McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Principles of Taxation: Advanced Strategies Chapter 7 Chapter 7 Distributions to Business Owners Distributions to Business Owners Slide 7-1

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc C Corporations Subject to double taxation Subject to double taxation Distributions out of earnings and profits taxable to shareholders as dividends Distributions out of earnings and profits taxable to shareholders as dividends Slide 7-2

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Earnings and Profits Slide 7-3 Two types: Two types:  Current Earnings and profits  Accumulated Earnings and profits Any payment out of either account will result in a taxable dividend to the shareholder Any payment out of either account will result in a taxable dividend to the shareholder

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Current Earnings and Profits Any distribution not in excess of current earnings and profits is a dividend Any distribution not in excess of current earnings and profits is a dividend Negative accumulated earnings and profits ignored if current earnings and profits positive Negative accumulated earnings and profits ignored if current earnings and profits positive Slide 7-4

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Accumulated Earnings and Profits Current earnings and profits reduced by dividends added into accumulated earnings and profits Current earnings and profits reduced by dividends added into accumulated earnings and profits If current earnings and profits is negative, it is netted from accumulated earnings and profits to determine if a distribution is a dividend If current earnings and profits is negative, it is netted from accumulated earnings and profits to determine if a distribution is a dividend Slide 7-5

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Nondividend Distributions Any distribution in excess of earnings and profits Any distribution in excess of earnings and profits Treated as a return of capital to extent of stock basis Treated as a return of capital to extent of stock basis  Stock basis must be reduced by nontaxable portion Any excess is capital gain Any excess is capital gain Slide 7-6

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Property Distributions Distributions of appreciated property cause a corporation to recognize gain Current earnings and profits also increased as a result of the gain recognized Losses not recognized on distributions of depreciated property Slide 7-7

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Stock Dividends Distributions of additional shares of stock Distributions of additional shares of stock Generally nontaxable to shareholder Generally nontaxable to shareholder Will be treated as a taxable distribution if shareholders can choose between stock and cash Will be treated as a taxable distribution if shareholders can choose between stock and cash Slide 7-8

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Constructive Dividends Slide 7-9 Payments or transfers for the benefit of the shareholders Payments or transfers for the benefit of the shareholders Treated as taxable dividends Treated as taxable dividends Examples: Examples:  Corporation pays personal expenses  Use of corporate property for personal purposes  Unreasonable compensation to shareholder/employee

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Penalty Taxes Designed to prevent conversion of ordinary income into capital gain by appreciation of corporate stock Designed to prevent conversion of ordinary income into capital gain by appreciation of corporate stock Types: Types:  Accumulated earnings tax  Personal holding company tax Slide 7-10

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Accumulated Earnings Tax Tax imposed upon corporation if a corporation accumulates funds beyond reasonable need of the business Tax imposed upon corporation if a corporation accumulates funds beyond reasonable need of the business Tax imposed at the highest individual income tax rate in effect for the year (38.7% for 2002) Tax imposed at the highest individual income tax rate in effect for the year (38.7% for 2002) Slide 7-11

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Accumulated Earnings Tax Base Tax imposed on after tax income reduced by Tax imposed on after tax income reduced by  Any dividends paid during the period  Accumulated earnings tax credit  Amount needed by corporation to meet reasonable business needs  Never less than $ 250,000 except for personal service corporations Slide 7-12

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Personal Holding Company Tax Imposed at the highest individual tax rate (38.7% for 2002) on undistributed personal holding company taxable income Imposed at the highest individual tax rate (38.7% for 2002) on undistributed personal holding company taxable income Corporation must be a personal holding company Corporation must be a personal holding company Slide 7-13

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Personal Holding Company 60% of ordinary adjusted income from investment sources such as dividends, interest, rent and royalties 60% of ordinary adjusted income from investment sources such as dividends, interest, rent and royalties Five or fewer individuals own directly or indirectly more than 50% of stock during the last half of the year Five or fewer individuals own directly or indirectly more than 50% of stock during the last half of the year Slide 7-14

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Undistributed Personal Holding Company Taxable Income Slide 7-15 Taxable income less dividends paid Taxable income less dividends paid Deficiency dividends can be paid to eliminate the tax Deficiency dividends can be paid to eliminate the tax

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Partnership Distributions Two types: Two types:  Current distribution – reduces partner’s capital account  Liquidating distribution – extinguishes partner’s interest in partnership Slide 7-16

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Cash Distributions Generally nontaxable Generally nontaxable  Exception: cash distribution in excess of partner’s outside basis Distributions reduce outside basis Distributions reduce outside basis Slide 7-17

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Property Distributions – Accounting Treatment Gain or loss recognized on distribution to extent property exceeds or is less than fair market value. Gain or loss recognized on distribution to extent property exceeds or is less than fair market value. Partner’s capital account reduced by fair market value of distribution Partner’s capital account reduced by fair market value of distribution  Exception: Basis of property received by partner cannot exceed partner’s outside basis before the distribution Slide 7-18

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Property Distributions – Tax Consequences Generally nontaxable to partner Generally nontaxable to partner No gain or loss recognized to partnership No gain or loss recognized to partnership Partner’s basis in property is same as partnership’s basis in property Partner’s basis in property is same as partnership’s basis in property Slide 7-19

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc S Corporation Distributions Generally nontaxable as long as does not exceed shareholder’s basis in stock Generally nontaxable as long as does not exceed shareholder’s basis in stock Cash distribution decreases shareholder’s basis in S corporation stock Cash distribution decreases shareholder’s basis in S corporation stock Slide 7-20

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Special Rules for S Corporations with Earnings and Profits Only applies to S corporations that were formerly C corporations Only applies to S corporations that were formerly C corporations Special rules do not apply if C corporation had no earnings and profits when S election made or all earnings and profits distributed Special rules do not apply if C corporation had no earnings and profits when S election made or all earnings and profits distributed Slide 7-21

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc S Corporations with E and P Cash distributions nontaxable to extent do not exceed accumulated adjustments account (AAA) Cash distributions nontaxable to extent do not exceed accumulated adjustments account (AAA) Any amount in excess of AAA treated as a taxable dividend to extent of earnings and profits Any amount in excess of AAA treated as a taxable dividend to extent of earnings and profits Any amount in excess of earnings and profits is a nontaxable return of capital up to shareholder’s basis in stock Any amount in excess of earnings and profits is a nontaxable return of capital up to shareholder’s basis in stock Slide 7-22

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Accumulated Adjustments Account Represents undistributed S corporation earnings Represents undistributed S corporation earnings Cash distributions reduce account Cash distributions reduce account Losses reduce AAA Losses reduce AAA Any distribution during a loss year is deemed made before account is decreased for the loss Any distribution during a loss year is deemed made before account is decreased for the loss Slide 7-23

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc C Corporation Conversions S corporations reverting to C corporations have a favorable transition rule on distributions S corporations reverting to C corporations have a favorable transition rule on distributions  Any distribution made within one year of conversion is nontaxable as long as AAA not exceeded Slide 7-24

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Property Distributions Generally C corporation rules apply to S corporations making these distributions Generally C corporation rules apply to S corporations making these distributions Gains but not losses recognized Gains but not losses recognized Slide 7-25