4-1 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-2 NONLIQUIDATING DISTRIBUTIONS (1 of 2)  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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-3 NONLIQUIDATING DISTRIBUTIONS (2 of 2)  Tax planning  Compliance and procedural considerations ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-4 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 (taxed at 15% in 2010) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-5 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-6 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 1 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-7 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) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-8 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-9 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) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-10 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-11 Nonliquidating Property Distributions  Shareholder consequences  Corporation’s consequences  Example 15  Example 16  Distribution’s effect on E&P  Constructive dividends ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-12 Shareholder Consequences  In non-cash distributions, amount of income equal to FMV of property received minus liabilities assumed  Amount of distribution cannot be <$0  Shareholder’s basis in non-cash property is FMV on distribution date  Holding period of property begins day after distribution date ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-13 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-14 Example 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-15 Example 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-16 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-17 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-18 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-19 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  May not treated as a dividend due to maximum 15% tax rate on dividends ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-20 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-21 Stock Dividends & Stock Rights Nontaxable 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-22 Stock Dividends & Stock Rights Nontaxable 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-23 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  Topic Review 3  Illustrates tax consequences to shareholders and distributing corporation ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-24 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-25 Stock Redemptions (2 of 2)  Redemptions not essentially equivalent to a dividend  Partial liquidations  Redemptions to pay death taxes  Redeeming corporation consequences ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-26 Shareholder Consequences  Sale treatment produces capital gain or loss  Dividend treatment produces ordinary income on entire distribution  Generally taxed at 15% (through 2010) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-27 §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% ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-28 §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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-29 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-30 Substantially Disproportionate Redemptions (2 of 2)  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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-31 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-32 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-33 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-34 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-35 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. ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-36 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-37 Preferred Stock Bailouts  §306 in general  Dispositions of §306 stock  Redemptions of §306 stock  Exceptions to §306 treatment ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-38 §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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-39 §306 in General (2 of 2)  If no Current or Accumulated E&P in issue year, §306 does not apply ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-40 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-41 Redemptions of §306 stock  Same dividend treatment as sale of §306 stock  Corporation’s E&P reduced by amount realized ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-42 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-43 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-44 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-45 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-46 Tax Planning (1 of 2)  Avoiding unreasonable compensation  Hedge agreement  S/h-employee agrees to repay any portion of salary IRS disallows as unreasonable  Bootstrap acquisitions  S/h sells part of stock to purchaser, then has corp redeem seller’s remaining shares ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-47 Tax Planning (2 of 2)  Timing of distributions  Make distributions when corp has little or no E&P so distributions treated as return of capital ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4-48 Compliance and Procedural Considerations  Corporate reporting of nondividend distributions  Agreement to terminate interest under §302(b)(3) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 4-49 ©2011 Pearson Education, Inc. Publishing as Prentice Hall