Chapter 13
Corporations:
Earnings & Profits
and Distributions
Essentials of Taxation
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
1
The Big Picture (slide 1 of 3)
• Lime Corporation, an ice cream manufacturer,
has had a very profitable year.
– To share its profits with its two shareholders, it
distributes the following:
• Cash of $200,000 to Orange Corporation, and
• Real estate worth $300,000 (adjusted basis of $20,000)
to Gustavo.
– The real estate is subject to a mortgage of $100,000, which
Gustavo assumes.
• The distribution is made on December 31,
Lime’s year-end.
The Big Picture (slide 2 of 3)
• Lime Corporation has had both good and bad
years in the past.
– More often than not, however, it has lost money.
– Despite this year’s banner profits, the GAAPbased balance sheet for Lime indicates a year-end
deficit in retained earnings.
• Consequently, the distribution of cash and land
is treated as a liquidating distribution for
financial reporting purposes, resulting in a
reduction of Lime’s paid-in capital account.
The Big Picture (slide 3 of 3)
• The tax consequences of the distributions to
the corporation and its shareholders depend on
a variety of factors.
– Identify these factors.
• Explain the tax effects of the distributions to
both Lime Corporation and its 2 shareholders.
• Read the chapter and formulate your response.
Taxable Dividends
• Distributions from corporate earnings and
profits (E & P)
– Treated as a dividend distribution
• Taxed as ordinary income or as preferentially taxed
dividend income
• Distributions in excess of E & P
– Nontaxable to extent of shareholder’s basis (i.e., a
return of capital)
• Excess distribution over basis is capital gain
Earnings & Profits
(slide 1 of 2)
• No definition of E & P in Code
• Similar to Retained Earnings (financial
reporting), but often not the same
Earnings & Profits
(slide 2 of 2)
• E & P represents:
– Upper limit on amount of dividend income
recognized on corporate distributions
– Corporation's economic ability to pay dividend
without impairing capital
Calculating Earnings & Profits
(slide 1 of 4)
• Calculation generally begins with taxable
income, plus or minus certain adjustments
– Add previously excluded income items and certain
deductions to taxable income including:
•
•
•
•
•
Muni bond interest
Excluded life insurance proceeds
Federal income tax refunds
Dividends received deduction
Domestic production activities deduction
Calculating Earnings & Profits
(slide 2 of 4)
• Calculation generally begins with taxable income,
plus or minus certain adjustments (cont’d)
– Subtract certain nondeductible items:
•
•
•
•
•
Nondeductible portion of meal and entertainment expenses
Related-party losses
Expenses incurred to produce tax-exempt income
Federal income taxes paid
Key employee life insurance premiums (net of increase in cash
surrender value)
• Fines, penalties, and lobbying expenses
Calculating Earnings & Profits
(slide 3 of 4)
• Certain E & P adjustments shift effect of transaction
from the year of inclusion in or deduction from
taxable income to year of economic effect, such as:
– Charitable contribution carryovers
– NOL carryovers
– Capital loss carryovers
• Gains and losses from property transactions
– Generally affect E & P only to extent recognized for tax
purposes
– Thus, gains and losses deferred under the like-kind
exchange provision and deferred involuntary conversion
gains do not affect E & P until recognized
Calculating Earnings & Profits
(slide 4 of 4)
• Other adjustments
– Accounting methods for E & P are generally more
conservative than for taxable income, for example:
•
•
•
•
Installment method is not permitted
Alternative depreciation system required
§ 179 expense must be deducted over 5 years
Percentage of completion must be used (no completed
contract method)
Calculating Earnings & Profits
(slide 4 of 4)
• Other adjustments
– Accounting methods for E & P are generally more
conservative than for taxable income, for example:
•
•
•
•
Installment method is not permitted
Alternative depreciation system required
§ 179 expense must be deducted over 5 years
Percentage of completion must be used (no completed
contract method)
Examples of E & P Adjustments (slide 1 of 2)
Examples of E & P Adjustments (slide 2 of 2)
Current vs Accumulated E & P
(slide 1 of 3)
• Current E & P
– Taxable income as adjusted
Current vs. Accumulated E & P
(slide 2 of 3)
• Accumulated E & P
– Total of all prior years’ current E & P (since
February 28, 1913) reduced by distributions from
E&P
Current vs. Accumulated E & P
(slide 3 of 3)
• Distinguishing between current and
accumulated E & P is important
– Taxability of corporate distributions depends
on how current and accumulated E & P are
allocated to each distribution made during year
Allocating E & P to Distributions
(slide 1 of 4)
• If positive balance in both current and
accumulated E & P
– Distributions are deemed made first from current E
& P, then accumulated E & P
– If distributions exceed current E & P, must allocate
current and accumulated E & P to each distribution
• Allocate current E & P pro rata (using dollar amounts)
to each distribution
• Apply accumulated E & P in chronological order
Allocating E & P to Distributions
(slide 2 of 4)
• When the tax years of the corporation and its
shareholders are not the same
– May be impossible to determine the amount of
current E & P on a timely basis
– Allocation rules presume that current E & P is
sufficient to cover every distribution made during
the year until the parties can show otherwise
Allocating E & P to Distributions
(slide 3 of 4)
• If current E & P is positive and accumulated E
& P has a deficit
– Accumulated E & P IS NOT netted against current
E&P
• Distribution is deemed to be taxable dividend to extent
of positive current E & P balance
The Big Picture – Example 11
Positive Current E & P,
Deficit In Accumulated E & P
• Return to the facts of The Big Picture on p. 5–1.
• Lime Corp. had a deficit in GAAP-based retained earnings at
the start of the year and banner profits during the year.
– Assume that this translates into an $800,000 deficit in accumulated
& P at the start of the year and current E & P of $600,000.
E
• In this case, current E & P would exceed the total cash and
property distributed to the shareholders.
– The distributions are treated as taxable dividends.
– They are deemed to be paid from current E & P even though Lime still
has a deficit in accumulated E & P at the end of the year.
Allocating E & P to Distributions
(slide 4 of 4)
• If accumulated E & P is positive and current
E&P is a deficit, net both at date of distribution
– If balance is zero or a deficit, distribution is a
return of capital
– If balance is positive, distribution is a dividend to
the extent of the balance
– Any current E & P is allocated ratably during the
year unless the parties can show otherwise
Cash Distribution Example
A $20,000 cash distribution is made at year end in each
independent situation:
1
2
3* .
Accumulated E & P,
beginning of year
100,000
(100,000) 15,000
Current E & P
50,000
50,000 (10,000)
Dividend:
20,000
20,000
5,000
*Since there is a current deficit, current and accumulated
E & P are netted before determining treatment of
distribution.
Property Dividends
(slide 1 of 4)
• Effect on shareholder:
– Amount distributed equals FMV of property
• Taxable as dividend to extent of E & P
• Excess is treated as return of capital to extent of basis in
stock
• Any remaining amount is capital gain
Property Dividends
(slide 2 of 4)
• Effect on shareholder (cont’d):
– Reduce amount distributed by liabilities assumed
by shareholder
– Basis of distributed property = fair market value
Property Dividends
(slide 3 of 4)
• Effect on corporation:
– Corp. is treated as if it sold the property for fair
market value
• Corp. recognizes gain, but not loss
– If distributed property is subject to a liability in
excess of basis
• Fair market value is treated as not being less than the
amount of the liability
Property Dividends
(slide 4 of 4)
• Effect on corporation’s E & P:
– Increases E & P for excess of FMV over basis of
property distributed (i.e., gain recognized)
– Reduces E & P by FMV of property distributed (or
basis, if greater) less liabilities on the property
– Distributions of cash or property cannot generate
or add to a deficit in E & P
• Deficits in E & P can arise only through corporate
losses
The Big Picture – Example 15
Property Dividends - Effect on the Shareholder
• Return to the facts of The Big Picture on p. 5–1.
• Lime Corporation distributed property to Gustavo,
one of its shareholders.
– Fair market value $300,000.
– Adjusted basis $20,000.
– Subject to a $100,000 mortgage, which Gustavo assumed.
• As a result, Gustavo has a taxable dividend of
$200,000
– $300,000 (fair market value) – $100,000 (liability).
– The basis of the property to Gustavo is $300,000.
The Big Picture – Example 17
Property Dividends - Effect on the Corporation
• Return to the facts of The Big Picture on p. 5–1.
• Lime Corporation distributed property to Gustavo,
one of its shareholders.
– Fair market value of $300,000
– Adjusted basis of $20,000
• As a result, Lime recognizes a $280,000 gain on the
distribution.
Property Distribution Example
Property is distributed (corporation’s basis = $20,000) in
each of the following independent situations. Assume
Current and Accumulated E & P are both $100,000 in each
case:
Fair market value
of distributed property
Liability on property
Gain(loss) recognized
E&P increased by gain
E & P decrease on dist.
1
2
3
60,000
-040,000
40,000
60,000
10,000
-0-0-020,000
40,000
15,000
20,000
20,000
25,000
.
Constructive Dividend
(slide 1 of 2)
• Any economic benefit conveyed to a
shareholder may be treated as a dividend for
tax purposes, even though not formally
declared
– Need not be pro rata
Constructive Dividend
(slide 2 of 2)
• Usually arises with closely held corporations
• Payment may be in lieu of actual dividend and
is presumed to take form for tax avoidance
purposes
• Benefit conveyed is recharacterized as a
dividend for all tax purposes
– Corporate shareholders are entitled to the
dividends received deduction
– Other shareholders receive preferential tax rates
Examples of Constructive Dividends
(slide 1 of 3)
• Shareholder use of corporate property at
reduced cost or no cost (e.g., company car to
non-employee shareholder)
• Bargain sale of property to shareholder (e.g.,
sale for $1,000 of property worth $10,000)
• Bargain rental of corporate property
Examples of Constructive Dividends
(slide 2 of 3)
• Payments on behalf of shareholder (e.g.,
corporation makes payments to satisfy
obligation of shareholder)
• Unreasonable compensation
Examples of Constructive Dividends
(slide 3 of 3)
• Below market interest rate loans to
shareholders
• High rate interest on loans from shareholder to
corporation
Avoiding Unreasonable Compensation
• Documentation of the following attributes will
help support payments made to an employeeshareholder:
– Employee’s qualifications
– Comparison of salaries with dividends made in past
– Comparable salaries for similar positions in same
industry
– Nature and scope of employee’s work
– Size and complexity of business
– Corporation’s salary policy for other employees
Stock Dividends
(slide 1 of 2)
• Excluded from income if pro rata distribution
of stock, or stock rights, paid on common
stock
– Five exceptions to nontaxable treatment deal with
various disproportionate distribution situations
• Effect on E & P
– If nontaxable, E & P is not reduced
– If taxable, treat as any other taxable property
distribution
Stock Dividends
(slide 2 of 2)
• Basis of stock received
– If nontaxable
• If shares received are identical to shares previously owned, basis =
(cost of old shares/total number of shares)
• If shares received are not identical, allocate basis of old stock
between old and new shares based on relative fair market value
• Holding period includes holding period of formerly held stock
– If taxable, basis of new shares received is fair market value
• Holding period starts on date of receipt
Stock Redemptions
(slide 1 of 3)
• Generally result in dividend income for
shareholder whose stock is redeemed unless
shareholder surrenders significant control
• Section 302 allows sale or exchange treatment
where either:
– All of the shareholder’s stock is redeemed
– After redemption, investor is a minority
shareholder and owns less than 80% of the interest
owned in the corporation before the redemption
Stock Redemptions
(slide 2 of 3)
• When transaction is treated as a dividend,
investor’s basis in redeemed shares does not
disappear but attaches to remaining shares
owned
• Other provisions also allow sale or exchange
treatment for a stock redemption
– In measuring the investor’s stock holdings before
and after the redemption, shares owned by related
taxpayers also are counted
Stock Redemptions
(slide 3 of 3)
• The tax consequences for the redeeming
corporation are summarized as follows
– If noncash property is used to acquire redeemed
shares, the corporation recognizes realized gain
(but not loss) on distributed assets
– E & P of redeeming corporation disappears to
extent of the number of shares redeemed as a
percentage of the shares outstanding before the
buyback
Liquidations—In General
• Corporation winds up affairs, pays debts, and
distributes remaining assets to shareholders
– Produces sale or exchange treatment to shareholder
– Liquidating corporation recognizes gains and
losses upon distribution of its assets, with certain
exceptions
Accumulated Earnings Tax
• Imposes a 20% tax on current year’s corporate
earnings accumulated without a reasonable business
need
– Most businesses are allowed a $250,000 minimum credit
– Beyond the minimum credit, earnings can be accumulated
for:
•
•
•
•
Working capital needs
Retirement of debt incurred in connection with the business
Investment or loans to suppliers or customers , or
Realistic business contingencies, including lawsuits or selfinsurance
Personal Holding Company (PHC) Tax
(slide 1 of 2)
• Enacted to discourage sheltering income in
corporations owned by individuals with high
marginal tax rates
• Imposes a 20% tax
– Designed to force a corporation to distribute
earnings to shareholders
– In any single year, the IRS cannot impose both the
PHC tax and the accumulated earnings tax
Personal Holding Company (PHC) Tax
(slide 2 of 2)
• A company is considered a PHC if:
– More than 50% of the value of the outstanding
stock was owned by five or fewer individuals at
any time during the last half of the year, and
– A substantial portion (60% or more) of
corporation’s income is comprised of passive types
of income (dividends, interest, rents, royalties, or
certain personal service income)
Refocus On The Big Picture (slide 1 of 4)
• A number of factors affect the tax treatment of Lime
Corporation’s distributions.
• The amount of current and accumulated E & P (which differ
from retained earnings) partially determines the tax effect on
the shareholders.
– Given that Lime Corporation has had a highly profitable year, it is
likely that there is sufficient current E & P to cover the distributions.
• If so, they are dividends to the shareholders rather than a return of capital.
• Orange Corporation receives $200,000 of dividend income
that is mostly offset by the dividends received deduction.
– The amount of the offsetting deduction depends on the ownership
percentage that Orange has in Lime.
Refocus On The Big Picture (slide 2 of 4)
• Gustavo has $200,000 of dividend income (i.e.,
$300,000 value of the land less the $100,000
mortgage).
– Assuming that Lime is a domestic corporation and that
Gustavo has held his stock for the entire year, the land is a
qualified dividend.
• As a result, the dividend is either tax-free (if Gustavo has a
marginal rate of 10% or 15%) or subject to a 15% (or 20%) tax rate
(depending on Gustavo’s marginal tax rate).
– Gustavo’s basis in the land is its fair market value at
distribution, or $300,000.
Refocus On The Big Picture (slide 3 of 4)
• From Lime Corporation’s perspective, the
distribution of appreciated property creates a deemed
gain of $280,000.
– $300,000 fair market value of the land less its $20,000
adjusted basis.
– While the gain increases Lime’s E & P, the distributions to
the shareholders reduce it by $200,000 for the cash and
$200,000 for the land ($300,000 fair market value reduced
by the $100,000 mortgage).
Refocus On The Big Picture (slide 4 of 4)
What If?
• What if current E & P is less than the cash and land distributed
to the shareholders?
• Current E & P is applied pro rata to the cash and the land.
– Since the amounts received by the two shareholders are equal
($200,000 each), the current E & P applied is taxed as a dividend
– To the extent that the distributions are not covered by current E & P,
accumulated E & P is then applied in a pro rata fashion.
• However, Lime probably has a deficit in accumulated E & P.
• As a result, the remaining amounts distributed to the two
shareholders are:
– First a tax-free recovery of stock basis, and
– Any excess is taxed as a sale of the stock (probably classified as capital
gain).
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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