Corporate Distributions PDF

1 STUDY UNIT FIFTEEN CORPORATE DISTRIBUTIONS 15.1 Earnings and Profits.................................................... 1 15.2 Shareholder Treatment of Distributions........................

1 STUDY UNIT FIFTEEN CORPORATE DISTRIBUTIONS 15.1 Earnings and Profits.................................................... 1 15.2 Shareholder Treatment of Distributions...................................... 8 15.3 Stock Distributions..................................................... 11 A distribution is any transfer of property by a corporation to any of its shareholders with respect to the shareholder’s shares in the corporation. Property is defined as 1) Money; 2) Bonds or other obligations (also of the distributing corporation); 3) Stock in other corporations (not issued by the distributor); and 4) Other property, including receivables. The amount of a distribution is calculated as follows: Money + Obligations (FMV), e.g., a bond + Property (FMV), other – Related liabilities, recourse or not = Distribution amount 15.1 EARNINGS AND PROFITS Significance 1. The amount of a distribution is treated as a dividend to the extent of the corporation’s earnings and profits (E&P). a. Distributions are presumed to come from the corporation’s E&P, unless there are no E&P. b. An E&P account provides an approximate measure of a corporation’s ability to pay a dividend (in the generic sense) to its shareholders. c. A corporate shareholder may prefer dividend treatment for a distribution it receives because of the availability of a dividends-received deduction. 1) Between 50% and 100% of the dividend amount may represent a current deduction. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com. 2 SU 15: Corporate Distributions d. An individual shareholder may benefit from nondividend treatment for a portion of a distribution (Form 5452, sample below). 1) Portions treated as recovery of capital are not subject to federal income taxes. 2) Portions treated as LTCG can offset capital losses and may be taxed at a lower maximum rate of 0%, 15%, or 20%, depending on the taxpayer’s total taxable income. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.  SU 15: Corporate Distributions 3 Computing E&P: The Formula 2. The IRC does not provide a mechanical definition of E&P. Section 312 and regulations provide rules that indicate how certain transactions or events are reported. a. Taxable income (TI). TI is the starting point for computing E&P. b. Adjustments. TI is adjusted up and down to compute the approximate dividend-paying ability of the corporation. Adjustment items may be categorized as follows: Adjustment Category Adjustment to Compute E&P 1) Income excluded from TI Add to TI 2) Expenses and losses that are nondeductible for TI Subtract from TI 3) Deferred income recognition items Add to or subtract from TI 4) Accelerated deduction items Add to or subtract from TI 5) Deductions not allowed for E&P Add to TI Income Excluded from TI 3. TI is adjusted upward for (most) items of economic income not included as gross income when computing TI. a. Add economic income that is 1) Not a contribution to capital but 2) Increases dividend-paying capacity. b. Add the following: 1) Refunds of prior years’ federal income tax 2) Recoveries of deduction items that produced no tax benefit (e.g., bad debts, casualty losses) 3) Tax-exempt interest income 4) The excludable portion of life insurance proceeds paid to the corporation Nondeductible Expenses and Losses 4. TI is adjusted downward for expenditures and losses to the extent they are not allowed as a deduction from gross income (GI) in computing TI. a. Subtract the following from TI: 1) Charitable contributions (excess over 10% of TI) 2) Capital losses (current year’s carried over) 3) Disallowed losses (e.g., sale to related party) 4) Federal income taxes 5) Penalties and fines 6) Political contributions 7) Expenses relating to tax-exempt income 8) The excludable portion of life insurance premiums (with corporation as beneficiary) b. Timing. The adjustment for corporations using the cash method of accounting is made when the item is paid. 1) A corporation using the accrual method of accounting generally reports the adjustment when it is accrued. c. Capacity. Each corporate item, including those previously listed, must be considered for its effect on dividend-paying capacity and on TI. 1) For example, life insurance premiums on policies in which the corporation is the beneficiary are subtracted net of the cash surrender value increase. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com. 4 SU 15: Corporate Distributions Deferred Recognition Items 5. Most income for which an exception defers recognition when determining TI is not included in E&P until recognized. a. Exceptions 1) Add to TI any unrecognized realized income/gain on an installment sale. EXAMPLE 15-1 Installment Sale Delaware Corp. engages in an installment sale of land that it has held as a potential plant site. Delaware is to receive 60% of the sales proceeds in the following tax year. Delaware’s realized gain on the sale is $1 million. Taxable income does not include realized gain not recognized, or $600,000 ($1,000,000 × 0.60). E&P include the gain that is currently recognized as well as the $600,000 deferred gain. 2) Recalculate income reported on a long-term contract reported using the completed- contract method as if the percentage-of-completion method were used. Accelerated Deduction Items 6. TI is adjusted to the extent deductions reduce TI in excess of economic costs due to premature recognition of anticipated economic decline. a. Adjust TI upward or downward for the difference between 1) Section 179 expense deducted and the amount deducted as if the cost is expensed ratably over 5 years 2) Realty depreciation deducted using the MACRS rules and depreciation computed over 39 years 3) ACRS deductions and straight-line ACRS deductions with extended recovery periods 4) MACRS deductions and the alternative depreciation system (ADS) deductions a) ADS applies straight-line depreciation over the property’s class life using a half-year convention. 5) Percentage depletion deductions claimed and cost depletion amounts 6) Intangible drilling costs (IDC) deducted and the IDC amounts amortized over 60 months Deductions Not Allowed for E&P 7. TI is adjusted upward for items that are currently deductible from GI in computing TI but do not currently reduce capacity to pay dividends. These items may have already reduced E&P in a prior tax year or may never reduce E&P. a. Add to TI any amounts deducted for 1) Charitable contribution carryovers 2) Net operating loss carryovers 3) Capital loss carryovers 4) Dividends-received deductions Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.  SU 15: Corporate Distributions 5 Distributions 8. A distribution by the corporation to one or more shareholders may trigger both upward and then downward adjustments to E&P (which may affect tax treatment of distributions to the distributee and other shareholders). a. Although distributions can occur at any time during the tax year, current E&P are determined at the end of the tax year. 1) Once current E&P are determined, the tax consequences of each distribution can be determined. b. When a corporation distributes property that has appreciated in value, the corporation must recognize a gain as if the corporation had sold its property for its FMV. 1) However, a corporation does not recognize any loss when it makes a distribution of property even if the sale would have resulted in a loss. 2) Gain recognized by the corporation on the distribution of appreciated property is included in TI. 3) Before distributions of appreciated property (other than the corporation’s obligations), earnings and profits must be increased by the excess of the FMV over the adjusted basis (AB) of the appreciated property. 4) If a liability attached to a distributed asset exceeds the FMV of the asset, the selling price is equal to the amount of the liability. 5) When noncash property is distributed, the gain included in TI may be different from the gain that is reported for E&P purposes. 6) When depreciable property is distributed, the gain reported for TI purposes is calculated using the property’s AB after reduction for MACRS depreciation. a) The AB used when calculating the E&P gain is reduced for the slower ADS depreciation. b) This difference reduces the gain (increases the loss) reported for E&P purposes. c) If liabilities exceed basis, FMV is treated as not less than the liabilities assumed by the shareholder. c. E&P are reduced by the property’s basis in the case of distributed property that is not appreciated property. d. Only after determining shareholder tax treatment for the tax year, reduce current E&P by the amounts constituting distributions from the corporation during the year, but not below zero. The amount of the E&P reduction is 1) Amount of money 2) Principal amounts of the corporation’s own obligations a) When a bond is issued with original issue discount (OID), use the issue price 3) FMV of appreciated property a) Less any liability assumed or acquired by the shareholder 4) AB of other property a) Less any liability assumed or acquired by the shareholder e. A distribution cannot produce a deficit in (i.e., reduce below zero) current E&P. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com. 6 SU 15: Corporate Distributions f. For corporate distributions from E&P, there are four scenarios: 1) When both current and accumulated E&P (AE&P) are positive, the corporation is required to allocate the current portion of E&P to all of the distributions and then apply AE&P in chronological order. 2) If both are negative E&P, all distributions (to the extent of basis) are a return of basis. Any distributions in excess of basis are treated as capital gains on the stock to the investor. 3) If current E&P are positive and AE&P are negative, the corporation does not net the two. Instead, all distributions to the extent of the current E&P are dividends, and the remainder are returns of basis. 4) If current E&P are negative and AE&P are positive, the corporation prorates negative E&P up to the point of each distribution, nets it with AE&P, and all distributions to the extent of the positive E&P netted amount are considered dividends, with the remainder being returns of basis. g. For each of the four scenarios above, once E&P are exhausted, the remainder of distributions are returns of basis to the extent of shareholder basis. Once shareholder basis is exhausted, the remainder of distributions are treated as if the underlying stock had been sold, and capital gain treatment is applied. 9. When a corporation has a loss in the current year, the loss is prorated over the year to determine the AE&P at the time of a distribution. EXAMPLE 15-2 Distributions A corporation has AE&P of $100,000 at the beginning of the year and a loss for the current year of $80,000. The corporation makes a distribution of $90,000 on April 1. Only $80,000 is considered a dividend because there are only $80,000 of AE&P at the time of the distribution [$100,000 – ($80,000 × 1/4)]. The $80,000 loss is prorated over the year. In addition, AE&P on December 31 is now $(60,000) ($0 basis of current E&P after April distribution – $60,000 April-December negative E&P). Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.  SU 15: Corporate Distributions 7 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com. 8 SU 15: Corporate Distributions 15.2 SHAREHOLDER TREATMENT OF DISTRIBUTIONS A distribution to a shareholder is equal to the FMV of the property distributed. This amount must be decreased by any liabilities that are assumed by the shareholder or to which the property is subject. Dividend 1. The amount of a distribution is first a dividend to the extent of any current earnings and profits (E&P) and then to the extent of any accumulated E&P (AE&P). a. When distributions during the year exceed current E&P, pro rata portions of each distribution are deemed to be from current E&P. 1) If the current E&P balance is positive, the positive balance is computed as of the close of the taxable year, without regard to the amount of E&P at the time of the distribution. 2) If the current E&P balance is negative, the negative balance is prorated to the date of each distribution made during the year. b. Treatment of a distribution is determined by reference to AE&P only after any current E&P have been accounted for. 1) AE&P constitute the remaining balance of E&P from prior tax years. 2) A deficit in AE&P never results from a distribution. It results from any aggregate excess of current E&P deficits over unused positive AE&P. a) A deficit in AE&P does not offset current E&P. 3) Current E&P are added to AE&P after determining treatment of distributions. c. When distributions exceed both current E&P and AE&P, allocate AE&P to distributions in their chronological order. Constructive Dividend d. Constructive dividends are tangible benefits to shareholders other than declared dividends and are included as income to the shareholder. 1) The corporate deduction taken for such expenses should be reversed, thereby increasing corporate E&P. 2) The following are examples: a) Excessively high salaries b) Forgiveness of shareholder debt c) Personal use of corporate equipment d) Excessive lease or purchase payment to shareholder e) Transfer of property to shareholder for less than FMV Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.  SU 15: Corporate Distributions 9 e. A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate. 1) A below-market loan generally is treated as an arm’s-length transaction in which the borrower is considered as having received both of the following: a) A loan in exchange for a note that requires payment of interest at the applicable federal rate and b) An additional payment in an amount equal to the forgone interest. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com. 10 SU 15: Corporate Distributions 2) If the shareholder receives a below-market term loan other than a gift or demand loan, the shareholder is treated as receiving an additional cash payment (as a dividend, etc.) on the date the loan is made. a) This payment is equal to the loan amount minus the present value, at the applicable federal rate, of all payments due under the loan. f. A constructive distribution will be treated as a dividend for tax purposes if sufficient E&P are available. g. If the corporation makes any payment that may be a dividend but is unable to confirm whether such payment is a dividend by the time the Form 1099-DIV must be filed, the entire amount of the payment must be reported as a dividend or as an amount paid with respect to a dividend. Capital Recovery 2. A shareholder treats the amount of a distribution in excess of dividends as tax-exempt return of capital to the extent of his or her basis in the stock. a. Basis in the stock is reduced (but not below zero). b. Apportion the distribution among the shares if they have different bases. EXAMPLE 15-3 Capital Recovery Corporation distributes $90,000 when E&P are $60,000. Shareholder N receives $30,000 of the distribution, of which $20,000 is a dividend (2/3). # of Shares Basis Dividend Capital Recovery Gain Block 1 1,000 $ 3,000 $10,000 $3,000 $2,000 Block 2 1,000 15,000 10,000 5,000 0 Gain on Sale 3. Any excess of the amount of a distribution over E&P and basis is treated as gain on the sale of the stock (e.g., the $2,000 in Example 15-3). a. Character depends on the nature of the stock in the hands of the shareholder as a capital asset or dealer property. b. Loss may be recognized only if the stock becomes worthless or is redeemed. Basis in Distributed Property 4. The shareholder’s basis in property received in a nonliquidating distribution is generally its FMV at the time of the distribution. a. Obligations of the distributing corporations have a basis equal to their FMV. b. If liabilities assumed or liabilities of property taken are 1) Less than FMV, then basis in the property is its FMV. 2) Greater than FMV, then the basis should equal the liability if the distributee shareholder assumes personal liability. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.  SU 15: Corporate Distributions 11 15.3 STOCK DISTRIBUTIONS A corporation recognizes no gain or loss on distribution of its own stock. 1. A proportionate distribution of stock issued by the corporation to the shareholders is generally not gross income to the shareholders. a. Generally, a shareholder does not include a distribution of stock or rights to acquire stock in gross income unless it is a 1) Distribution in lieu of money; 2) Disproportionate distribution; 3) Distribution on preferred stock; 4) Distribution of convertible preferred stock; or 5) Distribution of common and preferred stock, resulting in receipt of preferred stock by some shareholders and common stock by other shareholders. b. A shareholder allocates the aggregate adjusted basis (AB) in the old stock to the old and new stock in proportion to the FMV of the old and new stock. 1) Basis is apportioned by relative FMV to different classes of stock if applicable. c. The holding period of the distributed stock includes that of the old stock. d. Earnings and profits (E&P) are not altered for a tax-free stock dividend. Stock Rights 2. Treat a distribution of stock rights as a distribution of the stock. a. Basis is allocated based on the FMV of the rights. 1) Basis in the stock rights is zero if their aggregate FMV is less than 15% of the FMV of the stock on which they were distributed, unless the shareholder elects to allocate. b. Basis in the stock, if the right is exercised, is any basis allocated to the right, plus the exercise price. c. The holding period of the stock begins on the exercise date. d. No deduction is allowed for basis allocated to stock rights that lapse. 1) Basis otherwise allocated remains in the underlying stock. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com. 12 SU 15: Corporate Distributions 3. Taxable Stock Distribution a. The amount of a distribution subject to tax is the FMV of distributed stock or stock rights. Distributions of stock are subject to tax when 1) Any shareholder has an option to choose between a distribution of stock or a distribution of other property. a) The amount of the distribution is the greater of i) The FMV of stock or ii) The cash and FMV of other property. 2) Some shareholders receive property, and other shareholders receive an increase in their proportionate interests. a) Such a distribution of stock is treated as if it were a distribution of property. 3) Some common shareholders receive common stock, but others receive preferred. 4) Distribution is on preferred stock. a) Limited change in conversion ratios, by itself, does not trigger taxability. 5) Convertible preferred stock is distributed, and the effect is to change the shareholder’s proportionate stock ownership. 6) Constructive stock distributions change proportionate interests resulting from a transaction, such as a change in conversion ratio or redemption price. b. E&P are reduced by the FMV of stock and stock rights distributed. c. Basis in the underlying stock does not change. Basis in the new stock or stock rights is their FMV. d. The holding period for the new stock begins on the day after the distribution date. e. If a distribution of a stock dividend or stock right is taxable when received, the basis is the fair market value on the date of acquisition. 1) When the dividend is taxable, there is no tacking of the holding period for the underlying stock. a) The holding period begins the day following the acquisition date. Stock Split 4. A stock split is not a distribution. a. Basis in the old stock is also “split” and allocated to the new stock. b. The holding period of the new stock includes that of the old stock. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.