Module 14 Transactions Between a Corporation and Its Shareholders

Module Topics 1. Capital distributions 2. Earnings and profits 3. Distributions to shareholders 4. Taxation of stock redemptions 5. Taxation of liquidating distributions

Capital Distributions Key Learning Objectives n Why corporations pay dividends n Double taxation n How corporations avoid double taxation n Constructive or disguised dividends

In Class Exercise: Taking Money Out of a Corporation n Mary (the sole shareholder of a corporation) needs $10,000 u Mary’s MTR = 28% n The corporation taxable income = $40,000 u Corp’s MTR = 15% n What are the tax consequences of taking the money as salary, dividend, or loan? n Any other legal ways to get the money out?

Solution: In Class Exercise: Taking Money Out of a Corporation Increase (decrease) in income tax liability Corp Mary Corp Mary n Dividend N/A 2,800 n Salary (1,500) 2,800 n Loan N/A N/A

In Class Exercise: Taking Money Out of a Corporation Did you consider n Payroll taxes? n Unreasonable compensation? n §7872--gift loan? n If the corporation could pay the $10,000 directly and deduct it? n If there could there be a disguised dividend under any of the alternatives?

Earnings and Profits E&P Key Learning Objectives n n Computing earnings and profits n n Record keeping and reporting requirements

Two Types of E&P n n Current E&P Current tax year before any distributions or redemptions are subtracted n n Accumulated E&P Sum of all previous years current E&P (less distributions)

Common Items Increasing E&P n n Tax-exempt interest income n n Full gain on installment sale in year of sale n n Dividends received deduction n n Current annual LIFO layer n n Excess depreciation n n Federal income tax refund n n All carryovers utilized during year

Common Items Decreasing E&P n n Federal income taxes paid or accrued n n Excess charitable contribution n n Capital losses n n Current year ordinary losses n n Nondeductible expenses n n Fines and penalties

Common Items Decreasing E&P n Disallowed portion of R&D n Foreign tax credits n §280C--certain expenses for which credits are allowable n Installment sale gain recognized n Gains due to different adjusted bases

Record Keeping and Reporting Requirements Key Learning Objectives n n § 6042(d) requires corporations to furnish information needed to determine E&P n n Names of stockholders n n Year-by-year basis n n File Form 5452 if distribution not from E&P

Distributions to Shareholders Key Learning Objectives n Historical note: General Utilities Doctrine n Dividend distributions n Distributions taxability relative to earnings and profits n Other transactions between a corporation and its shareholders

Historical Note: General Utilities Doctrine n In a complete liquidation n There was a distribution of property to shareholder n Distributing corporation had no gain or loss recognition n Repealed in 1986

Distribution is Taxable Dividend to the Extent that n Distribution < current E&P n Distribution > current E&P BUT current E&P BUT < current and accumulated E&P n If current E&P < 0, AND distribution < accumulated E&P < accumulated E&P

Distribution is Non-Taxable Return of Capital n If distribution > current and accumulated E&P n Then distribution is return of capital to extent of shareholder’s basis in stock

Distribution is Taxable as Capital Gain n If distribution > current and accumulated E&P AND shareholder’s basis in stock n Then excess distribution is treated as a capital gain

In Class Exercise: How Much is a Taxable Dividend ? Current Accumulated Cash Case E & P E & P Distributed Current Accumulated Cash Case E & P E & P Distributed n A (4,000) 5,000 3,000 n B 5,000 (3,000) 4,000 n C 7,000 15,000 12,000 n D (8,000) (6,000) 1,000 n E 2,000 7,000 15,000

Solution: In Class Exercise: How Much is a Taxable Dividend? n Case A: $3,000 taxable as dividend n Case B: $4,000 taxable as dividend n Note that in both A and B you do not net current and accumulated E&P to determine the dividend n Case C: $12,000 taxable as dividend

Solution: In Class Exercise How Much is Taxable Dividend? Case D n No current or accumulated E & P u No taxable dividend n If shareholder’s basis in stock = $3,000 u $1,000 is non-taxable return of capital

Solution: In Class Exercise How Much is Taxable Dividend? Case E n 9,000 is taxable as dividend n If shareholder’s basis in stock = $2,000 u $4,000 is taxed as a capital gain u $2,000 is non-taxable return of capital

Property Distributions Key Learning Objectives n Property distribution is valued at FMV minus liabilities assumed by shareholder n The shareholder’s basis of property received is its FMV n Property will have a new holding period

Compliance Query: Distribution of Property Issues To Consider For corporation n If complete liquidation, §336--applies to gains and losses u Some exceptions to loss recognition n If non-liquidation distribution, §311(b)--applies to gains only

Compliance Query: Distribution of Property Issues to Consider For shareholder n n Any dividend? n n Any return of capital? n n Any capital gain? n n Basis in the new property? n n Holding period of new property?

Compliance Query: Distribution of Property When FMV >Basis n Current E&P = $10,000 n FMV land = $30,000 n Adjusted basis of land= $12,000 n Shareholder basis in stock = $5,000 n What are the tax consequences to u Corporation? u Shareholder?

Solution: Compliance Query Distribution of Property FMV > Basis n Both §336 and 311(b) apply to gains n Gain of $18,000 is recognized by Corp so u E&P is increased by $18,000 u Reduced by taxes paid on the gain n E&P is then reduced by $30,000 u FMV of distribution

Solution: Compliance Query Distribution of Property FMV >Basis n Total distribution to S/H is $30,000 n If nonliquidating distribution u S/H has dividend of $28,000 u Remaining $2,000 is return of capital n If liquidating distribution n S/H has a $25,000 capital gain u $30,000 - $5,000

Solution: Compliance Query Distribution of Property FMV > Basis §336 E&P 10,000 Gain 18,000 E&P at Dist 28,000 Distribution 30,000 Dividend N/A Return of capital 5,000 Capital gain 25,000 §311 (b) E&P 10,000 Gain 18,000 E&P at Dist 28,000 Distribution 30,000 Dividend 28,000 Return of capital 2,000 Capital gain/loss N/A

Compliance Query: Distribution of Property When FMV < Basis n E&P = $10,000 n FMV land = $30,000 n Adjusted basis of land = $40,000 n Shareholder basis in stock = $5,000 n What are the tax consequences to u Corporation? u Shareholder?

Solution: Compliance Query Distribution of Property FMV < Basis n Only §336 applies to losses n Loss of $10,000 is recognized by Corp if complete liquidation u E&P is decreased by $10,000 n In both cases, E&P is reduced by $30,000 u FMV of distribution

Solution: Compliance Query Distribution of Property FMV < Basis n Total distribution to S/H is $30,000 n If nonliquidating distribution S/H has dividend of $10,000 Return of capital of $5,000 Capital gain of$15,000 n If liquidating distribution n S/H has a $25,000 capital gain u $30,000 - $5,000

Solution: Compliance Query Distribution of Property FMV > Basis §336 E&P 10,000 Loss -10,000 E&P at Dist -0- Distribution 30,000 Dividend N/A Return of capital 5,000 Capital gain 25,000 §311 (b) E&P 10,000 Loss N/A E&P at Dist 10,000 Distribution 30,000 Dividend 10,000 Return of capital 5,000 Capital gain 15,000

Other Transactions between a Corporation and its Shareholders Key Learning Objectives n §1239--gain from sale of depreciable property n §267--losses, expenses, and interest n §482--allocations of income and deductions

Gain from Sale of Depreciable Property §1239--Gain from Sale of Depreciable Property n Sale or exchange occurs between a taxpayer and a related party n Property is subject to the allowance for depreciation or amortization n Gain recognized is automatically classified as ordinary income

Losses, Expenses, and Interest §267 Losses, Expenses, and Interest n Prevent the artificial creation of losses and deductions between related parties n Disallowing the loss to the seller n Requires the matching of income and expenses for transactions between related parties

§482--Allocations of Income and Deductions Among Taxpayers n Allows the IRS to reallocate income, expenses, and credits among two or more taxpayers n Requires taxpayers to conduct transactions at arm’s length

Taxation of Stock Redemptions n n Redemption vs. dividend income treatment n n Impact of redemption on corporate E&P n n Constructive stock ownership n n §306 stock

Stock Redemption Key Learning Objectives n If certain requirements are met n Stockholder is entitled to capital gains n When a corporation redeems all or part of stock n No gain or loss is recognized by the corporation n Shareholder treats a redemption as a sale to the corporation

Taxation of Liquidating Distributions Key Learning Objectives n Perspectives n Parent subsidiary liquidations n §338 election

Redemption vs. Dividend Income Treatment Key Learning Objectives n Redemption treated as a distribution in part or full payment in exchange for the stock n §302(b)(1) Not essentially equivalent to a dividend n §302(b)(2) Major change in ownership quantitative test n §302(b)(3) Complete liquidation of shareholder’s interest n §302(b)(4) Partial liquidation provisions n §303 Redemption upon death

Impact of Redemption on Corporate E&P Key Learning Objectives n Corporate E&P is reduced n By the lesser of the fair market value of the assets distributed or the percentage of stock redeemed multiplied by E&P n Distributions reduce E&P first, followed by redemptions

Constructive Ownership-- Family Attribution Key Learning Objectives n When computing the percentage ownership, the stock held by related parties must be considered n Related family members n Parents, spouse, children, and grandchildren n Brothers, sisters, and in-laws are not considered family members

Constructive Stock Ownership-- Entity Attribution Key Learning Objectives n If a corporation, partnership, estate, or trust owns stock n Partners or beneficiaries no minimum ownership threshold n Corporation, a 50% or greater (by value)

§306--Sale of Preferred Stock Key Learning Objectives n Treats the sale of preferred stock by the shareholder as ordinary income (not dividend income) n To the extent that the receipt of the original preferred stock would have been taxable as a dividend n Any excess is a return of capital and then a capital gain. No loss is allowed on the transaction.

Perspectives--Liquidating Corporation Key Learning Objectives n All the gains and losses are recognized as if the corporation sold its assets n Unamortized balance in organizations costs is deductible in the year of liquidation n If an item was previously expensed, such as supplies, and was still on hand when the corporation is liquidated, u income must be recognized. n All of the tax attributes of the liquidating corporation will be lost if they cannot be used before the corporation is dissolved

Perspectives--Shareholder Key Learning Objectives n Recognizes capital gain or loss on the difference between u Net FMV of the property and cash received and u The adjusted basis of the corporate stock n Basis in the new property is equal to its fair market value n Holding period starts anew

Parent-Subsidiary Liquidations Key Learning Objectives n Subsidiary acquires at least 80% of the stock of another corporation n Assets are now indirectly owned by the acquiring corporation n §332 Parent corporation has no gain or loss recognized on the receipt of property in return for its ownership interest n Tax attributes will be inherited by the parent company n Parent’s basis in the stock (called outside basis) of the target disappears n §332 is mandatory

§338 Election Key Learning Objectives n Permits an acquiring corporation to take a basis in the assets upon the liquidation of a subsidiary equal to the purchase price of the stock in the subsidiary n Beneficial when the adjusted basis of the subsidiary’s assets is less than the purchase price of the stock n Subsidiary is deemed to have sold all its assets n Could be a significant tax liability n Tax attributes of the subsidiary disappear