1 CORPORATE TAXATION I Today Today Finish Problem on Page 172Finish Problem on Page 172 General UtilitiesGeneral Utilities IRC § 311(a) & (b) and § 312IRC § 311(a) & (b) and § 312 Problem on Page 177Problem on Page 177 Distributions of Corporate ObligationsDistributions of Corporate Obligations Problem on Page 179Problem on Page 179 Nicholls v. CommissionerNicholls v. Commissioner Revenue Ruling Revenue Ruling Limitations on § 311(b)Limitations on § 311(b) Problem on Page 193Problem on Page 193

2 Problem on Page 172 Ann owns 100% of Pelican and her basis in the stock is $10K Ann owns 100% of Pelican and her basis in the stock is $10K 1(d) 1(d) 10K of current deficit in E&P and accumulated E&P of $10K10K of current deficit in E&P and accumulated E&P of $10K On April 1, Pelican distributes $10K to AnnOn April 1, Pelican distributes $10K to Ann On July 1, Ann sells ½ her stock to Baker Corp for $15KOn July 1, Ann sells ½ her stock to Baker Corp for $15K On October 1, Pelican distributes $5K to Ann and $5K to BakerOn October 1, Pelican distributes $5K to Ann and $5K to Baker

3 Problem on Page 172 Historical E&P with a current loss? YES. Historical E&P with a current loss? YES. Is the loss earmark-able to a particular part of the year? Is the loss earmark-able to a particular part of the year? No, so the loss is prorated over the year and then calculate the E&P at the time of the distributionNo, so the loss is prorated over the year and then calculate the E&P at the time of the distribution Historical E&P available on April 1 = $7,500Historical E&P available on April 1 = $7,500 Historical E&P available on October 1 = zeroHistorical E&P available on October 1 = zero

4 Problem on Page 172 Result: Result: April 1 distributionApril 1 distribution Historical E&P is applied on a 1 st come, 1 st serve basis. $7,500 is used to cover the balance of the April 1 distribution to Ann. The remaining $2,500 is a return of basis (resulting in a basis of $7,500) Historical E&P is applied on a 1 st come, 1 st serve basis. $7,500 is used to cover the balance of the April 1 distribution to Ann. The remaining $2,500 is a return of basis (resulting in a basis of $7,500) July Sale to BakerJuly Sale to Baker Ann’s basis in the stock sold at the time is $3,750K (1/2 her total basis) Ann’s basis in the stock sold at the time is $3,750K (1/2 her total basis) Proceeds is $15K Proceeds is $15K Gain on the sale is $11,250 Gain on the sale is $11,250

5 Problem on Page 172 October 1 distribution October 1 distribution Since there are no E&P on October 1 (i.e. a deficit of $5K), the entire $10,000 of the distribution is not a dividendSince there are no E&P on October 1 (i.e. a deficit of $5K), the entire $10,000 of the distribution is not a dividend For Baker, this is a return of capital reducing its basis from $15K to $10,000 For Baker, this is a return of capital reducing its basis from $15K to $10,000 For Ann, who still has $3,750K of basis, all $3,750K is return of basis and her remaining basis is zero. The additional $1,250 is capital gains. For Ann, who still has $3,750K of basis, all $3,750K is return of basis and her remaining basis is zero. The additional $1,250 is capital gains.

6 General Utilities Facts: Corporation negotiated the sale of appreciated corporate assets. In an effort to avoid the corporate level gain on the sale, it distributed the assets to its shareholders, who, several days later, sold the assets on the terms and conditions negotiated by the corporation prior to the distribution. Facts: Corporation negotiated the sale of appreciated corporate assets. In an effort to avoid the corporate level gain on the sale, it distributed the assets to its shareholders, who, several days later, sold the assets on the terms and conditions negotiated by the corporation prior to the distribution. Issues: was the gain on the sale taxable to the corporation either under an assignment of income theory or on the theory that the corporation had created an obligation to it’s shareholders that it satisfied through the distribution of appreciated property? Issues: was the gain on the sale taxable to the corporation either under an assignment of income theory or on the theory that the corporation had created an obligation to it’s shareholders that it satisfied through the distribution of appreciated property? Supreme Court stated that it was not an obligation to the shareholders and that the assignment of income was not properly raised below Supreme Court stated that it was not an obligation to the shareholders and that the assignment of income was not properly raised below

7 IRC § 311(a) and § 312(a) IRC § 311(a) – No recognition of gain or loss on the distribution of assets to its shareholders. IRC § 311(a) – No recognition of gain or loss on the distribution of assets to its shareholders. Shareholder receives a distribution equal to the FMV of the asset distributed. There was no gain or loss to be recognized for purposes of corporate income tax.Shareholder receives a distribution equal to the FMV of the asset distributed. There was no gain or loss to be recognized for purposes of corporate income tax. IRC § 312(b) – E&P are adjusted by the Corporation’s Adjusted Basis in the property distributed IRC § 312(b) – E&P are adjusted by the Corporation’s Adjusted Basis in the property distributed

8 IRC § 311(b) and § 312(b) IRC § 311(b) – In an non-liquidating distribution of assets (other than its own corporate obligations), a corporation must recognize gain (but not loss) on the distribution of assets to its shareholders in an amount equal to the difference between the Fair Market Value and the Corporation’s basis in the assets. IRC § 311(b) – In an non-liquidating distribution of assets (other than its own corporate obligations), a corporation must recognize gain (but not loss) on the distribution of assets to its shareholders in an amount equal to the difference between the Fair Market Value and the Corporation’s basis in the assets. IRC § 312(b) –in the case of appreciated property subject to § 311(b), the Fair Market Value is substituted for the Adjusted Basis in the E&P adjustment that results from the distribution IRC § 312(b) –in the case of appreciated property subject to § 311(b), the Fair Market Value is substituted for the Adjusted Basis in the E&P adjustment that results from the distribution

9 Problem on Page 177 Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has $25K in accumulated E&P. Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has $25K in accumulated E&P. Scenario (a): Sturdley distributes inventory with a basis of $11K and a FMV of $20K. Scenario (a): Sturdley distributes inventory with a basis of $11K and a FMV of $20K. Under § 311(b), corporation realizes gain of $9K on the distribution which also results in an increase in current E&P of $9K. The character of the gain is determined by the type of the asset being sold (i.e. Inventory so the gain is ordinary).Under § 311(b), corporation realizes gain of $9K on the distribution which also results in an increase in current E&P of $9K. The character of the gain is determined by the type of the asset being sold (i.e. Inventory so the gain is ordinary).

10 Problem on Page 177 Outcome: Outcome: Corporation has $9K of ordinary incomeCorporation has $9K of ordinary income At the time of the distribution the corporation has $9K of current E&P (from the deemed sale) and $25K of accumulated E&P. Thus, the entire amount of the distribution is a dividend ($9K out of current and $11K out of accumulated)At the time of the distribution the corporation has $9K of current E&P (from the deemed sale) and $25K of accumulated E&P. Thus, the entire amount of the distribution is a dividend ($9K out of current and $11K out of accumulated) The corporation will start the next year with $25K-$11K=$14K of E&PThe corporation will start the next year with $25K-$11K=$14K of E&P Shareholder takes a FMV basis in the inventoryShareholder takes a FMV basis in the inventory

11 Problem on Page 177 Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has no accumulated E&P. Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has no accumulated E&P. Scenario (b): Sturdley distributes inventory with a basis of $11K and a FMV of $20K. Scenario (b): Sturdley distributes inventory with a basis of $11K and a FMV of $20K. Under § 311(b), corporation realizes gain of $9K on the distribution which also results in an increase in current E&P of $9K. The character of the gain is determined by the type of the asset being sold (i.e. Inventory so the gain is ordinary).Under § 311(b), corporation realizes gain of $9K on the distribution which also results in an increase in current E&P of $9K. The character of the gain is determined by the type of the asset being sold (i.e. Inventory so the gain is ordinary).

12 Problem on Page 177 Outcome: Outcome: Corporation has $9K of ordinary incomeCorporation has $9K of ordinary income At the time of the distribution the corporation has $9K of current E&P (from the deemed sale) and no accumulated E&P. Thus, the amount of the distribution that is a dividend equals $9K.At the time of the distribution the corporation has $9K of current E&P (from the deemed sale) and no accumulated E&P. Thus, the amount of the distribution that is a dividend equals $9K. The corporation will start the next year with zero in accumulated E&PThe corporation will start the next year with zero in accumulated E&P Of the $11K that is not a dividend, $8K is a return of basis and $3K is capital gains on the sale of Sturdley Utilities, Inc. stock (i.e. LTCG since it was held 7 years).Of the $11K that is not a dividend, $8K is a return of basis and $3K is capital gains on the sale of Sturdley Utilities, Inc. stock (i.e. LTCG since it was held 7 years). Shareholder takes a FMV basis in the inventory (i.e. $20K)Shareholder takes a FMV basis in the inventory (i.e. $20K)

13 Problem on Page 177 E&P of Sturdley Utilities, Inc. E&P of Sturdley Utilities, Inc. Starting accumulated E&P = ZeroStarting accumulated E&P = Zero Current E&P from the deemed sale = $9KCurrent E&P from the deemed sale = $9K Dividend = -$9KDividend = -$9K Ending accumulated E&P = ZeroEnding accumulated E&P = Zero

14 Problem on Page 177 Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has no accumulated E&P. Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has no accumulated E&P. Scenario (c): Sturdley distributes land with a basis of $11K, a FMV of $20K and subject to a $16K mortgage. Scenario (c): Sturdley distributes land with a basis of $11K, a FMV of $20K and subject to a $16K mortgage. Under § 311(b), corporation realizes gain of $9K on the distribution which also results in an increase in current E&P of $9K. The character of the gain is determined by the type of the asset being sold (i.e. land so the gain is determined by § 1231).Under § 311(b), corporation realizes gain of $9K on the distribution which also results in an increase in current E&P of $9K. The character of the gain is determined by the type of the asset being sold (i.e. land so the gain is determined by § 1231).

15 Problem on Page 177 Outcome: Outcome: Corporation has $9K of gainCorporation has $9K of gain At the time of the distribution the corporation has $9K of current E&P (from the deemed sale) and $25K of accumulated E&P. The distribution is $20 minus the liability assumed (i.e. $16K) or $4K. All $4K is deemed to be dividend as there is $34K of E&P at the time ($25 plus $9K). Thus, all $4k is taken out of the Current $9K of E&P.At the time of the distribution the corporation has $9K of current E&P (from the deemed sale) and $25K of accumulated E&P. The distribution is $20 minus the liability assumed (i.e. $16K) or $4K. All $4K is deemed to be dividend as there is $34K of E&P at the time ($25 plus $9K). Thus, all $4k is taken out of the Current $9K of E&P. The corporation will start the next year with $34K-$4K (i.e. $20K-$16K)=$30K of E&PThe corporation will start the next year with $34K-$4K (i.e. $20K-$16K)=$30K of E&P Shareholder takes a FMV basis in the land of $20K (the $16K is included in the Shareholder’s basis under Crane).Shareholder takes a FMV basis in the land of $20K (the $16K is included in the Shareholder’s basis under Crane).

16 Problem on Page 177 Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has no accumulated E&P. Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has no accumulated E&P. Scenario (d): Sturdley distributes land with a basis of $30K, a FMV of $20K. Scenario (d): Sturdley distributes land with a basis of $30K, a FMV of $20K. Under § 311(a), corporation realizes no loss on the distribution.Under § 311(a), corporation realizes no loss on the distribution. Outcome: Outcome: Shareholder takes a FMV basis in the land of $20KShareholder takes a FMV basis in the land of $20K Sturdley takes a hit to E&P of $30K (the adjusted basis of the land) under § 312(a)Sturdley takes a hit to E&P of $30K (the adjusted basis of the land) under § 312(a) Accumulated E&P for the following year will be $25 + $15K - $30K = $10KAccumulated E&P for the following year will be $25 + $15K - $30K = $10K

17 Problem on Page 177 Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has no accumulated E&P. Facts: Zane owns 100% of the stock in Sturdley Utilities, Inc. Zane’s basis in his stock is $8K. Sturdley has no accumulated E&P. Scenario (d): Sturdley distributes machinery with an adjusted basis of $0K (for tax purposes) and a FMV of $10K. Scenario (d): Sturdley distributes machinery with an adjusted basis of $0K (for tax purposes) and a FMV of $10K. Under § 311(b), corporation realizes a gain of $10K on the distribution.Under § 311(b), corporation realizes a gain of $10K on the distribution. Outcome: Outcome: Shareholder takes a FMV basis in the machinery of $10KShareholder takes a FMV basis in the machinery of $10K Sturdley increases its E&P by $8K (difference between E&P basis and FMV) under § 312(b)Sturdley increases its E&P by $8K (difference between E&P basis and FMV) under § 312(b) Accumulated E&P for the following year will be $25 + $8K - $10K = $23KAccumulated E&P for the following year will be $25 + $8K - $10K = $23K

18 Problem on Page 179 Corporation has accumulated E&P of 100K. Distribution of the Corporations obligation with a FMV of $5K and a subsequent distribution of $100K in cash. Corporation has accumulated E&P of 100K. Distribution of the Corporations obligation with a FMV of $5K and a subsequent distribution of $100K in cash. Outcome: Outcome: Shareholder takes a $5K basis in the noteShareholder takes a $5K basis in the note Shareholder has received a dividend of $5K and following the distribution, shareholder has $95K of E&PShareholder has received a dividend of $5K and following the distribution, shareholder has $95K of E&P Upon the distribution of the $100K, $95K is dividend (the amount of the remaining E&P) and $5K is a return of basis (reducing Andy’s basis to $95K)Upon the distribution of the $100K, $95K is dividend (the amount of the remaining E&P) and $5K is a return of basis (reducing Andy’s basis to $95K)

19 Nicholls v. Commissioner Constructive Distributions Constructive Distributions Herbert Resenhoeft is the majority shareholder of Nicholls. Nicholls buys a yacht (the company’s 3 rd ) for “corporate” use, but his son ends up using the yacht 75% of the time for personal pleasureHerbert Resenhoeft is the majority shareholder of Nicholls. Nicholls buys a yacht (the company’s 3 rd ) for “corporate” use, but his son ends up using the yacht 75% of the time for personal pleasure Issue: Is this a constructive dividend to Herbert? If so, what is the amount of the dividend (the cost of the yacht or the rental value of 75% of the total rental value for the year)? Issue: Is this a constructive dividend to Herbert? If so, what is the amount of the dividend (the cost of the yacht or the rental value of 75% of the total rental value for the year)? Court Opinion: yes, it is a constructive dividend. Since the corporation retained ownership in all respects of the yacht, the proper amount of the dividend is the rental value of the use of the yacht Court Opinion: yes, it is a constructive dividend. Since the corporation retained ownership in all respects of the yacht, the proper amount of the dividend is the rental value of the use of the yacht

20 Revenue Ruling A owns 100% of corporations X & Y A owns 100% of corporations X & Y A has X sell assets to Y at a below market rate A has X sell assets to Y at a below market rate Deemed to be a distribution to A of the assets invoking the § 311(b) rules of gain to X and a Dividend to A Deemed to be a distribution to A of the assets invoking the § 311(b) rules of gain to X and a Dividend to A A is then deemed to have made a contribution to capital in Y of the same assets A is then deemed to have made a contribution to capital in Y of the same assets

21 Limitations Dividends received Deduction Testing Period for Common Stock Dividends received Deduction Testing Period for Common Stock Dividends received Deduction Testing Period for Preferred Stock Dividends received Deduction Testing Period for Preferred Stock If the corporate shareholder does not own the stock for the requisite period, then it does not get the dividends received deduction If the corporate shareholder does not own the stock for the requisite period, then it does not get the dividends received deduction DividendEx-dividend Date Test Period 45-days Pre-Ex-dividend 45-day Post-Ex-dividend DividendEx-dividend Date Test Period 90-days Pre-Ex-dividend 90-day Post-Ex-dividend

22 Limitations on § 311(b) Extraordinary Dividends under § 1059 Extraordinary Dividends under § 1059 For corporate shareholders onlyFor corporate shareholders only

23 Problem on Page 193