Broadbill corporation a calendar year c corporation

Federal Taxation Ch.19 Homework

30. LO.1, 4 At the start of the current year, Blue Corporation (a calendar year taxpayer)

has accumulated E & P of $100,000. Blue’s current E & P is $60,000, and at the end of

the year, it distributes $200,000 ($100,000 each) to its equal shareholders, Pam and Jon.

Pam’s stock basis is $11,000; Jon’s stock basis is $26,000. How is the distribution treated

for tax purposes?

33. LO.2 Sparrow Corporation (a calendar year, accrual basis taxpayer) had the following

transactions in 2013, its second year of operation.

Taxable income $330,000

Federal income tax liability paid 112,000

Tax-exempt interest income 5,000

Meals and entertainment expenses (total) 3,000

Premiums paid on key employee life insurance 3,500

Increase in cash surrender value attributable to life insurance premiums 700

Proceeds from key employee life insurance policy 130,000

Cash surrender value of life insurance policy at distribution 20,000

Excess of capital losses over capital gains 13,000

MACRS deduction 26,000

Straight-line depreciation using ADS lives 16,000

Section 179 expense elected during 2012 100,000

Dividends received from domestic corporations (less than 20% owned) 25,000

Sparrow uses the LIFO inventory method, and its LIFO recapture amount increased by

$10,000 during 2013. In addition, Sparrow sold property on installment during 2012.

The property was sold for $40,000 and had an adjusted basis at sale of $32,000. During

2013, Sparrow received a $15,000 payment on the installment sale. Finally, assume that

no additional first-year depreciation was claimed. Compute Sparrow’s current E & P.

F

42. LO.1, 2, 3, 4, 5 Cerulean Corporation has two equal shareholders, Eloise and Olivia.

Eloise acquired her Cerulean stock three years ago by transferring property worth

$700,000, basis of $300,000, for 70 shares of the stock. Olivia acquired 70 shares in Cerulean

Corporation two years ago by transferring property worth $660,000, basis of

$110,000. Cerulean Corporation’s accumulated E & P as of January 1 of the current year

is $350,000. On March 1 of the current year, the corporation distributed to Eloise property

worth $120,000, basis to Cerulean of $50,000. It distributed cash of $220,000 to Olivia.

On July 1 of the current year, Olivia sold her stock to Magnus for $820,000. On

December 1 of the current year, Cerulean distributed cash of $90,000 each to Magnus

and Eloise. What are the tax issues?

44. LO.2, 6 Parrot Corporation is a closely held company with accumulated E & P of

$300,000 and current E & P of $350,000. Tom and Jerry are brothers; each owns a 50%

share in Parrot, and they share management responsibilities equally. What are the tax

consequences of each of the following independent transactions involving Parrot, Tom,

and Jerry? How does each transaction affect Parrot’s E & P?

a. Parrot sells an office building (adjusted basis of $350,000; fair market value of

$300,000) to Tom for $275,000.

b. Parrot lends Jerry $250,000 on March 31 of this year. The loan is evidenced by a note

and is payable on demand. No interest is charged on the loan (the current applicable

Federal interest rate is 7%).

c. Parrot owns an airplane that it leases to others for a specified rental rate. Tom and

Jerry also use the airplane for personal use and pay no rent. During the year, Tom

used the airplane for 120 hours, and Jerry used it for 160 hours. The rental value of

the airplane is $350 per hour, and its maintenance costs average $80 per hour.

d. Tom leases equipment to Parrot for $20,000 per year. The same equipment can be

leased from another company for $9,000 per year.

51. LO.8, 9 Robert and Lori (Robert’s sister) own all of the stock in Swan Corporation

(E & P of $1 million). Each owns 500 shares and has a basis of $85,000 in the shares.

Robert wants to sell his stock for $600,000, the fair market value, but he will continue to

be employed as an officer of Swan Corporation after the sale. Lori would like to purchase

Robert’s shares and, thus, become the sole shareholder in Swan, but Lori is short

of funds. What are the tax consequences to Robert, Lori, and Swan Corporation under

the following circumstances?

a. Swan Corporation distributes cash of $600,000 to Lori, and she uses the cash to purchase

Robert’s shares.

b. Swan Corporation redeems all of Robert’s shares for $600,000.of funds. What are the tax consequences to Robert, Lori, and Swan Corporation under

the following circumstances?

a. Swan Corporation distributes cash of $600,000 to Lori, and she uses the cash to purchase

Robert’s shares.

b. Swan Corporation redeems all of Robert’s shares for $600,000.

19 C H A P T E RC H A P T E R

Corporations: Distributions Not in Complete Liquidation

L E A RN I NG O B J E C T I V E S : After completing Chapter 19, you should be able to:

LO.1 Explain the role that earnings and profits play in determining the tax treatment of distributions.

LO.2 Compute a corporation’s earnings and profits (E & P).

LO.3 Determine taxable dividends paid during the year by correctly allocating current and accumulated E & P to corporate distributions.

LO.4 Describe the tax treatment of dividends for individual shareholders.

LO.5 Evaluate the tax impact of property dividends by computing the shareholder’s dividend income, basis in the property received, and the effect on the distributing corporation’s E & P and taxable income.

LO.6 Recognize situations when constructive dividends exist and compute the tax resulting from such dividends.

LO.7 Compute the tax arising from receipt of stock dividends and stock rights and the shareholder’s basis in the stock and stock rights received.

LO.8 Identify various stock redemptions that qualify for sale or exchange treatment.

LO.9 Determine the tax impact of stock redemptions on the distributing corporation.

LO.10 Identify planning opportunities available to minimize the tax impact in corporate distributions, constructive dividends, and stock redemptions.

CHA P T E R OU T L I N E

19-1 Corporate Distributions—Overview, 19-2

19-2 Earnings and Profits (E & P), 19-3 19-2a Computation of E & P, 19-3 19-2b Summary of E & P Adjustments, 19-6 19-2c Current versus Accumulated E & P, 19-6 19-2d Allocating E & P to Distributions, 19-6

19-3 Dividends, 19-10 19-3a Rationale for Reduced Tax Rates on

Dividends, 19-10 19-3b Qualified Dividends, 19-11 19-3c Property Dividends, 19-12 19-3d Constructive Dividends, 19-15 19-3e Stock Dividends and Stock Rights, 19-18

19-4 Stock Redemptions, 19-19 19-4a Overview, 19-19 19-4b Historical Background, 19-22 19-4c Stock Attribution Rules, 19-22

19-4d Not Essentially Equivalent Redemptions, 19-23

19-4e Disproportionate Redemptions, 19-24 19-4f Complete Termination Redemptions, 19-25 19-4g Redemptions to Pay Death Taxes, 19-26

19-5 Effect on the Corporation Redeeming Its Stock, 19-28 19-5a Recognition of Gain or Loss, 19-28 19-5b Effect on Earnings and Profits, 19-28 19-5c Redemption Expenditures, 19-28

19-6 Other Corporate Distributions, 19-29

19-7 Tax Planning, 19-29 19-7a Corporate Distributions, 19-29 19-7b Planning for Qualified Dividends, 19-30 19-7c Constructive Dividends, 19-31 19-7d Stock Redemptions, 19-32

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T H E B I G P I C T U R E Tax Solutions for the Real World

TAXING CORPORATE DISTRIBUTIONS

Lime Corporation, an ice cream manufacturer, has had a very profitable year. To share its profits with its two equal shareholders, Orange Corporation and Gustavo, it distributes cash of $200,000 to Orange 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.

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 GAAP-based balance sheet for Lime indicates a year-end deficit in retained earnings. Consequently, the distribution of cash and land is treated as a liquidating dis- tribution for financial reporting purposes, resulting in a reduction of Lime’s paid-in capital account.

The tax consequences of the distributions to Lime Corporation and its shareholders depend on a variety of factors that are not directly related to the financial reporting treatment. Identify these factors and explain the tax effects of the distributions to both Lime Corporation and its two shareholders.

Read the chapter and formulate your response.

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19-1

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Chapter 18 examined the tax consequences of corporate formation. InChapters 19 and 20, the focus shifts to the tax treatment of corporate dis-tributions, a topic that plays a leading role in tax planning. The impor- tance of corporate distributions derives from the variety of tax treatments that may apply. From the shareholder’s perspective, distributions received from the corporation may be treated as ordinary income, preferentially taxed dividend income, capital gain, or a nontaxable recovery of capital. From the corporation’s perspective, distributions made to shareholders are generally not deductible. However, a corporation may recognize losses in liquidating distributions (see Chapter 20), and gains may be recognized at the corporate level on distributions of appreciated property. In the most common scenario, a distribution triggers dividend income to the shareholder and provides no deduction to the paying corporation, resulting in a double tax (i.e., a tax is levied at both the corporate and shareholder levels). This double tax may be mitigated by a variety of factors, including the corporate dividends received deduction and preferential tax rates on qualified dividends paid to individuals.

As will become apparent in the subsequent discussion, the tax treatment of corporate distributions can be affected by a number of considerations:

• The availability of earnings to be distributed. • Whether the distribution is a “qualified dividend.” • Whether the shareholder is an individual or another kind of taxpaying entity. • The basis of the shareholder’s stock. • The character of the property being distributed. • Whether the shareholder gives up ownership in return for the distribution. • Whether the distribution is liquidating or nonliquidating.

This chapter discusses the tax rules related to nonliquidating distributions of cash and property. Distributions of stock and stock rights are also addressed along with the tax treatment of stock redemptions. Corporate liquidations are discussed in Chapter 20.

19-1 CORPORATE DISTRIBUTIONS—OVERVIEW To the extent that a distribution is made from corporate earnings and profits (E & P), the shareholder is deemed to receive a dividend, taxed as ordinary income or as preferentially taxed dividend income.1 Generally, corporate distributions are pre- sumed to be paid out of E & P (defined later in this chapter) and are treated as dividends unless the parties to the transaction can show otherwise. Distributions not treated as dividends (because of insufficient E & P) are nontaxable to the extent of the shareholder’s stock basis, which is reduced accordingly. The excess of the distribution over the shareholder’s basis is treated as a gain from the sale or exchange of the stock.2

E X A M P L E 1 At the beginning of the year, Amber Corporation (a calendar year taxpayer) has E & P of $15,000. The corporation generates no additional E & P during the year. On July 1, the corporation distributes $20,000 to its sole shareholder, Bonnie, whose stock basis is $4,000. In this situation, Bonnie recognizes dividend income of $15,000 (the amount of E & P distributed). In addition, she reduces her stock basis from $4,000 to zero, and she recognizes a taxable gain of $1,000 (the excess of the distribution over the stock basis). n

LO.1

Explain the role that earnings and profits play in determining the tax treatment of distributions.

1§§ 301(c)(1), 316, and 1(h)(11). 2§§ 301(c)(2) and (3).

19-2 PART 6 Corporations

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19-2 EARNINGS AND PROFITS (E & P) The notion of earnings and profits (E & P) is similar in many respects to the account- ing concept of retained earnings. Both are measures of the firm’s accumulated capi- tal (E & P includes both the accumulated E & P of the corporation since February 28, 1913, and the current year’s E & P). A difference exists, however, in the way these figures are calculated. The computation of retained earnings is based on financial accounting rules, while E & P is determined using rules specified in the tax law.

E & P fixes the upper limit on the amount of dividend income that shareholders must recognize as a result of a distribution by the corporation. In this sense, E & P represents the corporation’s economic ability to pay a dividend without impairing its capital. Thus, the effect of a specific transaction on E & P may often be deter- mined by assessing whether the transaction increases or decreases the corpora- tion’s capacity to pay a dividend.

19-2a Computation of E & P The Code does not explicitly define the term earnings and profits. Instead, a series of adjustments to taxable income are identified to provide a measure of the corpo- ration’s economic income. Both cash basis and accrual basis corporations use the same approach when determining E & P.3

Additions to Taxable Income To determine current E & P, it is necessary to add all previously excluded income items back to taxable income. Included among these positive adjustments are inter- est on municipal bonds, excluded life insurance proceeds (in excess of cash surren- der value), and Federal income tax refunds from tax paid in prior years.

E X A M P L E 2A corporation collects $100,000 on a key employee life insurance policy (the corpora- tion is the owner and beneficiary of the policy). At the time the policy matured on the death of the insured employee, it possessed a cash surrender value of $30,000. None of the $100,000 is included in the corporation’s taxable income, but $70,000 is added to taxable income when computing current E & P (i.e., amount collected on the policy net of its cash surrender value). The collection of the $30,000 cash surrender value does not increase E & P because it does not reflect an increase in the corporation’s dividend-paying capacity. Instead, it represents a shift in the corporation’s assets from life insurance to cash. n

In addition to excluded income items, the dividends received deduction (see Chapter 17) and the domestic production activities deduction (see Chapter 7) are added back to taxable income to determine E & P. Neither of these deductions decreases the corporation’s assets. Instead, they are partial exclusions for specific types of income (dividend income and income from domestic production activ- ities). Because they do not impair the corporation’s ability to pay dividends, they do not reduce E & P.

Subtractions from Taxable Income When calculating E & P, it is also necessary to subtract certain nondeductible expenses from taxable income. These negative adjustments include the nondeduct- ible portion of meal and entertainment expenses; related-party losses; expenses incurred to produce tax-exempt income; Federal income taxes paid; nondeductible key employee life insurance premiums (net of increases in cash surrender value); and nondeductible fines, penalties, and lobbying expenses.

LO.2

Compute a corporation’s earnings and profits (E & P).

3Section 312 describes many of the adjustments to taxable income neces- sary to determine E & P. Regulation § 1.312–6 addresses the effect of accounting methods on E & P.

CHAPTER 19 Corporations: Distributions Not in Complete Liquidation 19-3Not For Sale

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E X A M P L E 3 A corporation sells property with a basis of $10,000 to its sole shareholder for $8,000. Because of § 267 (disallowance of losses on sales between related parties), the $2,000 loss cannot be deducted when calculating the corporation’s taxable income. However, because the overall economic effect of the transaction is a decrease in the corpora- tion’s assets by $2,000, the loss reduces the current E & P for the year of sale. n

E X A M P L E 4 A corporation pays a $10,000 premium on a key employee life insurance policy cover- ing the life of its president. As a result of the payment, the cash surrender value of the policy is increased by $7,000. Although none of the $10,000 premium is deductible for tax purposes, current E & P is reduced by $3,000 (i.e., amount of the premium payment net of the increase in the cash surrender value). The $7,000 increase in cash surrender value is not subtracted because it does not represent a decrease in the corporation’s ability to pay a dividend. Instead, it represents a shift in the corporation’s assets, from cash to life insurance. n

Timing Adjustments Some E & P adjustments shift the effect of a transaction from the year of its inclu- sion in or deduction from taxable income to the year in which it has an economic effect on the corporation. Charitable contributions, net operating losses, and capi- tal losses all necessitate this kind of adjustment.

E X A M P L E 5 During 2013, a corporation makes charitable contributions, $12,000 of which cannot be deducted when calculating the taxable income for the year because of the 10% tax- able income limitation. Consequently, the $12,000 is carried forward to 2014 and fully deducted in that year. The excess charitable contribution reduces the corporation’s current E & P for 2013 by $12,000 and increases its current E & P for 2014 (when the deduction is allowed) by the same amount. The increase in E & P in 2014 is necessary because the charitable contribution carryover reduces the taxable income for that year (the starting point for computing E & P) but already has been taken into account in determining the E & P for 2013. n

Gains and losses from property transactions generally affect the determination of E & P only to the extent they are 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. Accordingly, no timing adjustment is required for these items.

Accounting Method Adjustments In addition to the above adjustments, accounting methods used for determining E & P are generally more conservative than those allowed for calculating taxable income. For example, the installment method is not permitted for E & P purposes.4

Thus, an adjustment is required for the deferred gain from property sales made during the year under the installment method. All principal payments are treated as having been received in the year of sale.

E X A M P L E 6 In 2013, Cardinal Corporation, a cash basis calendar year taxpayer, sells unimproved real estate with a basis of $20,000 for $100,000. Under the terms of the sale, Cardinal will receive two annual payments of $50,000, beginning in 2014, each with interest of 9%. Cardinal Corporation does not elect out of the installment method. Because Cardi- nal’s taxable income for 2013 will not reflect any of the gain from the sale, the corpo- ration must make an $80,000 positive adjustment for 2013 (the deferred gain from the sale). Similarly, $40,000 negative adjustments will be required in 2014 and 2015 when the deferred gain is recognized under the installment method. n

4§ 312(n)(5).

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The alternative depreciation system (ADS) must be used for purposes of computing E & P.5 This method requires straight-line depreciation over a recovery period equal to the Asset Depreciation Range (ADR) midpoint life.6 Also, ADS prohibits additional first-year depreciation.7 If MACRS cost recovery is used for income tax purposes, a pos- itive or negative adjustment equal to the difference between MACRS and ADS must be made each year. Likewise, when assets are disposed of, an additional adjustment to taxable income is required to allow for the difference in gain or loss caused by the gap between income tax basis and the E & P basis.8 The adjustments arising from depre- ciation are illustrated in the following example.

E X A M P L E 7On January 2, 2011, White Corporation paid $30,000 to purchase equipment with an ADR midpoint life of 10 years and a MACRS class life of 7 years. The equipment was depreciated under MACRS. The asset was sold on July 2, 2013, for $27,000. For purposes of determining taxable income and E & P, cost recovery claimed on the equipment is summarized below. Assume that White elected not to claim § 179 expense or additional first-year depreciation on the property.

Year Cost Recovery Computation MACRS ADS Adjustment Amount

2011 $30,000 × 14.29% $ 4,287 $30,000 ÷ 10-year ADR recovery period

× ½ (half-year for first year of service) $1,500 $2,787 2012 $30,000 × 24.49% 7,347

$30,000 ÷ 10-year ADR recovery period 3,000 4,347 2013 $30,000 × 17.49% × ½ (half-year for

year of disposal) 2,624 $30,000 ÷ 10-year ADR recovery period

× ½ (half-year for year of disposal) 1,500 1,124 Total cost recovery $14,258 $6,000 $8,258

Each year, White Corporation will increase taxable income by the adjustment amount indicated previously to determine E & P. In addition, when computing E & P for 2013, White will reduce taxable income by $8,258 to account for the excess gain recognized for income tax purposes, as shown below.

Income Tax E & P

Amount realized $ 27,000 $ 27,000 Adjusted basis for income tax

($30,000 cost − $14,258 MACRS) (15,742) Adjusted basis for E & P ($30,000 cost − $6,000 ADS) (24,000) Gain on sale $ 11,258 $ 3,000

Adjustment amount ($3,000 − $11,258) ($ 8,258) n

In addition to more conservative depreciation methods, the E & P rules impose limitations on the deductibility of § 179 expense. In particular, this expense must be deducted over a period of five years.9 Thus, in any year that § 179 is elected, 80 percent of the resulting expense must be added back to taxable income to deter- mine current E & P. In each of the following four years, a subtraction from taxable income equal to 20 percent of the § 179 expense must be made.

The E & P rules also require specific accounting methods in various situations, mak- ing adjustments necessary when certain methods are used for income tax purposes.

5§ 312(k)(3)(A). 6See § 168(g)(2). The ADR midpoint lives for most assets are set out in Rev.Proc. 87–56, 1987–2 C.B. 674. The recovery period is 5 years for auto- mobiles and light-duty trucks and 40 years for real property. For assets with no class life, the recovery period is 12 years.

7§ 168(k)(2). This provision allowing additional first-year cost recovery applied to certain assets placed in service before January 1, 2005. In addi- tion, it is available for certain assets placed in service from 2008 through 2013.

8§ 312(f)(1). 9§ 312(k)(3)(B).

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For example, E & P requires cost depletion rather than percentage depletion.10 When accounting for long-term contracts, E & P rules specify the percentage of completion method rather than the completed contract method.11 As the E & P determination does not allow for the amortization of organizational expenses, any such expense deducted when computing taxable income must be added back to determine E & P.12

To account for income deferral under the LIFO inventory method, the E & P compu- tation requires an adjustment for changes in the LIFO recapture amount (the excess of FIFO over LIFO inventory value) during the year. Increases in LIFO recapture are added to taxable income, and decreases are subtracted.13 E & P rules also specify that intangible drilling costs and mine exploration and development costs be amortized over a period of 60 months and 120 months, respectively. For income tax purposes, however, these costs can be deducted in the current year.14

19-2b Summary of E & P Adjustments Recall that E & P serves as a measure of a corporation’s earnings that are available for distribution as taxable dividends to the shareholders. Current E & P is deter- mined by making a series of adjustments to the corporation’s taxable income that are outlined in Concept Summary 19.1. Other items that affect E & P, such as prop- erty dividends and stock redemptions, are covered later in the chapter.

19-2c Current versus Accumulated E & P Accumulated E & P is the total of all previous years’ current E & P (since February 28, 1913) reduced by distributions made from E & P in previous years. It is impor- tant to distinguish between current E & P and accumulated E & P because the taxabil- ity of corporate distributions depends upon how these two accounts are allocated to each distribution made during the year. A complex set of rules governs the allo- cation process.15 These rules are described in the following section and summar- ized in Concept Summary 19.2.

19-2d Allocating E & P to Distributions When a positive balance exists in both the current and accumulated E & P accounts, corporate distributions are deemed to be made first from current E & P and then from accumulated E & P. When distributions exceed the amount of current E & P, it becomes necessary to allocate current and accumulated E & P to each distribution made during the year. Current E & P is applied first on a pro rata basis (using dollar amounts) to each distribution. Then accumulated E & P is applied in chronological order, beginning with the earliest distribution. As shown in the following example, this allocation is important if any shareholder sells stock during the year.

E X A M P L E 8 On January 1 of the current year, Black Corporation has accumulated E & P of $10,000. Current E & P for the year amounts to $30,000. Megan and Matt are sole equal sharehold- ers of Black from January 1 to July 31. On August 1, Megan sells all of her stock to Helen. Black makes two distributions to the shareholders during the year: $40,000 to Megan and Matt ($20,000 each) on July 1 and $40,000 to Matt and Helen ($20,000 each) on December 1. Current and accumulated E & P are applied to the two distributions as follows:

Source of Distribution

Current E & P

Accumulated E & P

Return of Capital

July 1 distribution ($40,000) $15,000 $10,000 $15,000 December 1 distribution ($40,000) 15,000 –0– 25,000

10Reg. § 1.316–2(e). 11§ 312(n)(6). 12§ 312(n)(3).

13§ 312(n)(4). 14§ 312(n)(2). 15Regulations relating to the source of a distribution are at Reg. § 1.316–2.

LO.3

Determine taxable dividends paid during the year by correctly allocating current and accumulated E & P to corporate distributions.

19-6 PART 6 Corporations

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Because 50% of the total distributions are made on July 1 and December 1, respec- tively, one-half of current E & P is applied to each of the two distributions. Accumu- lated E & P is applied in chronological order, so the entire amount attaches to the July 1 distribution. The tax consequences to the shareholders are presented below.

Shareholder

Megan Matt Helen

July distribution ($40,000) Dividend income—

From current E & P ($15,000) $ 7,500 $ 7,500 $ –0– From accumulated E & P ($10,000) 5,000 5,000 –0–

Return of capital ($15,000) 7,500 7,500 –0–

CONCEPT SUMMARY 19.1

E & P Adjustments

Adjustment to Taxable Income to Determine

Current E & P

Nature of the Transaction Addition Subtraction

Tax-exempt income X Dividends received deduction X Domestic production activities deduction X Collection of proceeds from insurance policy on life of corporate officer (in excess of cash

surrender value) X Deferred gain on installment sale (all gain is added to E & P in year of sale) X Future recognition of installment sale gross profit X Excess charitable contribution (over 10% limitation) and excess capital loss in year incurred X Deduction of charitable contribution, NOL, or capital loss carryovers in succeeding taxable

years (increases E & P because deduction reduces taxable income while E & P was reduced in a prior year) X

Federal income taxes paid X Federal income tax refund X Loss on sale between related parties X Nondeductible fines, penalties, and lobbying expenses X Nondeductible meal and entertainment expenses X Payment of premiums on insurance policy on life of corporate officer (in excess of increase

in cash surrender value of policy) X Realized gain (not recognized) on an involuntary conversion No effect Realized gain or loss (not recognized) on a like-kind exchange No effect Excess percentage depletion (only cost depletion can reduce E & P) X Accelerated depreciation (E & P is reduced only by straight-line, units-of-production, or

machine hours depreciation) X X Additional first-year depreciation X Section 179 expense in year elected (80%) X Section 179 expense in four years following election (20% each year) X Increase (decrease) in LIFO recapture amount X X Intangible drilling costs deducted currently (reduce E & P in future years by amortizing

costs over 60 months) X Mine exploration and development costs (reduce E & P in future years by amortizing costs

over 120 months) X

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CHAPTER 19 Corporations: Distributions Not in Complete Liquidation 19-7Not For Sale

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Shareholder

Megan Matt Helen

December distribution ($40,000) Dividend income—

From current E & P ($15,000) $ –0– $ 7,500 $ 7,500 From accumulated E & P ($0) –0– –0– –0–

Return of capital ($25,000) –0– 12,500 12,500 Total dividend income $12,500 $20,000 $ 7,500

Nontaxable return of capital (assuming sufficient basis in the stock investment) $ 7,500 $20,000 $12,500

Because the balance in the accumulated E & P account is exhausted when it is applied to the July 1 distribution, Megan has more dividend income than Helen, even though both receive equal distributions during the year. In addition, each shareholder’s basis is reduced by the nontaxable return of capital; any excess over basis results in taxable gain. n

When the tax years of the corporation and its shareholders are not the same, it may be impossible to determine the amount of current E & P on a timely basis. For example, if shareholders use a calendar year and the corporation uses a fiscal year, then current E & P may not be ascertainable until after the shareholders’ returns have been filed. To address this timing issue, the allocation rules presume that current E & P is sufficient to cover every distribution made during the year until the parties can show otherwise.

E X A M P L E 9 Green Corporation uses a June 30 fiscal year for tax purposes. Carol, Green’s only shareholder, uses a calendar year. On July 1, 2013, Green Corporation has a zero bal- ance in its accumulated E & P account. For fiscal year 2013–2014, the corporation suf- fers a $5,000 deficit in current E & P. On August 1, 2013, Green distributes $10,000 to Carol. The distribution is dividend income to Carol and is reported when she files her income tax return for the 2013 calendar year on or before April 15, 2014. Because Carol cannot prove until June 30, 2014, that the corporation has a deficit for the 2013– 2014 fiscal year, she must assume that the $10,000 distribution is fully covered by cur- rent E & P. When Carol learns of the deficit, she can file an amended return for 2013 showing the $10,000 as a return of capital. n

Global Tax Issues

E & P in Controlled Foreign Corporations U.S. multinational companies often conduct business overseas using foreign subsidiaries known as “controlled foreign corporations,” or CFCs. This organizational structure would seem to be ideal for income tax avoidance if the CFC is incorporated in a low-tax jurisdiction (a tax haven country). In the absence of any rules to the contrary, the higher U.S. tax on foreign earnings could be deferred until the earnings are repatriated to the United States through dividends paid to the U.S. parent.

To prevent this deferral, the tax law compels a U.S. parent corporation to recognize some of the unrepatriated earnings of the CFC as income. The foreign corporation’s E & P is used to determine the amount of income that is recognized annually by the U.S. parent corporation. Determining the CFC’s E & P is no easy task. Foreign corporations (including CFCs) typically compute their book income using foreign generally accepted accounting principles (GAAP). Because the starting point for computing E & P for foreign corporations is U.S. GAAP book income rather than taxable income, an extra layer of complexity is introduced. First, the foreign company’s book income must be converted to a U.S. GAAP basis, and then a series of adjustments (similar to the adjustments reflected in Concept Summary 19.1) is made to U.S. book income to determine E & P.

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19-8 PART 6 Corporations

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Additional difficulties arise when either the current or the accumulated E & P account has a deficit balance. In particular, when current E & P is positive and accumulated E & P has a deficit balance, accumulated E & P is not netted against current E & P. Instead, the distribution is deemed to be a taxable dividend to the extent of the positive current E & P balance.

THE BIG PICTURE E X A M P L E 1 0

Return to the facts of The Big Picture on p. 19-1. Recall that Lime Corporation had a deficit in GAAP-based retained earnings at the start of the year and banner profits during the year. Assume that these financial results translate into an $800,000 defi- cit in accumulated E & P at the start of the year and current E & P of $600,000. In addition, for purposes of this example, assume that there is no mortgage on the real estate. In this case, current E & P would exceed the total cash and property dis- tributed 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.

In contrast to the previous rule, when a deficit exists in current E & P and a posi- tive balance exists in accumulated E & P, the accounts are netted at the date of dis- tribution. If the resulting balance is zero or negative, the distribution is a return of capital. If a positive balance results, the distribution is a dividend to the extent of the balance. Any loss in current E & P is deemed to accrue ratably throughout the year unless the parties can show otherwise.

E X A M P L E 1 1At the beginning of the current year, Gray Corporation (a calendar year taxpayer) has accumulated E & P of $10,000. During the year, the corporation incurs a $15,000 deficit in current E & P that accrues ratably. On July 1, Gray distributes $6,000 in cash to Hal, its sole shareholder. To determine how much of the $6,000 cash distribution represents dividend income to Hal, the balances of both accumulated and current E & P as of July 1 are determined and netted. This is necessary because of the deficit in current E & P.

Source of Distribution

Current E & P Accumulated E & P

January 1 $10,000 July 1 (½ of $15,000 current E & P deficit) ($7,500) 2,500 July 1 distribution of $6,000:

Dividend income: $2,500 Return of capital: $3,500

CONCEPT SUMMARY 19.2

Allocating E & P to Distributions

1. Current E & P is applied first to distributions on a pro rata basis; then accumulated E & P is applied (as neces- sary) in chronological order beginning with the earliest distribution. See Example 8.

2. Until the parties can show otherwise, it is presumed that current E & P covers all distributions. See Example 9.

3. When a deficit exists in accumulated E & P and a posi- tive balance exists in current E & P, distributions are regarded as dividends to the extent of current E & P. See Example 10.

4. When a deficit exists in current E & P and a positive balance exists in accumulated E & P, the two accounts are netted at the date of distribution. If the resulting balance is zero or negative, the distribution is treated as a return of capital, first reducing the basis of the stock to zero, then generating taxable gain. If a positive balance results, the distribution is a dividend to the extent of the balance. Any current E & P deficit is deemed to accrue ratably throughout the year unless the corporation can show otherwise. See Example 11.

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CHAPTER 19 Corporations: Distributions Not in Complete Liquidation 19-9Not For Sale

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The balance in E & P just before the July 1 distribution is $2,500. Thus, of the $6,000 distribution, $2,500 is taxed as a dividend, and $3,500 represents a return of capital. n

19-3 DIVIDENDS As noted earlier, distributions by a corporation from its E & P are treated as divi- dends. The tax treatment of dividends varies, depending on whether the share- holder receiving them is a corporation or another kind of taxpaying entity. All corporations treat dividends as ordinary income and are permitted a dividends received deduction (see Chapter 17). In contrast, individuals apply reduced tax rates on qualified dividend income while nonqualified dividends are taxed as ordi- nary income.

19-3a Rationale for Reduced Tax Rates on Dividends The double tax on corporate income has always been controversial. Arguably, tax- ing dividends twice creates several undesirable economic distortions, including:

• An incentive to invest in noncorporate rather than corporate entities. • An incentive for corporations to finance operations with debt rather than

with equity because interest payments are deductible. Notably, this behavior increases the vulnerability of corporations in economic downturns because of higher leverage.

• An incentive for corporations to retain earnings and structure distributions of profits to avoid the double tax.

Collectively, these distortions raise the cost of capital for corporate investments. Estimates are that eliminating the double tax would increase capital stock in the corporate sector by as much as $500 billion.16 In addition, some argue that elimina- tion of the double tax would make the United States more competitive globally. Bear in mind that a majority of our trading partners assess only one tax on corpo- rate income.

While many support a reduced or no tax rate on dividends, others contend that the double tax should remain in place because of the concentration of economic

ETHICS & EQUITY Shifting E & P

Ten years ago, Spencer began a new business venture with Robert.

Spencer owns 70 percent of the outstanding stock, and Robert owns 30 percent. The business has had some difficult times, but current prospects are favorable.

On November 15, Robert decides to quit the venture and plans to sell all of his stock to Spencer’s sister, Heidi, a longtime employee of the business. Robert will sell his stock to Heidi after the company pays out the current-year shareholder distribution of about $100,000. Spencer is looking forward to working with his sister, but he now faces a terrible dilemma.

The corporation has a $300,000 deficit in accumulated E & P and only about $20,000 of current E & P to date.

Within the next two months, however, Spencer expects to sign a major deal with a large client. If Spencer signs the contract before the end of the year, the corporation will have a large increase in current E & P, causing the upcoming distribution to be fully taxable to Robert as a dividend.

As a similar contract is not expected next year, most of next year’s distribution will be treated as a tax-free return of capital for Heidi. Alternatively, if Spencer waits until January, both he and Robert will receive a nontaxable distribution this year. However, next year’s annual distribution will be fully taxable to his sister as a dividend. What should Spencer do?

LO.4

Describe the tax treatment of dividends for individual shareholders.

16Integration of Individual and Corporate Tax Systems, Report of the Department of the Treasury (January 1992).

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19-10 PART 6 Corporations

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power held by publicly traded corporations. Furthermore, many of the distortions noted previously can be avoided through the use of deductible payments by C cor- porations and by utilizing other forms of doing business (e.g., partnerships, limited liability companies, and S corporations). Those favoring retention of the double tax also note that the benefits of reduced tax rates on dividends flow disproportion- ately to the wealthy.17

The United States continues to struggle to find the appropriate course to follow on the taxation of dividends. The reduced tax rate on qualified dividends for indi- viduals reflects a compromise between the complete elimination of tax on divi- dends and the treatment of dividends as ordinary income.

19-3b Qualified Dividends Qualified Dividends—Application and Effect Under current law, dividends that meet certain requirements are subject to a 15 percent tax rate for most individual taxpayers (a 20 percent rate applies to tax- payers in the 39.6 percent tax bracket). Dividends received by individuals in the 10 or 15 percent rate brackets are exempt from tax.18

Qualified Dividends—Requirements To be taxed at the lower rates, dividends must be paid by either domestic or certain qualified foreign corporations. Qualified foreign corporations include those traded on a U.S. stock exchange or any corporation located in a country that (1) has a comprehensive income tax treaty with the United States, (2) has an information-sharing agreement with the United States, and (3) is approved by the Treasury.19

Two other requirements must be met for dividends to qualify for the favorable rates. First, dividends paid to shareholders who hold both long and short positions in the stock do not qualify. Second, the stock on which the dividend is paid must be held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.20 To allow for settlement delays, the ex-dividend date is typically two days before the date of record on a dividend. This holding period rule parallels the rule applied to corporations that claim the dividends received deduction.21

Global Tax Issues

Corporate Integration From an international perspective, the double taxation of dividends is unusual. Most countries have adopted a policy of corporate integration, which imposes a single tax on corporate profits. Corporate integration takes several forms. One popular approach is to impose a tax at the corporate level, but allow shareholders to claim a credit for corporate-level taxes paid when dividends are received. A second alternative is to allow a corporate-level deduction for dividends paid to shareholders. A third approach is to allow shareholders to exclude corporate dividends from income. A fourth alternative suggested in the past by the U.S. Treasury is the “comprehensive business income tax,” which excludes both dividend and interest income while disallowing deductions for interest expense.

17The Urban Institute–Brookings Institution Tax Policy Center estimates that more than one-half—53%—of the benefits from the reduced tax rate on dividends go to the .2% of households with incomes over $1 million.

18See §§ 1(h)(1) and (11). 19In Notice 2006–101, 2006–2 C.B. 930, the Treasury identified 55 qualify- ing countries (among those included on the list are the members of the

European Union, the Russian Federation, Canada, and Mexico). Non- qualifying countries not on the list include most of the former Soviet republics (except Kazakhstan), Bermuda, and the Netherlands Antilles.

20§ 1(h)(11)(B)(iii)(I). 21See § 246(c) and the relevant discussion in Chapter 17.

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