Chapter 5 presentation

1. Chapter 5 Corporations: Earnings & Profits and Dividend Distributions

Lime Corporation, an ice cream manufacturer, has had a very profitable year.

To share its profits with its two shareholders, it distributes the following:

Cash of $200,000 to Orange Corporation, and

Real estate worth $300,000 (adjusted basis of $20,000) to Gustavo.

The real estate is subject to a mortgage of $100,000, which Gustavo assumes.

The distribution is made on December 31, Limes year-end.

Lime Corporation has had both good and bad years in the past.

More often than not, however, it has lost money.

Despite this years banner profits, the GAAP-based balance sheet for Lime indicates a year-end deficit in retained earnings.

Consequently, the distribution of cash and land is treated as a liquidating distribution for financial reporting purposes, resulting in a reduction of Limes paid-in capital account.

The tax consequences of the distributions to the corporation and its shareholders depend on a variety of factors.

Identify these factors.

Explain the tax effects of the distributions to both Lime Corporation and its 2 shareholders.

Read the chapter and formulate your response.

Distributions from corporate earnings and profits (E & P)

Treated as a dividend distribution

Taxed as ordinary income or as preferentially taxed dividend income

Distributions in excess of E & P

Nontaxable to extent of shareholders basis (i.e., a return of capital)

Excess distribution over basis is capital gain

No definition of E & P in Code

Similar to Retained Earnings (financial reporting), but often not the same

E & P represents:

Upper limit on amount of dividend income recognized on corporate distributions

Corporation's economic ability to pay dividend without impairing capital

Calculation generally begins with taxable income, plus or minus certain adjustments

Add previously excluded income items and certain deductions to taxable income including:

Muni bond interest

Excluded life insurance proceeds

Federal income tax refunds

Dividends received deduction

Domestic production activities deduction

Calculation generally begins with taxable income, plus or minus certain adjustments (contd)

Subtract certain nondeductible items:

Nondeductible portion of meal and entertainment expenses

Related-party losses

Expenses incurred to produce tax-exempt income

Federal income taxes paid

Key employee life insurance premiums (net of increase in cash surrender value)

Fines, penalties, and lobbying expenses

Certain E & P adjustments shift effect of transaction from the year of inclusion in or deduction from taxable income to year of economic effect, such as:

Charitable contribution carryovers

NOL carryovers

Capital loss carryovers

Gains and losses from property transactions

Generally affect E & P only to extent recognized for tax purposes

Thus, gains and losses deferred under the like-kind exchange provision and deferred involuntary conversion gains do not affect E & P until recognized

Other adjustments

Accounting methods for E & P are generally more conservative than for taxable income, for example:

Installment method is not permitted

Alternative depreciation system required

179 expense must be deducted over 5 years

Percentage of completion must be used (no completed contract method)

Effect on taxable income for E & P:

Transaction Add Subtract

Tax-exempt incomeX

Life insurance proceedsX

Deferred installment gainX

Excess charitable contribution X

Ded. of prior excess contribution X

Federal income taxes X

Officers life insurance premiumX

Accelerated depreciationX

Current E & P

Taxable income as adjusted

Accumulated E & P

Total of all prior years current E & P (since February 28, 1913) reduced by distributions fromE & P

Distinction between current and accumulated E & P is important

Taxability of corporate distributions dependson how current and accumulated E & P are allocated to each distribution made during year

If positive balance in both current and accumulated E & P

Distributions are deemed made first from current E & P, then accumulated E & P

If distributions exceed current E & P, must allocate current and accumulated E & P to each distribution

Allocate current E & P pro rata (using dollar amounts) to each distribution

Apply accumulated E & P in chronological order

When the tax years of the corporation and its shareholders are not the same

May be impossible to determine the amount of current E & P on a timely basis

Allocation rules presume that current E & P is sufficient to cover every distribution made during the year until the parties can show otherwise

If current E & P is positive and accumulated

E & P has a deficit

Accumulated E & P IS NOT netted against current E & P

Distribution is deemed to be taxable dividend to extent of positive current E & P balance

Return to the facts of The Big Picture on p. 52.

Lime Corp. had a deficit in GAAP-based retained earnings at the start of the year and banner profits during the year.

Assume that this translates into an $800,000 deficit in accumulatedE & P at the start of the year and current E & P of $600,000.

In this case, current E & P would exceed the $500,000 of cash and property distributed to the shareholders.

The distributions are treated as taxable dividends.

They are deemed to be paid from current E & P even though Lime still has a deficit in accumulated E & P at the end of the year.

If accumulated E & P is positive and current E&P is a deficit, net both at date of distribution

If balance is zero or a deficit, distribution is a return of capital

If balance is positive, distribution is a dividend to the extent of the balance

Any current E & P is allocated ratably during the year unless the parties can show otherwise

A $20,000 cash distribution is made in each independent situation:

Accumulated E & P,

beginning of year 100,000 (100,000)15,000

Current E & P 50,000 50,000 (10,000)

Dividend: 20,000 20,000 5,000

*Since there is a current deficit, current and accumulated

E & P are netted before determining treatment of distribution.

For individual taxpayers, qualified dividends are subject to a max 15% tax rate

Beginning in 2008, qualified dividends are exempt from tax for taxpayers in the 10% or 15% rate brackets

The lower rates on dividend income apply to both the regular income tax and the alternative minimum tax

Corporations treat dividends as ordinary income and are permitted a dividends received deduction

To qualify for lower rates, dividends must be:

Paid by domestic or certain qualified foreign corps

Qualified foreign corps include those traded on a U.S. stock exchange or any corp. located in a country that:

Has a comprehensive income tax treaty with the U.S.

Has an information-sharing agreement with the U.S. and

Is approved by the Treasury

Paid on stock held > 60 days during the 121-day period beginning 60 days before the ex-dividend date

Dividends paid to shareholders who hold both long and short positions in the stock do not qualify

Qualified dividends are not considered investment income for purposes of determining the investment interest expense deduction

An election is available to treat qualified dividends as ordinary income (taxed at regular rates) and include them in investment interest income

Thus, taxpayers subject to an investment interest expense limitation must compare relative benefits of low tax onqualifying dividends vs. increasedamount of deductible investment interest expense

Effect on shareholder:

Amount distributed equals FMV of property

Taxable as dividend to extent of E & P

Excess is treated as return of capital to extent of basis in stock

Any remaining amount is capital gain

Effect on shareholder (contd):

Reduce amount distributed by liabilities assumed by shareholder

Basis of distributed property = fair market value

Effect on corporation:

Corp. is treated as if it sold the property for fair market value

Corp. recognizes gain, but not loss

If distributed property is subject to a liability in excess of basis

Fair market value is treated as not being less than the amount of the liability

Effect on corporations E & P:

Increases E & P for excess of FMV over basis of property distributed (i.e., gain recognized)

Reduces E & P by FMV of property distributed (or basis, if greater) less liabilities on the property

Distributions of cash or property cannot generate or add to a deficit in E & P

Deficits in E & P can arise only through corporate losses

Lime Corporation distributed property to Gustavo, one of its shareholders.

Fair market value $300,000.

Adjusted basis $20,000.

Subject to a $100,000 mortgage, which Gustavo assumed.

As a result, Gustavo has a taxable dividend of $200,000

$300,000 (fair market value) $100,000 (liability).

The basis of the property to Gustavo is $300,000.

Lime Corporation distributed property to Gustavo, one of its shareholders.

Fair market value of $300,000

Adjusted basis of $20,000

As a result, Lime recognizes a $280,000 gain on the distribution.

Property is distributed (corporations basis = $20,000) in each of the following independent situations.Assume Current and Accumulated E & P are both $100,000 in each case:

Fair market value

of distributed property 60,000 10,000 40,000

Liability on property-0- -0-15,000

Gain(loss) recognized 40,000 -0- 20,000

E&P increased by gain 40,000 -0- 20,000

E & P decrease on dist. 60,000 20,000 25,000

Any economic benefit conveyed to a shareholder may be treated as a dividend for tax purposes, even though not formally declared

Need not be pro rata

Usually arises with closely held corporations

Payment may be in lieu of actual dividend and is presumed to take form for tax avoidance purposes

Benefit conveyed is recharacterized as a dividend for all tax purposes

Corporate shareholders are entitled to the dividends received deduction

Other shareholders receive preferential tax rates

Shareholder use of corporate property at reduced cost or no cost (e.g., company car to non-employee shareholder)

Bargain sale of property to shareholder (e.g., sale for $1,000 of property worth $10,000)

Bargain rental of corporate property

Payments on behalf of shareholder(e.g., corporation makes payments to satisfy obligation of shareholder)

Unreasonable compensation

Below market interest rate loans to shareholders

High rate interest on loans from shareholder to corporation

Documentation of the following attributes will help support payments made to an employee-shareholder:

Employees qualifications

Comparison of salaries with dividends made in past

Comparable salaries for similar positions in same industry

Nature and scope of employees work

Size and complexity of business

Corporations salary policy for other employees

Excluded from income if pro rata distribution of stock, or stock rights, paid on common stock

Five exceptions to nontaxable treatment deal with various disproportionate distribution situations

Effect on E & P

If nontaxable, E & P is not reduced

If taxable, treat as any other taxable property distribution

Basis of stock received

If nontaxable

If shares received are identical to shares previously owned,basis = (cost of old shares/total number of shares)

If shares received are not identical, allocate basis of old stock between old and new shares based on relative fair market value

Holding period includes holding period of formerly held stock

If taxable, basis of new shares received is fair market value

Holding period starts on date of receipt

Tax treatment of stock rights is same as for stock dividends

If stock rights are taxable

Income recognized = fair market value of stock rights received

Basis= fair market value of stock rights

If exercised, holding period begins on date rights are exercised

Basis of new stock = basis of rights plus any other consideration given

If stock rights are nontaxable

If value of rights received < 15% of value of old stock, basis in rights = 0

Election is available which allows allocation of some of basis of formerly held stock to rights

If value of rights is 15% or more of value of old stock, and rights are exercised or sold, must allocate some of basis in formerly held stock to rights

Maintain ongoing records of E & P:

Ensures return of capital is not taxed as dividend

No statute of limitations on E & P, so IRS can redetermine at any time

Accurate records minimize this possibility

Adjust timing of distribution to optimize tax treatment:

If accumulated E & P deficit and currentE & P loss, make distribution by end of tax year to achieve return of capital

If current E & P is likely, make distribution at beginning of next year to defer taxation

Structure transactions on arms length basis:

Reasonable rent, compensation, interest rates, etc...

Use mix of techniques to bail out corporate earnings such as:

Shareholder loans to corporation

Salaries to shareholder-employee

Rent property to corporation

Pay some dividends

Overdoing any one technique may attract attention of IRS

A number of factors affect the tax treatment of Lime Corporations distributions.

The amount of current and accumulated E & P (which differ from retained earnings) partially determines the tax effect on the shareholders.

Given that Lime Corporation has had a highly profitable year, it is likely that there is sufficient current E & P to cover the distributions.

If so, they are dividends to the shareholders rather than a return of capital.

Orange Corporation receives $200,000 of dividend income that is mostly offset by the dividends received deduction.

The amount of the offsetting deduction depends on the ownership percentage that Orange has in Lime.

Gustavo has $200,000 of dividend income (i.e., $300,000 value of the land less the $100,000 mortgage).

Assuming that Lime is a domestic corporation and that Gustavo has held his stock for the entire year, the land is aqualified dividend .

As a result, the dividend is either tax-free (if Gustavo has a marginal rate of 10% or 15%) or subject to a 15% tax rate.

Gustavos basis in the land is its fair market value at distribution, or $300,000.

From Lime Corporations perspective, the distribution of appreciated property creates a deemed gain of $280,000.

$300,000 fair market value of the land less its $20,000 adjusted basis.

While the gain increases Limes E & P, the distributions to the shareholders reduce it by $200,000 for the cash and $200,000 for the land ($300,000 fair market value reduced by the $100,000 mortgage).

What If?

What if current E & P is less than the cash and land distributed to the shareholders?

Current E & P is applied pro rata to the cash and the land.

Since the amounts received by the two shareholders are equal ($200,000 each), the current E & P applied is taxed as a dividend

To the extent that the distributions are not covered by current E & P, accumulated E & P is then applied in a pro rata fashion.

However, Lime probably has a deficit in accumulated E & P.

As a result, the remaining amounts distributed to the two shareholders are:

First a tax-free recovery of stock basis, and

Any excess is taxed as a sale of the stock (probably classified as capital gain).

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. DonaldR. Trippeer, CPA

[email_address]

SUNY Oneonta

Date post:	22-Jan-2015
Category:	Technology
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Chapter 5 presentation

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