Comprehensive Volume
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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.

•
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)

(slide 1 of 2)

(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 10
• Return to the facts of The Big Picture on p. 19-1.
•
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
E & P at the start of the year and current E & P of $600,000.
• 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
Current E & P
Dividend:
100,000
50,000
20,000
(100,000)
50,000
20,000
15,000
(10,000)
5,000
*Since there is a current deficit, current and accumulated
E & P are netted before determining treatment of distribution.

Qualified Dividends
(slide 1 of 3)
• For individual taxpayers, qualified dividends are subject to a max 20% tax rate
– Qualified dividends are exempt from tax for taxpayers in the 10% or 15% rate brackets
– The 20% rate applies to taxpayers in the 39.6% tax bracket
–
The lower rates on dividend income apply to both the regular income tax and the alternative minimum tax
•
Corporations treat dividends as ordinary income and are permitted a dividends received deduction

Qualified Dividends
(slide 2 of 3)
• To qualify for lower rates, dividends must be:
–
Paid by domestic or certain qualified foreign corps
• Qualified foreign corps include those traded on a U.S. stock exchange or any corp. located in a country that:
–
Has a comprehensive income tax treaty with the U.S.
–
Has an information-sharing agreement with the U.S. and
–
Is approved by the Treasury
– Paid on stock held > 60 days during the 121-day period beginning 60 days before the ex-dividend date
– Dividends paid to shareholders who hold both long and short positions in the stock do not qualify

Qualified Dividends
(slide 3 of 3)
• Qualified dividends are not considered investment income for purposes of determining the investment interest expense deduction
– An election is available to treat qualified dividends as ordinary income (taxed at regular rates) and include them in investment interest income
–
Thus, taxpayers subject to an investment interest expense limitation must compare relative benefits of low tax on qualifying dividends vs. increased amount of deductible investment interest expense

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 13
Property Dividends - Effect on the Shareholder
• Return to the facts of The Big Picture on p. 19-1.
•
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 16
Property Dividends - Effect on the Corporation
• Return to the facts of The Big Picture on p. 19-1.
•
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:
1 2 3 .
Fair market value of distributed property
Liability on property
Gain(loss) recognized
E&P increased by gain
E & P decrease on dist.
60,000
-0-
40,000
40,000
10,000
-0-
-0-
-0-
40,000
15,000
20,000
20,000
60,000 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

(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 Rights
(slide 1 of 2)
•
Tax treatment of stock rights is same as for stock dividends
–
If stock rights are taxable
•
Income recognized = fair market value of stock rights received
• Basis = fair market value of stock rights
•
If exercised, holding period begins on date rights are exercised
•
Basis of new stock = basis of rights plus any other consideration given

Stock Rights
(slide 2 of 2)
•
If stock rights are nontaxable
–
If value of rights received < 15% of value of old stock, basis in rights = 0
•
Election is available which allows allocation of some of basis of formerly held stock to rights
–
If value of rights is 15% or more of value of old stock, and rights are exercised or sold, must allocate some of basis in formerly held stock to rights

Effect of Redemption
(slide 1 of 3)
•
If qualified as a redemption:
–
Shareholder reports gain or loss on surrender of stock
•
Gain taxed at favorable capital gains rates
(0%/15%/20%)
•
Shareholder reduces gain by basis in stock redeemed
•
Capital gains may be offset by capital losses, if available

Effect of Redemption
(slide 2 of 3)
•
If transaction has appearance of a dividend, redemption will not be qualified:
–
For example, if shareholder owns 100% and corporation buys ½ of stock for $X, shareholder still owns 100%

Effect of Redemption
(slide 3 of 3)
•
If not qualified as a redemption:
–
Shareholder reports dividend income
• Individual shareholders may be taxed at 0%/15%/20% rates
• But, redemption proceeds may not be offset by basis in stock surrendered
• Cannot be offset by capital losses
– Corporate shareholders may prefer dividend treatment because of the dividends received deduction

The Big Picture – Example 26
• Return to the facts of The Big Picture on p. 19-1.
•
Assume Gustavo sells some of his shares of
Lime Corp. stock ($80,000 stock basis) to a third party for $1.2 million.
– If the transaction is treated as a sale or exchange
(return of the owner’s investment), Gustavo has a long-term capital gain of $1,120,000
•
$1.2 million (amount realized) – $80,000 (stock basis).

The Big Picture – Example 27
Redemption Treated as D
Distribution
(slide 1 of 2)
•
Return to the facts of The Big Picture on p. 19-1 and the previous example.
•
Assume that Lime Corp. redeems some of its shares from Gustavo ($80,000 stock basis) for
$1.2 million.
–
If the transaction is treated as a sale or exchange
(return of the owner’s investment), Gustavo has a long-term capital gain of $1,120,000
•
$1.2 million (amount realized) – $80,000 (stock basis).

The Big Picture – Example 27
Redemption Treated as D
Distribution
(slide 2 of 2)
•
Return to the facts of The Big Picture on p. 19-1 and the previous example.
•
Assume that Lime Corp. redeems some of its shares from Gustavo ($80,000 stock basis) for
$1.2 million.
–
If treated as a dividend distribution (return from the owner’s investment), Gustavo has $1.2 million of dividend income (assuming adequate E & P).

Transactions Treated as Redemptions
(slide 1 of 3)
•
The following types of distributions may be treated as a redemption of stock rather than as a dividend:
– Distributions not essentially equivalent to a dividend (subjective test)
–
Disproportionate distributions (mechanical rules)

Transactions Treated as Redemptions
(slide 2 of 3)
– Distributions in termination of shareholder’s interest (mechanical rules)
–
Partial liquidations of a corporation where shareholder is not a corporation, and either
•
(1) Distribution is not essentially equivalent to a dividend, or
•
(2) An active business is terminated
•
(May be subjective (1) or mechanical (2))

Transactions Treated as Redemptions
(slide 3 of 3)
– Distributions to pay death taxes (limitation on amount of allowed distribution is mechanical test)
•
Stock attribution rules must be applied, so distribution which appears to meet requirements may not qualify

Stock Attribution
(slide 1 of 3)
•
Qualified stock redemption must result in substantial reduction in shareholder’s ownership
– Stock ownership by certain related parties is attributed back to shareholder whose stock is redeemed

Stock Attribution
(slide 2 of 3)

Stock Attribution
(slide 3 of 3)
•
Family attribution rules can be waived for redemptions in complete termination of shareholder’s interest
•
Stock attribution rules do not apply to partial liquidations or redemptions to pay death taxes

The Big Picture – Example 31
Stock Attribution Rules
•
Return to the facts of The Big Picture on p. 19-1.
•
Assume instead that Gustavo owns only 30% of the stock in Lime Corp.
– 20% is owned by his two children.
•
For purposes of the stock attribution rules,
Gustavo is treated as owning 50% of the stock in Lime Corp.
–
He owns 30% directly and, because of the family attribution rules, 20% indirectly through his children.

Not Essentially Equivalent
Redemptions
(slide 1 of 3)
•
Redemption qualifies for sale or exchange treatment if “not essentially equivalent to a dividend”
– Subjective test
–
Provision was added to deal specifically with redemptions of preferred stock
•
Shareholders often have no control over when preferred shares redeemed
•
Also applies to common stock redemptions

Not Essentially Equivalent
Redemptions
(slide 2 of 3)
•
To qualify, redemption must result in a meaningful reduction in shareholder’s interest in redeeming corp.
• Stock attribution rules apply
•
Indicators of a meaningful reduction include:
– A decrease in the redeeming shareholder’s voting control
–
Reduction in rights of redeeming shareholders to
•
Share in corporate earnings, or
• Receive corporate assets upon liquidation

Not Essentially Equivalent
Redemptions
(slide 3 of 3)
•
If redemption fails to satisfy any of the qualifying stock redemption rules
–
Treated as ordinary dividend
–
Basis in stock redeemed attaches to remaining stock owned (directly or constructively)

Qualifying Disproportionate
Redemption
(slide 1 of 4)
•
Redemption qualifies as disproportionate redemption if:
–
Shareholder owns less than 80% of the interest owned prior to redemption
–
Shareholder owns less than 50% of the total combined voting power in the corporation after the redemption

Qualifying Disproportionate
Redemption
(slide 2 of 4)

Qualifying Disproportionate
Redemption
(slide 3 of 4)

Qualifying Disproportionate
Redemption
(slide 4 of 4)
•
Shareholder has 46 2/3% ownership represented by 35 voting shares (60-25) of 75
(100-25) outstanding voting shares
•
Redemption is qualified disproportionate redemption because:
–
Shareholder owns < 80% of the 60% owned prior to redemption (80%
×
60% = 48%), and
–
Shareholder owns < 50% of total combined voting power of corporation

Complete Termination Redemptions
•
Termination of entire interest generally qualifies for sale or exchange treatment
–
Often will not qualify as disproportionate redemption due to stock attribution rules
–
Family attribution rules will not apply if:
•
Former shareholder has no interest (other than as creditor) for at least 10 years
•
Agree to notify IRS of any disallowed interest within
10 year period

Redemptions in Partial Liquidation
(slide 1 of 3)
•
Noncorporate shareholder gets sale or exchange treatment for partial liquidation including:
– Distribution not essentially equivalent to a dividend
–
Under a safe-harbor rule, distribution pursuant to termination of an active business

Redemptions in Partial Liquidation
(slide 2 of 3)
•
To qualify, distribution must be made within taxable year plan is adopted or the succeeding taxable year
•
Not essentially equivalent test looks at effect on corporation
–
Requires genuine contraction of the business of the corporation
•
Difficult to apply due to lack of objective tests
•
Advanced ruling from IRS should be obtained

Redemptions in Partial Liquidation
(slide 3 of 3)
•
Under the safe-harbor rule, to meet the complete termination of a business test, the corporation must:
–
Have two or more active trades or businesses that have been in existence for at least five years
• Distribution must consist of the assets of a qualified trade or business or the proceeds from the sale of such assets
–
Terminate one trade or business and continue a remaining trade or business

Redemptions to Pay Death Taxes
(slide 1 of 2)
•
Allows sale or exchange treatment if value of stock exceeds 35% of value of adjusted gross estate
– Stock of 2 or more corps may be treated as stock of single corp for 35% test if 20% or more of each corp was owned by decedent
–
Special treatment limited to sum of:
•
Death Taxes
•
Funeral and administration expenses

Redemptions to Pay Death Taxes
(slide 2 of 2)
•
Basis of stock is stepped up to fair market value on date of death (or alternate valuation date)
– When redemption price equals stepped-up basis, no tax consequences to estate

Effect of Redemption on Corporation
(slide 1 of 2)
•
Gain or loss recognition
–
If property other than cash used for redemption
• Corporation recognizes gain on distribution of appreciated property
• Loss is not recognized
– Corporation should sell property, recognize loss, and use proceeds from sale for redemption

Effect of Redemption on Corporation
(slide 2 of 2)
•
Effect on Earnings and Profits
–
E & P is reduced in a qualified stock redemption by an amount not in excess of the ratable share of
E & P attributable to stock redeemed
•
Corporate expenditures incurred in a stock redemption are not deductible
– e.g., accounting, brokerage, legal and loan fees

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.
–
In this situation, Orange would likely qualify for a dividends received deduction of $160,000 ($200,000 X 80%).

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
© 2015 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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