Chapter 18
Corporate Taxation: Nonliquidating
Distributions
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
1.
2.
Explain the basic tax law framework that applies to
property distributions from a corporation to a
shareholder
Compute a corporation’s earnings and profits and
calculate the dividend amount received by a
shareholder
3.
Identify situations in which a corporation may be
deemed to have paid a “constructive dividend” to a
shareholder
4.
Comprehend the basic tax rules that apply to stock
dividends
18-2
Learning Objectives
4.
Comprehend the different tax consequences that can
arise from stock redemptions
5.
Contrast a partial liquidation from a stock redemption and
describe the difference in tax consequences to the
shareholders
18-3
Framework for Property Distributions

Corporations cannot deduct dividend distributions
and this creates the “double taxation” of the
corporation’s income.

Distributions to shareholders generally receive
preferential tax treatment:

Dividends may be taxed as income (albeit at a lower tax
rate).

Distributions may result in a tax-free return of capital.

Distributions may result in capital gains.
18-4
Framework for Property Distributions

Some payments to shareholders are deductible
by the corporation if the payment relates to other
services provided by the shareholder (such as
salary, bonus, interest, or rent).

If these payments are unreasonable, then the
distribution is a constructive dividend and the
payment is no longer deductible.
18-5
Computing Earnings and Profits

Overview of distributions:

The portion of a distribution that is a dividend is included
in the shareholder’s gross income.

The portion of the distribution that is not a dividend
reduces the shareholder’s tax basis in the corporation’s
stock

The portion of the distribution that is not a dividend and
is in excess of the shareholder’s stock tax basis is
treated as gain from sale or exchange of the stock
18-6
Determining the Dividend

A “dividend” for tax purposes is:

any distribution of property made by a corporation to its
shareholders out of its earnings and profits (E&P)

Two separate E&P accounts to be maintained
 Current earnings and profits
 Accumulated earnings and profits

Current E&P not distributed to shareholders is added to
accumulated E&P at the beginning of the next taxable
year
18-7
Determining the Dividend

Computing Earnings and Profits

Adjustments fall into four broad categories:

Income that is excluded from taxable income

Disallowed deductions that do not require an economic outflow

Deduction of expenses that require an economic outflow but are
not deducted for computing taxable income

Adjustment of timing for deductions or income because of
accounting methods required for E&P computation
18-8
Determining the Dividend

Ordering of E&P Distributions

Positive Current E&P and Positive Accumulated E&P

Positive current E&P, negative accumulated E&P

Negative current E&P, positive accumulated E&P

Negative current E&P, negative accumulated E&P
18-9
Determining the Dividend


Tax Consequences to a Corporation Paying Noncash
Property as a Dividend

The corporation recognizes gains (but not losses) on the
distribution of noncash property as a dividend

Gain is recognized to the extent of fair market value in excess
of tax basis in the property
Liabilities

If the property’s fair market value is less than liabilities
assumed by the shareholder, the fair market value is deemed
to be the liability
18-10
Stock Dividends



A stock dividend increases the number of shares
outstanding and thereby reduces the (value)
price per share.
Most stock dividends take the form of a stock
split, which is a 2-for-1 stock dividend.
Stock dividends are nontaxable to shareholders
if two conditions are met:


Made with respect to common stock and
Pro rata (proportionate interests maintained)
18-11
Stock Redemptions

Form of a Stock Redemption

A redemption occurs when a corporation acquires its
stock from a shareholder in exchange for property


It does not matter if the acquired stock is canceled, retired, or
held as treasury stock.
A redemption may result in a dividend to the shareholder or a
sale of the redeemed shares.

Individuals prefer exchange treatment because of the
preferential tax rates for capital gains.

Corporate shareholders prefer dividend treatment
because of the dividends received deduction.
18-12
Stock Redemptions

Three types of redemptions are treated as
exchanges:



Redemptions that are Substantially Disproportionate
are treated as sales.
Redemptions in Complete Redemption of all of the
Stock of the Corporation Owned by the Shareholder
Redemptions that are not Essentially Equivalent to a
Dividend
18-13
Stock Redemptions

Stock ownership tests are required for treatment as
substantially disproportionate:



The shareholder owns less than 50 percent of the voting
power immediately after the exchange
The shareholder’s percentage of voting stock and aggregate
value after the redemption is less than 80 percent of the
percentage before the redemption
In computing the percentage ownership tests, the constructive
ownership rules must be considered:
 Family attribution
 Attribution from entities to owners or beneficiaries
 Attribution from owners or beneficiaries to entities
 Option attribution
18-14
Stock Redemptions

If the redemption is treated as an exchange

Gain is always recognized.

Loss is recognized unless the shareholder is a related
person to the corporation (§267) – Shareholder owns
more than 50% of the stock’s value.



Ownership is determined using the §267(c) attribution rules.
“Family” attribution now includes the taxpayer’s brothers and
sisters, spouse, ancestors, and lineal descendents.
The basis of the property received is fair market value.
18-15
Stock Redemptions

Tax Consequences to the Distributing Corporation



If the redemption is a dividend, then E&P is reduced by
the cash and fair market value of other property
distributed.
If the redemption is an exchange, E&P is reduced by the
percentage of stock redeemed, not to exceed the fair
market value of the property distributed.
E&P is reduced by dividends before reducing its E&P for
redemptions treated as exchanges.
18-16
Partial Liquidations

Corporations can contract either by:



Distributing stock of a subsidiary to shareholders
Selling a business and distributing the proceeds to
shareholders in partial liquidation.
Distributions may require the shareholders to exchange
some shares of stock or may be pro rata to all the
shareholders without an actual exchange of stock.


Noncorporate shareholders receive exchange treatment
Corporate shareholders determine their tax consequences
using the change-in-stock ownership rules that apply to stock
redemptions.
18-17