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

2. 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

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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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 4-49 ©2011 Pearson Education, Inc. Publishing as Prentice Hall