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Chapter 4: Corporate Nonliquidating Distributions

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Presentation on theme: "Chapter 4: Corporate Nonliquidating Distributions"— Presentation transcript:

1 Chapter 4: Corporate Nonliquidating Distributions

2 Nonliquidating DISTRIBUTIONS (1 of 2)
Nonliquidating distributions in general Computing current E&P Current vs. accumulated E&P Nonliquidating property distributions Constructive dividends

Stock dividends and stock rights Stock redemptions Preferred stock bailouts Redemptions by related corporations

4 Nonliquidating Distributions (1 of 2)
Dividend distributions A distribution of property based upon a corporation’s earnings & profits Property includes money, securities & other assets Does not include stock or stock rights of distributing corp Dividends treated as ordinary income by s/h (generally taxed at 15%)

5 Nonliquidating Distributions (2 of 2)
Earnings and profits (E&P) E&P not defined in the Code E&P consists of current & accumulated Distributions are based upon current E&P first & accumulated E&P second Distributions in excess of E&P are considered a return of capital

6 Computing Current E&P (1 of 2)
E&P computed on annual basis at end of tax year Generally E&P based on corp’s economic income instead of taxable income Adjustments to taxable income for permanent & timing differences including use of different depreciation methods Refer to Table C4-1

7 Computing Current E&P (2 of 2)
Taxable income + Inc. excluded from TI but incl. in E&P + TI deferred to later year, but included in E&P in current year +/-Inc. & ded that must be recomputed when computing E&P + Deductions for TI not allowed in for E&P - Nondeduct exp/loss for TI that reduce E&P = Current E&P (or current E&P deficit)

8 Current vs Accumulated E&P (1 of 3)
Current E&P computed on last day of the corp’s tax year Distributions greater than CE&P CE&P allocated to distributions pro rata regardless of payment date Then Accumulated E&P allocated to distributions in chronological order

9 Current vs Accumulated E&P (2 of 3)
Distributions greater than E&P Cannot create an E&P deficit Distributions in excess of all E&P is a return of capital to s/h and reduce s/h’s basis in stock. Distributions in excess of basis result in a gain (usually capital gain)

10 Current vs Accumulated E&P (3 of 3)
If CE&P is positive and beginning AE&P is a deficit Distributions will produce ordinary income to shareholder until CE&P reaches zero CE&P allocated on a pro-rata basis

11 Consequences of Nonliquidating Distributions
Shareholder consequences Corporation’s consequences Example C4-15 Example C4-16 Distribution’s effect on E&P

12 Shareholder Consequences
In non-cash distributions, amount of income equal to FMV of property received minus liabilities assumed Amount of distribution cannot be <$0 S/h’s basis in non-cash property is FMV on distribution date Holding period of property begins day after distribution date

13 Corporation’s Consequences
Appreciated non-cash property produces gain as if corp sold property for FMV on distribution date Loss recognition NOT permitted If liabilities exceed FMV, then FMV is assumed to be no less than amount of the liability

14 Example C4-15 FMV of land $60,000 Adjusted basis 20,000
Capital Gain 40,000 FMV of land $12,000 Adjusted Basis 20,000 No loss recognition by corporation

15 Example C4-16 FMV of land $25,000 Mortgage 35,000
Adjusted basis ,000 Capital Gain ,000 Shareholder’s basis $35,000

16 Distribution’s Effect on E&P (1 of 2)
Gain on non-cash distribution increases Current E&P E&P is reduced by Amount of cash distributed Greater of FMV or adjusted basis of property distributed minus liability assumed by shareholder Tax liability on gain recognized

17 Distribution’s Effect on E&P (2 of 2)
E&P is reduced by (continued) Principal amount of the corporation’s own notes, bonds, debentures or other obligations distributed to shareholders

18 Constructive Dividends (1 of 2)
Most likely in closely held corps Indirect payment made to a s/h without formal board action Economic benefit provided to a s/h Intentionally avoiding dividend status Deduct. for excessive comp no longer constructive div due to max 15% tax on div, but corp still denied deduct.

19 Constructive Dividends (2 of 2)
Examples “Loans” to shareholders Excessive rent paid to shareholder Payments for shareholder’s benefit Bargain purchase Use of corporate property

20 Stock Dividends & Stock Rights (1 of 2)
Tax-free distribution of additional shares of stock to existing s/h If shares identical, basis allocated by dividing old basis by total shares held If shares different, basis allocated between old and new shares in proportion to FMV on distribution date

21 Stock Dividends & Stock Rights (2 of 2)
Tax-free distribution of right to purchase add’l shares of stock unless proportionate interest changes or could change If the value of right <15% of underlying stock, basis of right is zero If value 15% of underlying stock, basis allocated based on relative FMV

22 Stock Redemptions Acquisition by a corporation of its own stock in exchange for property Shareholder consequences Attribution rules Redemptions qualifying for sale treatment Substantially disproportionate redemptions Redeeming corporation consequences

23 Shareholder Consequences
Sale treatment produces capital gain or loss Dividend treatment produces ordinary income on entire distribution Generally taxed at 15%

24 §318 Attribution Rules (1 of 2)
Family attribution Spouse, children, grandchildren, & parents Attribution from entities Proportionate ownership for stock owned by or for partnership, estate, or trust Proportionate ownership for stock owned by C corp only for s/h owning  50%

25 §318 Attribution Rules (2 of 2)
Attribution to entities Stock owned by partners or beneficiaries considered owned by partnership, estate, or trust Stock owned by  50% s/h of C corp considered owned by corp Option attribution

26 Redemptions Qualifying for Sale Treatment
Substantially disproportionate Complete termination of interest Not essentially equivalent to a dividend Partial liquidation of corp to a non-corporate shareholder Made in order to pay death taxes

27 Substantially Disproportionate Redemptions
After the redemption, the s/h Owns < 50% of voting power of all classes of stock Owns < 80% of his/her percentage ownership of voting stock before the redemption Owns < 80% of his/her percentage ownership of common stock before the redemption

28 Redeeming Corporation Consequences
Sale treatment may produce gains but no losses E&P must be reduced by Full amount for dividends (if dividend) OR Proportionate amount for sale treatment after adjusting for gains net of taxes

29 Preferred Stock Bailouts
§306 in general Shareholder consequences Exceptions to §306

30 §306 in General §306 stock defined
Stock other than common stock Issued on a tax free basis, then sold Ordinary income equal to FMV of stock limited by corporation’s E&P at distribution date If no Current or Accumulated E&P in issue year, §306 does not apply

31 Shareholder Consequences
Dividend income to the extent of CE&P in year of redemption Amounts in excess are considered a return of capital Amounts recovered in excess of basis are capital gains Any unrecovered basis is added to remaining common stock

32 Exceptions to §306 Complete termination of interest
Complete redemption of all holdings Redemption in a partial liquidation Gift transfer (stock remains tainted) No tax avoidance as a principal purpose

33 Redemptions by Related Corporations
A sale of a corp’s stock by controlling s/h to a second corp controlled by same s/h treated as a redemption §304 applies to both brother-sister and parent-subsidiary controlled groups

34 Brother-Sister Controlled Groups
Redemption is by the corp buying stock from the shareholder If a dividend, E&P of acquiring corp and then the issuing corp (if necessary) is reduced Basis of redeemed stock added to basis of stock held in acquiring corp

35 Parent-Subsidiary Controlled Group
Sale of parent stock by s/h to sub If a dividend, E&P of sub and then parent are both available S/h’s basis in remaining parent stock increased by basis of stock redeemed by subsidiary

36 End of Chapter 4 Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business

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