McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 18 Corporate Taxation: Nonliquidating Distributions

18-2 Learning Objectives 1. Explain the basic tax law framework that applies to property distributions from a corporation to a shareholder 2. Compute a corporation’s earnings and profits and calculate the dividend amount received by a shareholder 3. Identify situations in which a corporation may be deemed to have paid a “constructive dividend” to a shareholder 4. Comprehend the basic tax rules that apply to stock dividends

18-3 Learning Objectives 4. Comprehend the different tax consequences that can arise from stock redemptions 5. Contrast a partial liquidation from a stock redemption and describe the difference in tax consequences to the shareholders

18-4 Framework for Property Distributions Corporations cannot deduct dividend distributions and this creates the “double taxation” of the corporation’s income. Distributions to shareholders generally receive preferential tax treatment: Dividends may be taxed as income (albeit at a lower tax rate). Distributions may result in a tax-free return of capital. Distributions may result in capital gains.

18-5 Framework for Property Distributions Some payments to shareholders are deductible by the corporation if the payment relates to other services provided by the shareholder (such as salary, bonus, interest, or rent). If these payments are unreasonable, then the distribution is a constructive dividend and the payment is no longer deductible.

18-6 Overview of distributions: The portion of a distribution that is a dividend is included in the shareholder’s gross income. The portion of the distribution that is not a dividend reduces the shareholder’s tax basis in the corporation’s stock The portion of the distribution that is not a dividend and is in excess of the shareholder’s stock tax basis is treated as gain from sale or exchange of the stock Computing Earnings and Profits

18-7 A “dividend” for tax purposes is: any distribution of property made by a corporation to its shareholders out of its earnings and profits (E&P) Two separate E&P accounts to be maintained Current earnings and profits Accumulated earnings and profits Current E&P not distributed to shareholders is added to accumulated E&P at the beginning of the next taxable year Determining the Dividend

18-8 Computing Earnings and Profits Adjustments fall into four broad categories: Income that is excluded from taxable income Disallowed deductions that do not require an economic outflow Deduction of expenses that require an economic outflow but are not deducted for computing taxable income Adjustment of timing for deductions or income because of accounting methods required for E&P computation Determining the Dividend

18-9 Ordering of E&P Distributions Positive Current E&P and Positive Accumulated E&P Positive current E&P, negative accumulated E&P Negative current E&P, positive accumulated E&P Negative current E&P, negative accumulated E&P Determining the Dividend

18-10 Tax Consequences to a Corporation Paying Noncash Property as a Dividend The corporation recognizes gains (but not losses) on the distribution of noncash property as a dividend Gain is recognized to the extent of fair market value in excess of tax basis in the property Liabilities If the property’s fair market value is less than liabilities assumed by the shareholder, the fair market value is deemed to be the liability Determining the Dividend

18-11 Stock Dividends A stock dividend increases the number of shares outstanding and thereby reduces the (value) price per share. Most stock dividends take the form of a stock split, which is a 2-for-1 stock dividend. Stock dividends are nontaxable to shareholders if two conditions are met: Made with respect to common stock and Pro rata (proportionate interests maintained)

18-12 Stock Redemptions Form of a Stock Redemption A redemption occurs when a corporation acquires its stock from a shareholder in exchange for property It does not matter if the acquired stock is canceled, retired, or held as treasury stock. A redemption may result in a dividend to the shareholder or a sale of the redeemed shares. Individuals prefer exchange treatment because of the preferential tax rates for capital gains. Corporate shareholders prefer dividend treatment because of the dividends received deduction.

18-13 Three types of redemptions are treated as exchanges: Redemptions that are Substantially Disproportionate are treated as sales. Redemptions in Complete Redemption of all of the Stock of the Corporation Owned by the Shareholder Redemptions that are not Essentially Equivalent to a Dividend Stock Redemptions

18-14 Stock ownership tests are required for treatment as substantially disproportionate: The shareholder owns less than 50 percent of the voting power immediately after the exchange The shareholder’s percentage of voting stock and aggregate value after the redemption is less than 80 percent of the percentage before the redemption In computing the percentage ownership tests, the constructive ownership rules must be considered:  Family attribution  Attribution from entities to owners or beneficiaries  Attribution from owners or beneficiaries to entities  Option attribution Stock Redemptions

18-15 If the redemption is treated as an exchange Gain is always recognized. Loss is recognized unless the shareholder is a related person to the corporation (§267) – Shareholder owns more than 50% of the stock’s value. Ownership is determined using the §267(c) attribution rules. “Family” attribution now includes the taxpayer’s brothers and sisters, spouse, ancestors, and lineal descendents. The basis of the property received is fair market value. Stock Redemptions

18-16 Stock Redemptions Tax Consequences to the Distributing Corporation If the redemption is a dividend, then E&P is reduced by the cash and fair market value of other property distributed. If the redemption is an exchange, E&P is reduced by the percentage of stock redeemed, not to exceed the fair market value of the property distributed. E&P is reduced by dividends before reducing its E&P for redemptions treated as exchanges.

18-17 Partial Liquidations Corporations can contract either by: Distributing stock of a subsidiary to shareholders Selling a business and distributing the proceeds to shareholders in partial liquidation. Distributions may require the shareholders to exchange some shares of stock or may be pro rata to all the shareholders without an actual exchange of stock. Noncorporate shareholders receive exchange treatment Corporate shareholders determine their tax consequences using the change-in-stock ownership rules that apply to stock redemptions.