Chapter 07 Corporate Taxation: Nonliquidating Distributions

Learning Objectives 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 Identify situations in which a corporation may be deemed to have paid a “constructive dividend” to a shareholder Comprehend the basic tax rules that apply to stock dividends

Learning Objectives Comprehend the different tax consequences that can arise from stock redemptions Contrast a partial liquidation with other types of stock redemptions and describe the difference in tax consequences to the shareholders

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 must be included in gross income (albeit generally taxed at a lower tax rate). Distributions may result in a tax-free return of capital. Distributions may result in capital gains.

Framework for Property Distributions Payments to shareholders are deductible by the corporation if the payment relates to services provided by the shareholder (such as salary, bonus, interest, or rent). If these payments are unreasonable, then the unreasonable (excessive) portion may be treated as a constructive dividend and the payment is no longer deductible.

Constructive Dividends Examples of disguised (constructive) dividends – Unreasonable compensation Bargain sales of property to shareholders Shareholder use of corporate assets without an arm’s-length payment Loans from shareholders at excessive interest rates Corporate payments of the shareholder’s personal expenses

Constructive Dividend 90. On June 30, 2011, Ral Corporation had earnings and profits of $100,000. On that date, it sold a plot of land to a noncorporate stockholder for $50,000. Ral had paid $40,000 for the land in 2003, and it had a fair market value of $80,000 when the stockholder bought it. The amount of dividend income taxable to the stockholder in 2011 is a. $0 b. $10,000 c. $20,000 d. $30,000

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 Computing Earnings and Profits

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 concepts must be understood 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 Determining the Dividend

Computing Earnings and Profits from Taxable Income Adjustments to taxable income fall into four broad categories: Income that is excluded from taxable income 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 Determining the Dividend

Earnings and Profits 81. At the beginning of the year, Cable, a C corporation, had accumulated earnings and profits of $100,000. Cable reported the following items on its current year tax return: Taxable income $50,000 Federal income taxes paid 5,000 Current year charitable contributions in excess of 10% limitation 1,000 Net capital loss for current year 2,000 What is Cable’s accumulated earnings and profits at the end of the year? a. $142,000 b. $145,000 c. $147,000 d. $150,000

AE&P Balance 80. At the beginning of the year, Westwind, a C corporation, had a deficit of $45,000 in accumulated earnings and profits. For the current year, Westwind reported earnings and profits of $15,000. Westwind distributed $12,000 during the year. What was the amount of Westwind’s accumulated earnings and profits deficit at year-end? a. $(30,000) b. $(42,000) c. $(45,000) d. $(57,000)

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 Determining the Dividend

Taxable dividend 85. Kent Corp. is a calendar-year, accrual-basis C corporation. In 2011, Kent made a nonliquidating distribution of property with an adjusted basis of $150,000 and a fair market value of $200,000 to Reed, its sole shareholder. The following information pertains to Kent: Reed’s basis in Kent stock at January 1, 2011 $500,000 Accumulated earnings and profits at January 1, 2011 125,000 Current earnings and profits for 2011 60,000 What was taxable as dividend income to Reed for 2011? a. $ 60,000 b. $150,000 c. $185,000 d. $200,000

Dividend Income 82. On January 1, 2011, Locke Corp., an accrual-basis, calendar-year C corporation, had $30,000 in accumulated earnings and profits. For 2011, Locke had current earnings and profits of $20,000 and made two $40,000 cash distributions to its shareholders, one in April and one in September of 2011. What amount of the 2011 distributions is classified as dividend income to Locke’s shareholders? a. $0 b. $20,000 c. $50,000 d. $80,000

Example 1 Current E&P = $1,000,000 Accumulated E&P = ($500,000) The corporation distributes $1M on July 1. The entire distribution is deemed to come from current E&P and is a dividend to the shareholders. This is because CE&P is measured as of the close of the taxable year without regard to what it was on the actual date of distribution. 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^ $500,000 is a treated as a dividend to the extent of the AE&P that is available to pay out on the date of distribution. ^ E&P should be apportioned on a daily basis, but for our purposes you can use months. Determining the Dividend

Distributions of Noncash Property to Shareholders 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 Determining the Dividend

Loss Recognition 87. Tour Corp., which had earnings and profits of $400,000, made a nonliquidating distribution of property to its shareholders in 2012. This property, which had an adjusted basis of $30,000 and a fair market value of $20,000 at date of distribution, did not constitute assets used in the active conduct of Tour’s business. How much loss did Tour recognize on this distribution? a. $30,000 b. $20,000 c. $10,000 d. $0

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. Under §311(b)(1), Sunny Corporation reports a gain of $100 on the distribution ($200 FMV - $100 AB). 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. Under §311(b)(2), Sunny Corporation reports a gain of $200 on the distribution ($300 Liab - $100 AB). The property’s FMV is deemed to be the amount of the liability assumed because it exceeds the property’s fair market value. Determining the Dividend

Noncash Property Distributions affect E&P Determining the Dividend

Effect on E&P 91. On December 1, 2011, Gelt Corporation declared a dividend and distributed to its sole shareholder a parcel of land that was not an inventory asset. On the date of the distribution, the following data were available: Adjusted basis of land $ 6,500 Fair market value of land 14,000 Mortgage on land 5,000 For the year ended December 31, 2011, Gelt had earnings and profits of $30,000 without regard to the dividend distribution. If the mortgage on the land was assumed by the sole shareholder, by how much should the dividend distribution reduce Gelt’s earnings and profits? a. $ 1,500 b. $ 6,500 (-$6,500 AB + $5,000 mortg.) = -$1,500 c. $ 9,000 d. $14,000 (+$7,500 gain - $14,000 FMV + $5,000 mortg.) = -$1,500

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, such as a 2-for-1 stock dividend. Stock dividends are generally nontaxable to shareholders if two conditions are met: Made with respect to common stock and Pro rata (proportionate interests maintained)

Stock Dividends Non-pro rata stock dividends usually are taxable as dividends

Stock Dividend In January 2012, Joan Hill bought one share of Orban Corp. stock for $300. On March 1, 2012, Orban distributed one share of preferred stock for each share of common stock held. This distribution was nontaxable. On March 1, 2012, Joan’s one share of common stock had a fair market value of $450, while the preferred stock had a fair market value of $150. 14. After the distribution of the preferred stock, Joan’s bases for her Orban stocks are Common Preferred a. $300 $0 b. $225 $ 75 PS = ($150/$600) x $300 = $75 c. $200 $100 CS = ($450/$600) x $300 = $225 d. $150 $150

Stock Dividend Holding Period In January 2012, Joan Hill bought one share of Orban Corp. stock for $300. On March 1, 2012, Orban distributed one share of preferred stock for each share of common stock held. This distribution was nontaxable. On March 1, 2012, Joan’s one share of common stock had a fair market value of $450, while the preferred stock had a fair market value of $150. 15. The holding period for the preferred stock starts in a. January 2012. b. March 2012. c. September 2012. d. December 2012.

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 may be treated as a sale or exchange of the redeemed shares if certain requirements are met. Individuals prefer exchange treatment because of the ability to recover their stock basis. Corporate shareholders prefer dividend treatment because of the dividends received deduction.

Three types of redemptions are treated as exchanges by determining the effect of the redemption on the redeemed shareholder: 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 Stock Redemptions

Stock Redemption 92. Two unrelated individuals, Mark and David, each own 50% of the stock of Pike Corporation, which has accumulated earnings and profits of $250,000. Because of his inactivity in the business in recent years, Mark has decided to retire from the business and wishes to sell his stock. Accordingly, Pike will distribute cash of $500,000 in redemption of all of the stock owned by Mark. If Mark’s adjusted basis for his stock at date of redemption is $300,000, what will be the tax effect of the redemption to Mark? a. $125,000 dividend. b. $200,000 dividend. c. $200,000 capital gain. d. $250,000 dividend.

Stock ownership tests must be met for treatment as substantially disproportionate under Sec. 302(b)(2): 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, constructive ownership rules under Sec. 318 must be used: Family attribution (spouse, children, grandchildren, parents) Attribution from entities to owners or beneficiaries Attribution from owners or beneficiaries to entities Option attribution 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)? < 50% < 80% x 60% = < 48% 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. Stock Redemptions

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 E&P for redemptions treated as exchanges.

§312(n)(7) example Spartan Inc. has AE&P at 1/01/11 of $100,000. Current E&P for 2011 is $75,000. Spartan redeems all of Shareholder A’s stock on July 1 for $80,000. 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. CE&P after the dividends is $50,000 ($75,000 - $25,000). AE&P at 7/01/11 is $100,000 + ½ ($50,000) = $125,000. Under §312(n)(7), Spartan reduces AE&P as a result of the redemption in an amount equal to the lesser of: 25% x $125,000 = $31,500 $80,000 (fair value of the distribution) Stock Redemptions

Partial Liquidations Corporations can contract in size either by: Distributing stock of a subsidiary to shareholders (generally treated as a nontaxable spin-off) Selling a business and distributing the proceeds to shareholders in partial liquidation (qualifies non corporate shareholders for exchange treatment) Whether a redemption qualifies as a partial liquidation is determined at corporate level by determining whether there has been a genuine corporate contraction; whether other types of redemptions qualify for exchange treatment is determined by the effect of the redemption on the shareholder 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. Shareholders who are not corporations (non corporate shareholders) receive exchange treatment if the redemption is a partial liquidation Corporate shareholders determine their tax consequences using the change-in-stock ownership rules that apply to stock redemptions.

Partial Liquidation 93. How does a non corporate shareholder treat the gain on a redemption of stock that qualifies as a partial liquidation of the distributing corporation? a. Entirely as capital gain. b. Entirely as a dividend. c. Partly as capital gain and partly as a dividend. d. As a tax-free transaction.