4-1 ©2008 Prentice Hall, Inc.

4-2 ©2008 Prentice Hall, Inc. NONLIQUIDATING DISTRIBUTIONS  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

4-3 ©2008 Prentice Hall, Inc. 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 (generally taxed at 15%)

4-4 ©2008 Prentice Hall, Inc. 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

4-5 ©2008 Prentice Hall, Inc. 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 C4-1

4-6 ©2008 Prentice Hall, Inc. 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)

4-7 ©2008 Prentice Hall, Inc. 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

4-8 ©2008 Prentice Hall, Inc. 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)

4-9 ©2008 Prentice Hall, Inc. 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

4-10 ©2008 Prentice Hall, Inc. Nonliquidating Property Distributions  Shareholder consequences  Corporation’s consequences  Example C4-15  Example C4-16  Distribution’s effect on E&P  Constructive dividends

4-11 ©2008 Prentice Hall, Inc. 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

4-12 ©2008 Prentice Hall, Inc. 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

4-13 ©2008 Prentice Hall, Inc. Example C4-15 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

4-14 ©2008 Prentice Hall, Inc. Example C4-16 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

4-15 ©2008 Prentice Hall, Inc. 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

4-16 ©2008 Prentice Hall, Inc. 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

4-17 ©2008 Prentice Hall, Inc. 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

4-18 ©2008 Prentice Hall, Inc. 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 due to maximum 15% tax rate on dividends

4-19 ©2008 Prentice Hall, Inc. 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

4-20 ©2008 Prentice Hall, Inc. Stock Dividends & Stock Rights Tax-Free 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

4-21 ©2008 Prentice Hall, Inc. Stock Dividends & Stock Rights Tax-Free 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

4-22 ©2008 Prentice Hall, Inc. 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

4-23 ©2008 Prentice Hall, Inc. 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

4-24 ©2008 Prentice Hall, Inc. Stock Redemptions (2 of 2)  Redemptions not essentially equivalent to a dividend  Partial liquidations  Redemptions to pay death taxes  Redeeming corporation consequences

4-25 ©2008 Prentice Hall, Inc. Shareholder Consequences  Sale treatment produces capital gain or loss  Dividend treatment produces ordinary income on entire distribution  Generally taxed at 15%

4-26 ©2008 Prentice Hall, Inc. §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%

4-27 ©2008 Prentice Hall, Inc. §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

4-28 ©2008 Prentice Hall, Inc. 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

4-29 ©2008 Prentice Hall, Inc. Substantially Disproportionate Redemptions (2 of 2)  Receive sale treatment  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

4-30 ©2008 Prentice Hall, Inc. 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

4-31 ©2008 Prentice Hall, Inc. 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

4-32 ©2008 Prentice Hall, Inc. 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

4-33 ©2008 Prentice Hall, Inc. 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

4-34 ©2008 Prentice Hall, Inc. 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.

4-35 ©2008 Prentice Hall, Inc. 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

4-36 ©2008 Prentice Hall, Inc. Preferred Stock Bailouts  §306 in general  Dispositions of §306 stock  Redemptions of §306 stock  Exceptions to §306 treatment

4-37 ©2008 Prentice Hall, Inc. §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

4-38 ©2008 Prentice Hall, Inc. §306 in General (2 of 2)  If no Current or Accumulated E&P in issue year, §306 does not apply

4-39 ©2008 Prentice Hall, Inc. 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

4-40 ©2008 Prentice Hall, Inc. Redemptions of §306 stock  Same dividend treatment as sale of §306 stock  Corporation’s E&P reduced by amount realized

4-41 ©2008 Prentice Hall, Inc. 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

4-42 ©2008 Prentice Hall, Inc. 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

4-43 ©2008 Prentice Hall, Inc. 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

4-44 ©2008 Prentice Hall, Inc. 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

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