Chapter 14
Corporate Nonliquidating and
Liquidating Distributions
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This
document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
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.
Explain the basic tax rules that apply to stock dividends
14-2
Learning Objectives
5.
Comprehend the different tax consequences that can
arise from stock redemptions, including partial
liquidations
6.
Calculate the tax consequences of a complete liquidation
of a corporation
14-3
Framework for Property Distributions

Corporations cannot deduct dividend distributions


This creates “double taxation” of a corporation’s income
Distributions to shareholders:


Dividends taxed as income

To extent of E&P

Preferential rate of 0%, 15%, or 20%, depending on taxpayer’s income level

Dividends could be subject to 3.8% Medicare Contribution Tax on net investment
income, depending on taxpayer’s income level
Nontaxable return of capital


To extent of basis
Capital gains

Distributions in excess of E&P and basis.
14-4
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 rest of the distribution is treated as gain from sale or
exchange of the stock
14-5
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
14-6
Determining the Dividend

Computing Earnings and Profits


Start with taxable income and make adjustments to taxable
income
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
14-7
14-8
14-9
Determining the Dividend

Ordering of E&P Distributions in the following four
situations

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
14-10
Constructive Dividends

Disguised dividends – Examples

Unreasonable compensation

Bargain sales to shareholders

Shareholder use of corporate assets in excess of what
would be paid in an arm’s-length transaction

Loans from shareholders at excessive interest rates

Corporate payments made on behalf of the shareholder
14-11
Determining the Dividend

Distributions of Noncash Property to
Shareholders

Money received + Fair market value of other property
received – liabilities assumed by the shareholder on
property received = Amount distributed
14-12
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

For both regular tax and Current E&P purposes
14-13
Determining the Dividend

Noncash Property Distributions affect E&P
14-14
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)
14-15
Stock Dividends

Nontaxable stock dividend new stock basis

Non-pro rata stock dividends usually are taxable as
dividends

Basis fair market value (if taxable)
14-16
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.

Could be 0%, 15% or 20%, depending on taxpayer’s income level

Could be subject to 3.8% Medicare Contribution Tax on net investment income,
depending on taxpayer’s income level
Corporate shareholders generally prefer dividend treatment
because of the dividends received deduction.
14-17
Stock Redemptions

Three types of redemptions are treated as
sales:

Redemptions that are Substantially Disproportionate.


Redemptions in Complete Redemption of all of the
Stock of the Corporation Owned by the Shareholder


Bright-line test
Must meet certain requirements
Redemptions that are not Essentially Equivalent to a
Dividend

Facts and circumstances test
14-18
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
14-19
Stock Redemptions

If the redemption is treated as a sale 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.
14-20
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.
14-21
Partial Liquidations

Corporation contracts (shrinks) and distributes capital to
shareholders—called a partial liquidation


Treated as a redemption
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 in partial liquidation of a corporation 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
14-22
redemptions.
Complete Liquidation of a Corporation

Occurs when a corporation acquires all of its
stock from all of its shareholders in exchange for
“all” of its net assets, after which time the
corporation ceases to do business

For tax purposes, Form 966 needs to be filed by
corporation in order to inform IRS of its intention
to liquidate its tax existence

Form should be filed within 30 days after the
owners resolve to liquidate the corporation
14-23
Fully Taxable Liquidations

Shareholder tax consequences

Treated as a sale of stock


Amount realized – basis = capital gain or loss
Fair market value basis in assets received
14-24
Fully Taxable Liquidations

Liquidating Corporation

Treated as though sold each asset at fair market
value

Fair market value – basis = gain or loss


Character depends on asset
Ability to deduct loss may be limited
14-25
Corporate Loss Limitations

Corporate losses in liquidations may be
disallowed in certain circumstances

Loss disallowed on property distributed to related
persons (more than 50% ownership see §267)



that is not distributed pro-rata, or
that is disqualified property.
Pre-contribution loss on certain property
distributed or sold by a liquidating corporation

Loss disallowed if tax avoidance motive

Two-year presumption
14-26
Disqualified Property

Property acquired by liquidating corporation


In §351 transaction or as contribution to capital
during 5-year period ending on date of distribution
Doesn’t matter whether property had built-in loss
or built-in gain at the time of contribution to
liquidating corporation
14-27
Nontaxable and Partially Taxable
Complete Liquidations


Applies when corporate shareholder owns at
least 80% of the liquidating corporation’s
stock
Tax consequences to Shareholders

Corporate shareholder


No gain or loss on liquidation
Takes carryover basis in each asset from liquidating
corporation
14-28
Nontaxable and Partially Taxable
Complete Liquidations

Tax consequences to Shareholders

Minority interest shareholder




Same as a fully taxable liquidation
FMV of property received minus stock basis equals
capital gain or loss recognized
FMV basis in property received in liquidation
Liquidating corporation


No gain or loss to extent property distributed to
corporate shareholder
Gain but not loss recognized on property distributed to
minority interest.
14-29