1. 4-1 ©2008 Prentice Hall, Inc.

2. 4-2 ©2008 Prentice Hall, Inc. NONLIQUIDATING DISTRIBUTIONS  Nonliquidating distributions in general  Earnings and profits (E&P)  Nonliquidating property distributions  Stock dividends and stock rights  Stock redemptions  Preferred stock bailouts  Stock redemptions by related corps

3. 4-3 ©2008 Prentice Hall, Inc. Nonliquidating Distributions in General (1 of 2)  Dividend distributions  A distribution of property based upon a corporation’s earnings & profits (E&P)  Property includes  Money, securities and other assets  Does not include stock or stock rights of distributing corp  Dividends treated as ordinary income by shareholder (generally taxed at 15%)

4. 4-4 ©2008 Prentice Hall, Inc. Nonliquidating Distributions in General (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

5. 4-5 ©2008 Prentice Hall, Inc. Earnings and Profits 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

6. 4-6 ©2008 Prentice Hall, Inc. Earnings and Profits Current E&P (2 of 2) Taxable income +Excluded taxable income +Taxable income deferred to another year +/-Inc & deduct recomputed under E&P rules +Deductions disallowed for E&P -Nondeductible items that reduce E&P =Current E&P (or current E&P deficit)

7. 4-7 ©2008 Prentice Hall, Inc. Earnings and Profits Current vs. Accumulated E&P (1 of 3)  Current E&P (CE&P) computed on last day of the corp’s tax year  Distributions first from CE&P  Distributions greater than CE&P  CE&P allocated to distributions pro rata regardless of payment date  Then AE&P (only if positive) allocated to distributions in chronological order

8. 4-8 ©2008 Prentice Hall, Inc. Earnings and Profits 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 shareholders and reduce shareholders’ basis in stock  Distributions in excess of basis result in a gain (usually capital gain)

9. 4-9 ©2008 Prentice Hall, Inc. Earnings and Profits 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  Deficit in CE&P transferred to AE&P before classifying distributions

10. 4-10 ©2008 Prentice Hall, Inc. Nonliquidating Property Distributions  Shareholder consequences  Corporation’s consequences  Example C4-15  Example C4-16  Distribution’s effect on E&P  Constructive dividends

11. 4-11 ©2008 Prentice Hall, Inc. Shareholder Consequences  In non-cash distributions, amount of income equal to FMV of property received minus liabilities assumed  Amount of distribution cannot be <$0  Shareholder’s basis in non-cash property is FMV on distribution date  Holding period of property begins day after distribution date

12. 4-12 ©2008 Prentice Hall, Inc. 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

13. 4-13 ©2008 Prentice Hall, Inc. Example C4-15 Corporate Gain/Loss on Property Distribution 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

14. 4-14 ©2008 Prentice Hall, Inc. Example C4-16 Corporate Gain and Shareholder Basis FMV of land$25,000 Mortgage 35,000 Adjusted basis 20,000 Capital Gain 15,000 FMV cannot be less than liability Shareholder’s basis$35,000

15. 4-15 ©2008 Prentice Hall, Inc. 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

16. 4-16 ©2008 Prentice Hall, Inc. 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

17. 4-17 ©2008 Prentice Hall, Inc. Constructive Dividends (1 of 3)  IRS or courts recharacterize payments to shareholder where substance of transaction is a dividend  All or part of income recharacterized as a dividend  Need not be pro-rata distribution  May be intentional way to bail out E&P without triggering dividend treatment

18. 4-18 ©2008 Prentice Hall, Inc. Constructive Dividends (2 of 3)  Tax consequences  Corporation denied deduction on benefit given to shareholder  Dividend income to shareholder for benefit received  Excessive compensation  Ordinary income to shareholder due to maximum 15% tax rate on dividends

19. 4-19 ©2008 Prentice Hall, Inc. Constructive Dividends (3 of 3)  Examples  “Loans” to shareholders  Excessive rent paid to shareholder  Payments for shareholder’s benefit  Bargain purchase  Use of corporate property  Excessive compensation

20. 4-20 ©2008 Prentice Hall, Inc. Stock Dividends & Stock Rights Tax-Free Stock Dividends  Tax-free distribution of additional shares of stock to existing shareholder  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. 4-21 ©2008 Prentice Hall, Inc. Stock Dividends & Stock Rights Tax-Free Stock Rights  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. 4-22 ©2008 Prentice Hall, Inc. Stock Dividends & Stock Rights Taxable Stock Dividends and Stock Rights  Distribution amount = FMV of stock or rights on distribution date  Dividend to extent of E&P  Recipient takes FMV as basis

23. 4-23 ©2008 Prentice Hall, Inc. Stock Redemptions (1 of 2)  Acquisition by a corporation of its own stock in exchange for property  Shareholder consequences  Attribution rules  Substantially disproportionate redemptions  Complete termination of shareholder’s interest

24. 4-24 ©2008 Prentice Hall, Inc. Stock Redemptions (2 of 2)  Redemptions not essentially equivalent to a dividend  Partial liquidations  Redemptions to pay death taxes  Redeeming corporation consequences

25. 4-25 ©2008 Prentice Hall, Inc. Shareholder Consequences  Sale treatment produces capital gain or loss  Dividend treatment produces ordinary income on entire distribution  Generally taxed at 15%

26. 4-26 ©2008 Prentice Hall, Inc. §318 Attribution Rules (1 of 2)  Family attribution  Spouse, children, grandchildren, & parents  Stock cannot be reattributed to another family member  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%

27. 4-27 ©2008 Prentice Hall, Inc. §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% shareholder of C corp considered owned by corp  Option attribution  Option owner treated as owning stock

28. 4-28 ©2008 Prentice Hall, Inc. Substantially Disproportionate Redemptions (1 of 2)  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

29. 4-29 ©2008 Prentice Hall, Inc. Substantially Disproportionate Redemptions (2 of 2)  Receive sale treatment  Redemptions receiving sale treatment  Complete termination of interest  Not essentially equivalent to dividend  Partial liquidation of corp to a non- corporate shareholder  Made in order to pay death taxes

30. 4-30 ©2008 Prentice Hall, Inc. Complete Termination of Interest  Redemption of shareholder’s entire interest corporation consisting of nonvoting stock  Normally would not qualify because no reduction in voting power occurs  Family attribution rules may be waived to allow complete termination to qualify

31. 4-31 ©2008 Prentice Hall, Inc. Redemptions not Essentially Equivalent to a Dividend (1 of 2)  Facts and circumstances test  No safe harbor or mechanical test  Generally applies to  Redemptions of nonvoting preferred stock if no common stock owned

32. 4-32 ©2008 Prentice Hall, Inc. Redemptions not Essentially Equivalent to a Dividend (2 of 2)  Generally applies to (continued)  Redemptions resulting in substantial reduction in shareholder’s right to vote and exercise control, participate in earnings, or share in assets upon liquidation

33. 4-33 ©2008 Prentice Hall, Inc. Partial Liquidations (1 of 2)  Corp discontinues one line of business  Distributes assets to shareholders  Continues other line(s) of business  Determined at corporate level  Must be bona fide business contraction

34. 4-34 ©2008 Prentice Hall, Inc. Partial Liquidations (2 of 2)  Tax consequences to shareholders  Noncorp shareholder treats redemption as a sale  Corp treats as a dividend unless redemption meets one of other tests for sale treatement.

35. 4-35 ©2008 Prentice Hall, Inc. Effect of Redemptions on Distributing Corporation  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

36. 4-36 ©2008 Prentice Hall, Inc. Preferred Stock Bailouts  §306 in general  Dispositions of §306 stock  Redemptions of §306 stock  Exceptions to §306 treatment

37. 4-37 ©2008 Prentice Hall, Inc. §306 in General (1 of 2)  §306 stock defined  Stock other than common stock  Issued on a tax free basis  Substantially same as a stock dividend  Sale results in ordinary income equal to FMV of stock  Limited by corporation’s E&P at distribution date

38. 4-38 ©2008 Prentice Hall, Inc. §306 in General (2 of 2)  If no Current or Accumulated E&P in issue year, §306 does not apply

39. 4-39 ©2008 Prentice Hall, Inc. Dispositions of §306 stock  Dividend income to the extent of E&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

40. 4-40 ©2008 Prentice Hall, Inc. Redemptions of §306 stock  Same dividend treatment as sale of §306 stock  Corporation’s E&P reduced by amount realized

41. 4-41 ©2008 Prentice Hall, Inc. Exceptions to §306  §306 does not apply in the following circumstances  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

42. 4-42 ©2008 Prentice Hall, Inc. Stock Redemptions by Related Corporations  A sale of a corp’s stock by controlling shareholder to a second corp controlled by same shareholder treated as a redemption  §304 applies to both  brother-sister and  parent-subsidiary controlled groups

43. 4-43 ©2008 Prentice Hall, Inc. 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 issuingcorp (if necessary) is reduced  Basis of redeemed stock added to basis of stock held in acquiring corp

44. 4-44 ©2008 Prentice Hall, Inc. Parent-Subsidiary Controlled Group  Sale of parent stock by shareholder to subsidiary  If a dividend, E&P of sub and then parent are both available  Shareholder’s basis in remaining parent stock increased by basis of stock redeemed by subsidiary

45. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 4-45 ©2008 Prentice Hall, Inc.