Chapter 7
Corporate Taxation: Nonliquidating
Distributions
McGraw-Hill/Irwin
Copyright © 2013 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
7-2
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
7-3
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.
7-4
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.
7-5
Constructive Dividends

Disguised dividends – Examples
7-6
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
7-7
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
7-8
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
7-9
7-10
7-11
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
7-12
Determining the Dividend

Example 1

Current E&P = $1,000,000

Accumulated E&P = ($500,000)

The corporation distributes $1M on July 1.
7-13
Determining the Dividend

Example 2

Current E&P = ($1,000,000)

Accumulated E&P = $1,000,000

The corporation distributes $1M on July 1.
AE&P as of July 1 = $1M  ½($1M) = $500,000
7-14
Determining the Dividend

Distributions of Noncash Property to
Shareholders
7-15
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
7-16
Determining the Dividend

Example 1
Cher Holder receives a property distribution from Sunny
Corporation with a fair value of $200. Cher assumes a
$100 mortgage attached to the property. Sunny’s basis in
the property distributed is $100.
7-17
Determining the Dividend

Example 2
Cher Holder receives a property distribution from Sunny
Corporation with a fair value of $200. Cher assumes a
$300 mortgage attached to the property. Sunny’s basis in
the property distributed is $100.
7-18
Determining the Dividend

Noncash Property Distributions affect E&P
7-19
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)
7-20
Stock Dividends

Non-pro rata stock dividends usually are taxable as
dividends
7-21
Stock Redemptions

Form of a Stock Redemption

A redemption occurs when a corporation acquires its
stock from a shareholder in exchange for property

It is irrelevant if the acquired stock is canceled or retired.

A redemption results in either a dividend 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.
7-22
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
7-23
Stock Redemptions

Stock ownership tests are required for treatment as
substantially disproportionate:

Shareholder does not control the corporation after the
exchange (less than 50 percent of voting power)

Shareholder’s percentage of voting stock and aggregate value is
less than 80 percent of the percentage before the redemption

Constructive ownership rules must be considered:
 Family attribution
 Attribution from entities to owners or beneficiaries
 Attribution from owners or beneficiaries to entities
 Option attribution
7-24
Stock Redemptions

Example
A shareholder owns 60 of the corporation’s 100 shares of
voting common stock before the redemption.

What percentage ownership test(s) must be met for the
shareholder to receive exchange treatment under §302(b)(2)?
7-25
Stock Redemptions

How many shares of stock must the corporation redeem
to meet the §302(b)(2) tests to have the redemption
treated as an exchange to the shareholder?
7-26
Stock Redemptions

If the redemption is treated as an exchange the
shareholder tax consequences are:

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.
7-27
Stock Redemptions

Tax Consequences to the Distributing Corporation

For a dividend, current E&P is reduced by the cash and
fair market value of other property (and adjusted for gain
recognized and liabilities distributed).

For an exchange, current and accumulated E&P is
reduced by the percentage of stock redeemed (limited to
the fair market value of the property distributed).

Current E&P is reduced by dividends before reducing its
current E&P for redemptions treated as exchanges.
7-28
Stock Redemptions

§312(n)(7) example
Spartan Inc. has AE&P at 1/01/10 of $100,000. Current E&P for
2010 is $75,000. Spartan redeems all of Shareholder A’s stock on
July 1 for $60,000. The stock redeemed represents 25% of
Spartan stock. On December 31, Spartan pays its remaining
shareholders dividends of $25,000. A treats the redemption as an
exchange.
7-29
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.
7-30