Chapter 18 Notes
Nonliquidating Distributions
Distributions in form of:
- Cash
- Property or
- Stock
Distributions are taxed in one of the following ways:
- Taxed as income
- Return of capital
- Capital gains
Taxable distributions from corporations = double taxation.
Deductible distributions:
- reasonable salary
- reasonable interest payments
- reasonable rent
Unreasonable payments are taxed as Constructive dividends.
Constructive Dividends
- result in double taxation
- Recharacterizing by the IRS can
Common examples of constructive dividends include:
Unreasonable compensation.
Bargain sales to shareholders.
Shareholder use of corporate assets without an arm’s-length payment.
Loans from shareholders at excessive interest rates.
Corporate payments made on behalf of the shareholder.
DRB ch 18 notes
Page 1
Computing Earnings And Profits And Determining The Dividend Amount
Received By A Shareholder
When a corporation distributes property to shareholders, tax consequences
are as follows:
 The property dividend is included in gross income.
 The property dividend reduces the shareholder’s tax basis that is, it is
a nontaxable return of capital
 The distribution that is not a dividend or is in excess of the
shareholder’s stock tax basis is treated as gain from sale or exchange
of the stock (capital gain).
Definition of a Dividend
The tax law defines a dividend as any distribution of property made by a
corporation to its shareholders out of its earnings and profits (E&P) account.
The IRC requires a corporation to keep two separate E&P accounts
 The current year (current earnings and profits)
 Undistributed earnings and profits accumulated in all prior years
(accumulated earnings and profits).
Pecking order for distributions: first distributions paid out of current E&P,
excess deemed paid from accumulated E&P.
Current E&P not distributed added to accumulated E&P at the beginning of
the next year.
A corporation that pays a distribution in excess of its total E&P must
report the distribution on Form 5452 and include a calculation of its
E&P balance to support the tax treatment.
DRB ch 18 notes
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Computing Earnings and Profits (corporation economic earnings) (see exhibit
18-1)
Earnings and profits include taxable and nontaxable income
Separate accounting system to be maintained.
The corporation begins its computation of E&P with taxable income or loss.
It then makes adjustments:
1) Inclusion of income that is excluded from taxable income
(a) “all income exempted by statute” must be added back to taxable
income in computing E&P.
(b) Common examples of tax-exempt income included in E&P are taxexempt interest and tax-exempt life insurance proceeds.
(c) Exempt income not included in E&P includes gifts and bequests
and contributions to capital.
2) Disallowance of certain expenses:
(a) Examples – Dividends received deduction, net capital loss
carryovers from a different tax year, net operating loss carryovers
from a different tax year, and charitable contribution carryovers
from a prior tax year.
3) Deduction of certain expenses that are excluded from the
computation of taxable income but do require an economic
outflow.
(a) A corporation reduces its E&P for certain items that are not
deductible in computing its taxable income but requires a cash
outflow.
(b) Examples of such expenses are
- Federal income taxes paid or accrued
- Expenses incurred in earning tax-exempt income
- Current year charitable contributions in excess of 10 percent
of taxable income (there is no 10 percent limitation for E&P
purposes).
- Premiums on life insurance contracts in excess of the increase
in the policy’s cash surrender value.
- Current year net capital loss (there is no limit on capital
losses).
- Meals and entertainment expenses disallowed (generally 50
percent of the total).
- Nondeductible lobbying expenses and political contributions.
- Penalties and fines.
DRB ch 18 notes
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DRB ch 18 notes
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Ordering of E&P Distributions (There are four possible scenarios)
Positive current E&P, positive accumulated E&P
Current E&P first.
If distributions exceed current E&P, the amount distributed out
of current E&P is allocated pro rata to all of the distributions
made during the year.
Positive current E&P, negative accumulated E&P
Current E&P are taxable as dividends.
Distributions in excess of current E&P would first be treated as
nontaxable reductions in the shareholders’ tax basis in their
stock.
Any excess received over their stock basis would be treated as a
(capital) gain from sale of the stock.
Example:
Current E&P = $1,000,000
Accumulated E&P = ($500,000)
The corporation distributes $1,000,000 on July 1.
The entire distribution is deemed to come from current
E&P and is a dividend to the shareholders.
Negative current E&P, positive accumulated E&P
(a) When current E&P is negative, the tax status of a dividend is
determined by total E&P on the date of the distribution.
(b) The corporation prorates the negative current E&P to the
distribution date and add it to accumulated E&P at the beginning
of the year to determine total E&P at the distribution date.
(c) Distributions in excess of total E&P are treated as reductions in the
shareholders’ tax basis in their stock. Any excess over their stock
basis would be treated as a capital gain.
Example:
Current E&P = ($1,000,000)
Accumulated E&P = $1,000,000
The corporation distributes $1,000,000 on July 1.
Current E&P is apportioned on a per day basis
AE&P as of July 1 = $1M − ½($1M) = $500,000
Thus $500,000 is a treated as a dividend.
DRB ch 18 notes
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Negative current E&P, negative accumulated E&P
(a) None of the distribution is treated as a dividend.
(b) Distributions treated as reductions in the shareholders’ tax basis in
their stock.
(c) Any excess over their stock basis would be treated as a capital
gain.
Distributions of Noncash Property to Shareholders
As a general rule, a shareholder’s tax basis in noncash property received as a
dividend equals the property’s fair market value.
DRB ch 18 notes
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The Tax Consequences to a Corporation Paying Noncash Property as a
Dividend
Only taxable gains (but not losses) are recognized by a corporation on the
distribution of noncash property as a dividend.
If the fair market value of property distributed as a dividend exceeds the
corporation’s tax basis in the property; the corporation recognizes a
taxable gain on the distribution which increases current E&P
If the fair market value of the property distributed is less than the
corporation’s tax basis in the property, the corporation does not recognize
a deductible loss on the distribution.
E&P is reduced by the distributed property’s fair market value if the
property is appreciated (gain is recognized) and by the property’s E&P
basis if the property is depreciated (loss is not recognized).
Example :
Cher 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.
Sunny Corporation reports a gain of $100 on the distribution ($200 −
$100).
Example:
Cher 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.
Sunny Corporation reports a gain of $200 on the distribution ($300 −
$100).
The property’s FMV is deemed to be the amount of the liability assumed
because it exceeds the property’s fair market value.
Liabilities
If the property’s FMV < Liab assumed, the property’s fair market value is
deemed to be the amount of the liability assumed by the shareholder.
If the Liab < FMV, the gain recognized on the distribution is the excess
of the property’s fair market value over its tax basis (that is, the liability
is ignored).
DRB ch 18 notes
Page 7
Stock Dividend
- A stock dividend increases the number of shares outstanding
- Stock dividends can also take the form of a stock split (e.g., 2-for-1, 3 for 2,
ect. stock split)
- Stock dividends are nontaxable to shareholders if two conditions are met:
- Made with respect to common stock and
- Pro rata (proportionate equity position is maintained)
- Non-pro rata usually taxable
The recipient of a nontaxable stock dividend allocates a portion of the tax basis
from the stock on which the stock dividend was issued to the newly issued stock.
The holding period of the new stock = holding period for which the shareholder
held the old stock.
DRB ch 18 notes
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Stock Redemptions
The Form of a Stock Redemption
The tax law defines redemption as acquisition by a corporation of its stock
from a shareholder in exchange for property
Form of an exchange: the shareholders exchange their stock in the
corporation for property, usually cash.
Gain or Loss is computed by comparing the amount realized with tax basis
in the stock exchanged
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
Redemptions That Contract the Shareholder’s Stock Ownership Interest
The IRC allows a shareholder to treat redemption as an exchange if the
transaction meets one of three change-in-stock-ownership tests.
Redemptions That Are Substantially Disproportionate with Respect to the
Shareholder
1) If the redemption is “substantially disproportionate with respect to the
shareholder”
2) A shareholder meets this requirement by satisfying three mechanical
(“bright line”) stock ownership tests
(a) Immediately after the exchange, the shareholder owns less than 50
percent of the total combined voting power of all classes of stock
entitled to vote.
(b) The shareholder’s percentage ownership of voting stock after the
redemption is less than 80 percent of his or her percentage
ownership before the redemption.
(c) The shareholder’s percentage ownership of the aggregate fair
market value of the corporation’s common stock (voting and
nonvoting) after the redemption is less than 80 percent of his or her
percentage ownership before the redemption.
DRB ch 18 notes
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Example:
Tom owns 60 of the corporation’s 100 shares of voting common stock.
1. What percentage ownership test(s) must be met for the Tom to receive
exchange treatment?
2. How many shares of stock must the corporation redeem to have Tom treat
the redemption as an exchange?
Two tests must be met:
First: after the redemption Tom must own less than 50% of the outstanding
shares.
Second: Tom’s percentage ownership after the redemption must be less than
80 percent of his percentage ownership before the redemption.
In this case, Tom ’s 60 percent ownership must drop to less than 48%
(80% × 60% = 48%).
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
The redeemed shareholder may be related if they owns more than
50% of the stock’s value
Note that ownership is determined using the §267(c) attribution
rules
Tax Consequences to the Distributing Corporation
Recognizes gain on distributions of appreciated property
noloss on distribution of property with a fair market value less than its
tax basis.
If the shareholder treats the redemption as a dividend, the corporation
reduces its E&P by the cash distributed and the fair market value of other
property distributed.
If the shareholder treats the redemption as an exchange, the corporation
reduces E&P at the date of distribution by the percentage of stock
redeemed (that is, if 50 percent of the stock is redeemed, E&P is reduced
by 50 percent), not to exceed the fair market value of the property
distributed.
DRB ch 18 notes
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The distributing corporation reduces its E&P by any dividend
distributions made during the year before reducing its E&P for
redemptions treated as exchanges.
Example:
Acme Inc. has AE&P at 1/1/15 of $100,000 and CE&P for 2015 is $75,000. Acme
redeems all of Bill’s stock on July 1 for $60,000. The stock redeemed represents
25% of Acme stock. On December 31, Acme pays its remaining shareholders
dividends of $25,000. Bill treats the redemption as an exchange.
What is the effect on Acme’s AE&P and CE&P?
1. CE&P after the dividends is $50,000 ($75,000 − $25,000)
2. AE&P at 7/01/14 is $100,000 + ½($50,000) = $125,000
3. Acme reduces AE&P to the lesser of:
25% × $125,000 = $31,250 or
$60,000 (fair value of the distribution)
Trends in Stock Redemptions by Publicly Traded Corporations
1) Publicly traded corporations viewed stock redemptions as a tax
efficient means to return cash to their shareholders.
2) Redemptions allow shareholders to “declare their own dividends” by
voluntarily selling shares back to the corporation.
3) Individuals have a tax incentive to participate in redemption because
gain recognized as a result of the redemption usually is capital gain.
4) Losses produced by the buyback generally can be deducted against
capital gains.
Partial Liquidations
Noncorporate shareholders receive exchange treatment.
Corporate shareholders determine their tax consequences using the change-instock ownership rules that apply to stock redemptions.
DRB ch 18 notes
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