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. 50