©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

NONLIQUIDATING DISTRIBUTIONS (2 of 2) Tax planning Compliance and procedural considerations ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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% through 2010) ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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) ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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) ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

Nonliquidating Property Distributions Shareholder consequences Corporation’s consequences Example 15 Example 16 Distribution’s effect on E&P Constructive dividends ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

Stock Redemptions (2 of 2) Redemptions not essentially equivalent to a dividend Partial liquidations Redemptions to pay death taxes Redeeming corporation consequences ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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

§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% ©2010 Pearson Education, Inc. Publishing as Prentice Hall

§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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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. ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

Preferred Stock Bailouts §306 in general Dispositions of §306 stock Redemptions of §306 stock Exceptions to §306 treatment ©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall §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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall §306 in General (2 of 2) If no Current or Accumulated E&P in issue year, §306 does not apply ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall Redemptions of §306 stock Same dividend treatment as sale of §306 stock Corporation’s E&P reduced by amount realized ©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 issuing corp (if necessary) is reduced Basis of redeemed stock added to basis of stock held in acquiring corp ©2010 Pearson Education, Inc. Publishing as Prentice Hall

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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

Compliance and Procedural Considerations Corporate reporting of nondividend distributions Agreement to terminate interest under §302(b)(3) ©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall