the
distributions. Accumulated E&P, in contrast, is apportioned among distributions
chronologically—that is, early distributions are drawn from AE&P before later ones. The
net effect of the AE&P apportionment rules is to apportion a greater percentage of AE&P to
early distributions than to later ones.
Example 7: Snap, Inc. made two distributions to its shareholders during the
year. The first distribution, in the amount of $100,000 was paid to
shareholders on March 15, and the second, in the amount of $50,000, was
paid to shareholders on December 1. Snap had AE&P at January 1 of $45,000.
Its CE&P for the year was $60,000. Thus, only $105,000 of the current year
distributions will be taxable to Snap’s shareholders as dividend income. The
dividend portion of each distribution will be determined as follows.
First, current E&P will be apportioned pro rata among the two distributions.
Two-thirds of the company’s total distributions were distributed on March
15 and one-third on December 1. Current E&P will thus be allocated 2/3rds to
the first distribution and 1/3rd to the second. Accumulated E&P, in contrast,
must be apportioned chronologically. Thus, the entire $45,000 of AE&P will
be attributed to the first distribution and none to the second:
AE&P
Distribution
March 15
December 1
Totals
CE&P
$40,000
20,000
$60,000
$45,000
0
$45,000
Total Taxed
as Dividend
$85,000
20,000
$105,000
The balance in AE&P as of January 1 of the next year will be zero.
As illustrated in Examples 5 and 6, a deficit in current E&P will reduce accumulated E&P for
purposes of determining the amount available for distribution to shareholders, but the
reverse is not true: a deficit in AE&P is ignored for purposes of measuring the amount of
E&P available for the shareholders. Where a CE&P deficit is applied against AE&P, the
amount by which AE&P is reduced is determined as of the date of the distribution. For a
distribution occurring on the 100th day of the year, for example, only 100/365ths of the
deficit in CE&P will be applied against AE&P for purposes of determining the amount
available at the date of the distribution. Finally, note that E&P is reduced by dividend
distributions, but not by the portion of corporate distributions that is treated as a return of
capital. That is, E&P is only reduced by that portion of a corporate distribution that is
deemed to have been paid from E&P.
Income Tax Consequences of Dividends
As noted previously, individuals but not corporations compute the tax liability on qualified
dividend income using special lower tax rates. Under current law, individuals are taxed at a
maximum rate of 15 percent on qualified dividends, while dividends received by
corporations are taxed at the corporation’s regular marginal tax rate (after reduction for
the dividends received deduction). Thus, in determining the shareholder tax consequences
with regard to dividend distributions, it is important to determine whether the dividend is
qualified.
“Qualified Dividend Income”
Section 61(a)(7) provides that dividends are included in the recipient's gross income for
purposes of the federal income tax. The statute does not distinguish between “qualified”
and non-qualified dividends. However, §1(h) provides that the lower tax rate on dividends
for individuals is available only for qualified dividends.
“Qualified” dividends are defined as dividends received during the taxable year from a
domestic corporation or from a qualified foreign corporation. A qualified foreign
corporation is any foreign corporation:
(1) incorporated in a U.S. possession; or
(2) whose stock (with respect to which a dividend is paid) is readily tradable on an
established securities market in the United States; or
(3) which is eligible for the benefits of a comprehensive income tax treaty with the
United States that the Secretary determines is satisfactory for this purpose and
that includes an exchange of information provision.
Qualified dividends received by a corporate taxpayer are not subject to special tax rates but
are eligible for the dividends received deduction as discussed previously.
Reporting Requirements
A corporation must file Form 1099-DIV each year reporting to both the IRS and its
shareholders the amounts distributed to shareholders (IRC § 6042). Form 1099-DIV
contains separate lines to report dividend and non-dividend distributions. If the
corporation does not know whether a distribution constitutes a dividend or non-dividend
payment, the distribution should be reported as a dividend.
Distributions of Property Other than Cash
Under §301, when a corporation distributes property other than cash to a shareholder, the
amount of the distribution is deemed to be equal to the fair market value of such property.
If the property’s tax basis just prior to the distribution was less than its fair market value,
the corporation is treated as having sold the property and then immediately distributed the
proceeds from sale to the shareholder. The corporation will recognize gain but not loss on
the deemed sale. The gain recognized by the corporation will be equal to the difference
between (1) the corporation’s tax basis in the distributed property and (2) such propety's
fair market value. Any gain realized will increase the corporation's E&P, and any additional
income tax owed in connection with the deemed sale will decrease E&P. Because the
deemed sale occurs before the deemed distribution of the proceeds, these adjustments to
E&P will be made before determining the portion of the distribution treated as a dividend.
Thus, the subsequent reduction in E&P will be equal to the lesser of the net FMV of the
distributed property or the adjusted balance in E&P before the deemed distribution. That
is, E&P will not be reduced below zero by the property distribution itself.
Example 8: Boondoggle Inc. had a deficit in accumulated E&P (AE&P) as of
January 1 of ($100,000). During the current year, the company distributed
property to its shareholders with a tax basis of $115,000 and a fair market
value of $520,000. The company’s current year taxable income before
accounting for the property distribution was $30,000. Boondoggle will be
treated as having sold the property to its shareholders for $520,000,
followed immediately by a distribution back to those shareholders in the
amount of the net proceeds of sale. The deemed sale will trigger a taxable
gain to the corporation of $405,000 ($520,000 less the property’s $115,000
tax basis). This gain will increase the company’s taxable income this year to
$435,000. Assuming it has no other items of income or deduction, the
company’s income tax liability will be $147,900. Thus, its CE&P (assuming no
necessary adjustments other than for income taxes) will be $287,100. The
total distribution to its shareholders will be $520,000 (the fair market value
of the distributed property), of which $287,100 will be classified as a
dividend (there is no AE&P), and the remainder as a return of capital.
The shareholders will take a fair market value basis in property received as a distribution
from the corporation. This will be true whether or not the distribution is wholly or partially
treated as a dividend for federal income tax purposes, and regardless of whether or not the
corporation recognized a gain on the property or realized a non-deductible loss. For this
reason, a corporation considering the distribution of property with a tax basis higher than
its fair value should consider selling the depreciated property rather than distributing it.
Sale to an unrelated party will allow the company to deduct its loss for tax purposes; it can
then distribute the proceeds received from the sale. Note that a loss will be denied the
corporation under §267 if it sells the property to a controlling shareholder or group of
shareholders. Thus, if either the corporation or its shareholders want ownership of the
property to remain with one or more shareholders, any corporate tax savings associated
with the potential deductibility of the loss will be forfeited.
Distribution of Encumbered Property
Where property distributed by the corporation is encumbered by debt, and such debt is
assumed by the shareholder(s), the consequences to the corporation are the same—gain
but not loss will be recognized in an amount equal to the difference between the tax basis
and fair market value of the property. The amount recorded by the shareholders as a
dividend, however, will be reduced by the amount of liabilities assumed in connection with
the distribution. Note that the assumption of debt in connection with the receipt of
property from a corporation will reduce the amount of the deemed distribution received
from the corporation, but will not reduce the shareholder’s tax basis in the property
received. This is because the shareholder is deemed to have purchased the property for its
fair value prior to receiving a distribution of the net proceeds from the deemed sale.
Example 9: Gonsales Corporation distributed property with a tax basis of
$350,000 and a fair market value of $675,000 to its shareholders this year.
The property was encumbered by a $215,000 mortgage for which the
shareholders assumed responsibility. The two parties will account for the
distribution as indicated in the following accounting entries.
Gonsales Corporation:
“Cash” (675 FMV – 215 debt)
Mortgage
Property
Gain
$460,000
215,000
Dividends paid
“Cash”
$460,000
$350,000
325,000
$460,000
Shareholders:
Property
Mortgage
Dividend income
$675,000
$215,000
$460,000
NOTE: The above entries assume sufficient E&P for the entire distribution to
be classified as a dividend.
Constructive Dividends
As noted previously, compensatory payments to shareholders for services or property
provided to the corporation by a shareholder, are not treated as dividends. Rather, such
payments are deductible by the corporation and taxable to the shareholder as ordinary
income. If, however, the amount of the payment is not “reasonable” in comparison to the
value of the services or property provided by the shareholder to the corporation, any
portion of the payment in excess of that deemed reasonable will be taxable as a “disguised”
or “constructive” dividend. The net result will be that the unreasonable portion of the
payment will be added back to the corporation’s taxable income, and will be taxable to the
shareholder at the rate applicable to dividends (15% for individuals).
Concerns regarding constructive dividends are generally limited to closely held
corporations. Although a compensatory payment is usually taxed to the recipient
shareholder at a higher tax rate, the availability of a deduction for the corporation usually
results in a lower combined tax burden when the corporation and shareholder returns are
considered together. Thus, the IRS closely scrutinizes payments for salaries, rents, and
similar arrangements between a closely held corporation and its shareholders or their
families.
Non-dividend Distributions and Extraordinary Dividends
Non-dividend Distributions
Distributions by a corporation with neither accumulated nor current E&P will not be
classified by the recipient shareholders as dividends.
Under §301(c)(2) , a non-dividend distribution, or return of capital, is applied against the
adjusted basis of the shareholder's stock in the distributing corporation. To the extent the
distribution exceeds the shareholder’s stock basis, the excess triggers capital gain to the
shareholder under §301(c)(3) as discussed previously in this chapter. Where the
shareholder holds multiple blocks of stock, the basis of all such blocks should be
aggregated in determining the extent to which the non-dividend distribution triggers gain
(Fink v. Comm’r, 483 US 89, 1987). In contrast, where the shareholder holds more than one
class of stock (e.g., common and preferred), unless the distribution can be shown to have
been made with regard to both classes, aggregation of the tax bases of the two classes of
stock will presumably not be allowed.
Extraordinary Dividends
Because a corporate shareholder can use the dividends received deduction to shelter
dividend income from taxation, corporate shareholders will generally prefer that large
payments received from other corporations be classified as dividends rather than returns
of capital. To protect the tax authority against the potential for abuse, §1059 that a
corporate shareholder must reduce its basis in stock it owns in a dividend paying
corporation to the extent of the nontaxed portion of any “extraordinary dividend” received.
An extraordinary dividend is a dividend that equals or exceeds a 10% of the recipient
corporation’s basis in the stock of the paying corporation, unless the stock was held for
more than two years before the dividend announcement date. For preferred stock, the
triggering percentage is 5 percent.
Under §1059(c)(4), the recipient shareholder may elect to use the fair market value of its
stock, rather than the tax basis, in calculating the 5 percent or 10 percent thresholds.
Distribution of Corporation's Own Debt Obligations
In some cases, a corporation may distribute a note payable or a similar debt obligation to
its shareholders in lieu of cash or property. For example, a shareholder in a closely held
corporation might receive an emergency cash distribution from the corporation to satisfy a
personal obligation. Such a distribution would be in violation of state law if other
shareholders holding the same class of stock did not receive a similar distribution. If the
corporation lacked the funds to make similar distributions to other shareholders, it could
distribute notes payable or other debt instruments to those shareholders to be paid at a
later date.
Under §311(b)(1)(A), a corporation does not recognize gain on the distribution of its own
obligations. This is consistent with the general rule that the issuance of a debt instrument is
not an income realization event to the debtor. However, the transaction is treated as a
legitimate distribution. As such, the corporation must reduce its E&P by the deemed issue
price of the distributed obligations. Generally, the deemed issue price will be equal to the
principal amount of the obligation. However, if the debt obligations do not bear interest at
market rates, the deemed issue price will be reduced to account for the discount under
§1273(b)(4).
The shareholder will recognize dividend income in an amount equal to the fair market
value of the obligations received (assuming the corporation has sufficient E&P). His or her
(or its) tax basis in the debt obligations will also equal their fair market value, so that no
additional income will be recognized when the obligations are paid. Payments of interest,
including imputed interest, will be taxable to the shareholder as ordinary income, rather
than dividend or capital gain income.
Stock Distributions
For a variety of reasons, corporations often distribute stock dividends rather than cash.
Such distributions may take the form of common or preferred stock and may be paid on a
different class of stock than that being distributed (i.e., a distribution of preferred shares to
holders of the corporation’s common stock). Stock dividends are usually nontaxable to the
recipient shareholders under §305(a), so long as the distribution consists solely of
qualified stock in the issuing corporation and it does not change the shareholders’ relative
interests in the issuing corporation.
If the shareholders have the option of receiving either stock or cash, the distribution will be
taxable even if the shareholder opts to receive stock (§ 305(b)(1)). This result will hold
even if all shareholders opt to receive stock. Reg. § 1.305-2(a) provides that if any
shareholder has the right to an election or option with respect to whether a distribution
shall be made either in money or any other property, or in stock or rights to acquire stock
of the distributing corporation, then, with respect to all shareholders, the distribution of
stock or rights to acquire stock is treated as a distribution of property to which IRC § 301
applies. Similarly, if a corporation has two classes of common stock outstanding and one
class of shareholders receives cash dividends while those in the other class receive stock
dividends, the stock dividends will be fully taxable (§ 305(b)(2)).
Likewise, if some shareholders receive distributions of common stock while others receive
distributions of preferred stock, all of the shareholders will be taxable under § 305(b)(3).
By distributing different classes of stock to different shareholders, some shareholders will
realize an increase of their proportionate interest in the corporation, so all distributions
will be taxed as if the shareholders had received cash which they used to purchase the
shares they actually received.
Finally, any stock dividend paid on preferred shares will change the relative economic
interests in the corporation of the preferred shareholders and will thus be fully taxable
under § 305(b)(4). Likewise, any distribution of convertible preferred stock, regardless of
the class of shareholders to which it is distributed, will be fully taxable under § 305(b)(5).
Because some shareholders may choose to convert their preferred shares into common,
while others may choose to redeem their shares, the distribution has the potential to
enhance some shareholders’ economic interests in the corporation relative to others.
Receipt of Cash in Lieu of Fractional Shares
To allow a corporation to avoid the necessity of issuing fractional shares, the Code allows
corporations to convert such fractional shares to cash without tainting the nontaxable
nature of the overall distribution. Because these transactions involve less than one full
share for each shareholder, the amount involved in subsequent price changes is usually
modest.
Stock Splits
Shares received by a shareholder in connection with a stock split are not taxable as
dividends. In a stock split, the corporation “splits” each outstanding share of its stock into
two or more shares. Thus, in a two-for-one stock split, each shareholder will receive one
additional share of stock for each share she owned immediately prior to the split. Such
additional shares are treated the same as stock dividends.
Shareholder Tax Consequences
Upon the receipt of a nontaxable stock dividend, §307 requires the shareholder to reallocate her tax basis in the shares she originally held among the original and the new
shares. The allocation is made in proportion to the fair market values of the old stock and
the new stock on the date of distribution. The holding period of the original shares “tacks”
onto the new shares under §1223(4) .
Of course, if the stock distribution is taxable, the shareholders take a fair market basis in
the stock received in the distribution and their holding periods in the newly received
shares begins the day after its acquisition (Rev. Rul. 76-53, 1976-1 CB 87).