Betekintés: Corporations, Earnings and Profits and Dividend Distribution

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CHAPTER 4 – COPRORATIONS: EARNINGS & PROFITS AND DIVIDEND DISTRIBUTIONS Based on West Federal Taxation, Corporations, Partnerships, Estates, & Trusts, 2001 ed. I. TAXABLE DIVIDENDS- IN GENERAL Generally, corporate distributions are presumed paid from earnings and profits (E & P) and are treated as dividends. Distributions not treated as dividends are nontaxable to the extent of the shareholder’s basis in the stock. II. EARNINGS AND PROFIT (E & P) – §312 E & P establishes the maximum amount of dividends distributable and is the accumulation of profits since the corporation formation or 1913 whichever is later. A. COMPUTATION OF E & P p. 4-3 Both cash basis and accrual basis corporations use this method. 1. Additions to Taxable Income a. Interest on municipal bonds b. Excluded life insurance proceeds (in excess of surrender value) c. Federal income tax refunds from prior years d. Dividends received deduction 2. Subtractions from Taxable Income a.

Related party losses b. Excess capital losses c. Expenses incurred to produce tax-exempt income d. Federal income taxes paid e. Nondeductible key employee life insurance premiums f. Nondeductible fines and penalties PROBLEM 24, 25 3. Timing Adjustments a. If a corporation has a tax deduction that must be carried forward (e.g., charitable contribution carryover, net operating loss carryover, and / or capital loss carryover), it must reduce its current E & P by the carryover to get a true reflection of its E & P. The reverse adjustment must take place in the following years. b. No adjustment is made for gains and losses unless they are recognized for tax purposes. PROBLEM 30 4. Accounting Methods Adjustments a. The installment method is not recognized for E & P purposes. When income is received by the corporation, it is treated as having been received immediately. (See Ex. 6 in text) b. The alternative depreciation system (ADS) must be used for purposes of computing

E&P. (1) This method requires annual adjustments for E & P equal to the difference in the depreciation method used and straight-line depreciation over a recovery period equal to the Asset Depreciation Range midpoint life. (2) When assets are disposed of, an additional adjustment to taxable income is required. 1 c. E & P rules impose limitations on deducting §179 expense (must be deducted over 5 yrs). 2 d. B. C. D. When §179 is elected (1) 80% of resulting expenses must be added back to taxable income to determine current E & P in the year §179 is deducted. (2) In each of the following four years, a negative adjustment equal to 20% of the expense must be made. SUMMARY OF E & P ADJUSTMENTS p. 4-7 1. E & P measures a corporation’s earnings that are available as taxable dividend distributions to shareholders. 2. See “Concept Summary 4-1" on p. 4-8 for the adjustments needed. CURRENT VERSUS ACCUMULATED E & P p. 4-7 1. Accumulated E

& P is the total of all previous years’ current E & P as computed on the first day of each tax year, reduced by distributions made from E & P. 2. See “Concept Summary 4-2" on p. 4-9. ALLOCATING E & P TO DISTRIBUTIONS p. 4 -7 1. Current E & P is allocated on a pro rata basis to each distribution. Accumulated E & P is applied in chronological order, beginning with the earliest distribution. 2. When the corporation’s tax year and the shareholder’s tax year are not the same: a. The allocation rules presume current E & P is sufficient to cover every distribution made during the year. b. Once the corporation reaches the end of its tax year and can show definite grounds for a loss, the shareholder can file an amended return and reflect the distribution as a return of capital instead of a dividend payment. 3. Deficit balances in the E & P account: a. Positive current E & P and negative accumulated E & P: (1) DO NOT NET. (2) Any

distribution is considered a taxable dividend up to the current E & P balance. b. Negative current E & P and positive accumulated E & P: (1) NET THE ACCOUNTS (2) If balance is zero or less, the distribution is a return of capital. (3) If balance is more than zero, the distribution is a dividend to extent of the balance. PROBLEM 26, 27, 29 III. PROPERTY DIVIDENDS- IN GENERAL A. In General – Distributions of property with a basis that differs from its FMV raise several tax questions. B. PROPERTY DIVIDENDS- EFFECT ON THE SHAREHOLDER p. 4-11 1. Amount of distribution? a. FMV of property on the date of distribution. b. Less: (1) Any liabilities to which the distributed property is subject immediately before or after the distribution. 3 C. (2) Any liabilities assumed by the shareholder. 2. Shareholder’s basis in property? FMV of the property on the date of distribution. PROPERTY DIVIDENDS- EFFECT ON THE CORPORATION p. 4 -12 1. Recognition of Gain or Loss? a. All

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distributions of appreciated property generate gain for distributing corporation. b. Distributions are treated as if corp. sold property to shareholder for its FMV. c. The distributing corporation does not recognize loss on distributions of property. d. If the distributed property is subject to a liability which exceeds the property’s basis, use the liability amount as the FMV of the property. 2. Effect of Corporate Distributions on E & P? Use the following formula: a. Beginning of the year corporate E & P b. Add: Any recognized gain of the corp. c. Less: Any realized loss of the corp. d. Less: (1) IF CASH: Amount of money distributed AND (2) IF PROPERTY: The greater of (a) FMV less any liability on the property OR (b) Adjusted basis of property distributed less any liability on the property. e. Under no circumstance can a distribution (either cash or property) either generate a deficit in E & P or add to a deficit in E & P. PROBLEM 36, 40 IV. CONSTRUCTIVE

DIVIDENDS A. IN GENERAL 1. Any measurable economic benefit conveyed by a corporation to its shareholders can be treated as a dividend for income tax purposes even though not formally declared or designated as a dividend. 2. A constructive dividend is no required to be issued equally to all shareholders. 3. A constructive dividend need not satisfy various state law requirements of a dividend. B. TYPES OF CONSTRUCTIVE DIVIDENDS p. 4-14 1. Shareholder Use of Corporate-Owned Property (at no cost to shareholder) a. Watch for: Shareholder’s personal use of corporation property such as automobiles, yachts, hunting lodges, etc. b. Shareholder must recognize a constructive dividend equal to the fair rental value (FRV) of property during its personal use. 2. Bargain Sale of Corporate Property to a Shareholder a. Watch for: Shareholder purchase of corporate property at a cost below property’s FMV. b. Shareholder must recognize a constructive dividend equal to the difference between the

FMV at the time of the sale and the price paid by the shareholder. Consider using appraisals to eliminate some of this problem. 3. Bargain Rental of Corporate Property a. Watch for: Shareholder renting corporate property at a rental price below property’s FRV. b. Shareholder must recognize a constructive dividend equal to the difference between the FRV of the property and the rental price paid by the shareholder. 4. Payments for the Benefit of a Shareholder a. Watch for: (1) Corporate payment of a shareholder’s personal (legal or moral) obligation OR (2) Corporate forgiveness of a shareholder debt OR 4 b. (3) Corporate payment of price exceeding FRV of shareholder property OR (4) Corporate payment of price exceeding FMV of shareholder property. Shareholder must recognize a constructive dividend equal to the benefit he received. 5. Unreasonable Compensation a. Watch for: (1) Employee qualifications. (2) Comparison of salaries with dividend distributions. (3) Comparison of

salaries in similar business. (4) Nature and scope of employee’s work. (5) Size and complexity of the business. (6) Comparison of salaries paid with gross and net income. (7) Taxpayer’s salary policy toward all employees. (8) For small corporations, the amount paid the employee in question in previous years. b. Shareholder must recognize a const. div. = to portion of his salary deemed “unreasonable.” 6. Loans to Shareholders a. Watch for: (1) Advances to shareholders which are not bona fide loans (2) Low (or no) interest loans to shareholders. b. Shareholder must recognize a constructive dividend equal to the advance he receives or the portion of interest he should have paid. 7. Loans to a Corporation by Shareholders a. Watch for: “Thin capitalization” situation discussed in chapter 3. b. Shareholder may be required to recognize a constructive dividend equal to the portion of interest and principal payments made by the corporation. PROBLEM 38 C. TAX TREATMENT OF

CONSTRUCTIVE DIVIDENDS p. 4–16 Constructive dividends are treated the same for tax purposes as actual distributions. V. STOCK DIVIDENDS AND STOCK RIGHTS A. STOCK DIVIDENDS p. 4-17 1. As a general rule, stock dividends are excluded from income if they are pro rata distributions of stock or stock rights, paid on common stock. Following five (5) exceptions require distribution to be taxed. a. Distributions payable in either stock or property at the election of the shareholder. b. Distributions of property to some shareholders, with a corresponding increase in proportionate interest of other shareholders in either assets of E&P of the distributing corporation. c. Distributions of preferred stock to some common shareholders and of common stock to other common shareholders. d. Distributions of stock to preferred shareholders. e. Distributions of convertible preferred stock, unless it can be shown that the distributions will not result in a disproportionate distribution. 5

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2. 3. If stock dividends are not taxable: a. b. The corporation’s E & P is not reduced. The basis of the stock on which the dividend is distributed is reallocated. Method depends on whether stock dividend was identical to the type of shares previously owned: (1) If shares are identical (e.g., common for common) BASIS = Old basis in stock / Total number of shares now owned (2) If the dividend shares are not identical (e.g., preferred for common) BASIS = (FMV of preferred / FMV of all stock) x Old basis in stock. c. Holding period for new stock includes the holding period of the formerly held stock. If stock dividends are taxable: a. b. c. B. The corporation treats the distribution the same as any other taxable property distribution. The basis of the newly received shares to the shareholder is FMV Holding period begins on the date of receipt of those new shares. STOCK RIGHTS p. 4-18 1. Rules for determining stock rights are identical to those for determining taxability

of stock dividends: a. If the rights are taxable (1) Recipient has income to the extent of the FMV of the rights. (FMV becomes shareholder-distributee’s basis in rights.) (2) If rights are exercised (a) Holding period for new stock begins on the date rights are exercised. (b) Basis of new stock = Basis of rights + Any other consideration given. b. If stock rights are not taxable, compare the value of the rights with the value of the old stock: (1) If FMV of rights < 15% of value of old stock, basis of rights = 0. (a) Shareholder may elect to have some of the basis in formerly held stock allocated to the rights. (b) Election made by attaching a stmt. to the shareholder’s return for year rights are received. (2) VI. If FMV of rights is 15%or > of value of old stock and rights are exercised or sold, shareholder must allocate some of basis in formerly held stock to rights. TAX PLANNING CONSIDERATIONS A. B. CORPORATE DISTRIBUTIONS p. 4-19 1. E & P is measure of

dividend income, so its periodic determination is essential to corporate planning. E & P account should be established and maintained. 2. Accum. E & P = sum of past years’ current E & P. No statute of limitation on computing E & P. 3. Distribution can be planned to avoid or minimize dividend exposure. CONSTRUCTIVE DIVIDENDS p. 4-21 6 1. Shareholders should try to minimize their dealings with corp and be as formal as possible. 2. A balanced mix of possible alternatives lessens risk of constructive dividend treatment if shareholders wish to bail out corporate profits in form of deductible to corporation. 3. When testing for reasonableness, IRS looks at total compensation package. Indirect payments must not be overlooked 7