1. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Essentials of Taxation 1 Chapter 13 Corporations: Earnings & Profits and Distributions

2. The Big Picture (slide 1 of 3) Lime Corporation, an ice cream manufacturer, has had a very profitable year. –To share its profits with its two shareholders, it distributes the following: Cash of $200,000 to Orange Corporation, and Real estate worth $300,000 (adjusted basis of $20,000) to Gustavo. –The real estate is subject to a mortgage of $100,000, which Gustavo assumes. The distribution is made on December 31, Lime’s year-end.

3. The Big Picture (slide 2 of 3) Lime Corporation has had both good and bad years in the past. – More often than not, however, it has lost money. –Despite this year’s banner profits, the GAAP- based balance sheet for Lime indicates a year-end deficit in retained earnings. Consequently, the distribution of cash and land is treated as a liquidating distribution for financial reporting purposes, resulting in a reduction of Lime’s paid-in capital account.

4. The Big Picture (slide 3 of 3) The tax consequences of the distributions to the corporation and its shareholders depend on a variety of factors. –Identify these factors. Explain the tax effects of the distributions to both Lime Corporation and its 2 shareholders. Read the chapter and formulate your response.

5. Taxable Dividends Distributions from corporate earnings and profits (E & P) –Treated as a dividend distribution Taxed as ordinary income or as preferentially taxed dividend income Distributions in excess of E & P –Nontaxable to extent of shareholder’s basis (i.e., a return of capital) Excess distribution over basis is capital gain

6. Earnings & Profits (slide 1 of 2) No definition of E & P in Code Similar to Retained Earnings (financial reporting), but often not the same

7. Earnings & Profits (slide 2 of 2) E & P represents: –Upper limit on amount of dividend income recognized on corporate distributions –Corporation's economic ability to pay dividend without impairing capital

8. Calculating Earnings & Profits (slide 1 of 4) Calculation generally begins with taxable income, plus or minus certain adjustments –Add previously excluded income items and certain deductions to taxable income including: Muni bond interest Excluded life insurance proceeds Federal income tax refunds Dividends received deduction Domestic production activities deduction

9. Calculating Earnings & Profits (slide 2 of 4) Calculation generally begins with taxable income, plus or minus certain adjustments (cont’d) –Subtract certain nondeductible items: Nondeductible portion of meal and entertainment expenses Related-party losses Expenses incurred to produce tax-exempt income Federal income taxes paid Key employee life insurance premiums (net of increase in cash surrender value) Fines, penalties, and lobbying expenses

10. Calculating Earnings & Profits (slide 3 of 4) Certain E & P adjustments shift effect of transaction from the year of inclusion in or deduction from taxable income to year of economic effect, such as: –Charitable contribution carryovers –NOL carryovers –Capital loss carryovers Gains and losses from property transactions –Generally affect E & P only to extent recognized for tax purposes –Thus, gains and losses deferred under the like-kind exchange provision and deferred involuntary conversion gains do not affect E & P until recognized

11. Calculating Earnings & Profits (slide 4 of 4) Other adjustments –Accounting methods for E & P are generally more conservative than for taxable income, for example: Installment method is not permitted Alternative depreciation system required § 179 expense must be deducted over 5 years Percentage of completion must be used (no completed contract method)

12. Calculating Earnings & Profits (slide 4 of 4) Other adjustments –Accounting methods for E & P are generally more conservative than for taxable income, for example: Installment method is not permitted Alternative depreciation system required § 179 expense must be deducted over 5 years Percentage of completion must be used (no completed contract method)

13. Examples of E & P Adjustments (slide 1 of 2)

14. Examples of E & P Adjustments (slide 2 of 2)

15. Current vs Accumulated E & P (slide 1 of 3) Current E & P –Taxable income as adjusted

16. Current vs. Accumulated E & P (slide 2 of 3) Accumulated E & P –Total of all prior years’ current E & P (since February 28, 1913) reduced by distributions from E & P

17. Current vs. Accumulated E & P (slide 3 of 3) Distinguishing between current and accumulated E & P is important –Taxability of corporate distributions depends on how current and accumulated E & P are allocated to each distribution made during year

18. Allocating E & P to Distributions (slide 1 of 4) If positive balance in both current and accumulated E & P –Distributions are deemed made first from current E & P, then accumulated E & P –If distributions exceed current E & P, must allocate current and accumulated E & P to each distribution Allocate current E & P pro rata (using dollar amounts) to each distribution Apply accumulated E & P in chronological order

19. Allocating E & P to Distributions (slide 2 of 4) When the tax years of the corporation and its shareholders are not the same –May be impossible to determine the amount of current E & P on a timely basis –Allocation rules presume that current E & P is sufficient to cover every distribution made during the year until the parties can show otherwise

20. Allocating E & P to Distributions (slide 3 of 4) If current E & P is positive and accumulated E & P has a deficit –Accumulated E & P IS NOT netted against current E & P Distribution is deemed to be taxable dividend to extent of positive current E & P balance

21. The Big Picture – Example 11 Positive Current E & P, Deficit In Accumulated E & P Return to the facts of The Big Picture on p. 5–1. Lime Corp. had a deficit in GAAP-based retained earnings at the start of the year and banner profits during the year. –Assume that this translates into an $800,000 deficit in accumulated E & P at the start of the year and current E & P of $600,000. In this case, current E & P would exceed the total cash and property distributed to the shareholders. –The distributions are treated as taxable dividends. –They are deemed to be paid from current E & P even though Lime still has a deficit in accumulated E & P at the end of the year.

22. Allocating E & P to Distributions (slide 4 of 4) If accumulated E & P is positive and current E&P is a deficit, net both at date of distribution –If balance is zero or a deficit, distribution is a return of capital –If balance is positive, distribution is a dividend to the extent of the balance –Any current E & P is allocated ratably during the year unless the parties can show otherwise

23. Cash Distribution Example A $20,000 cash distribution is made at year end in each independent situation: 1 2 3*. Accumulated E & P, beginning of year100,000(100,000) 15,000 Current E & P 50,000 50,000(10,000) Dividend: 20,000 20,000 5,000 *Since there is a current deficit, current and accumulated E & P are netted before determining treatment of distribution.

24. Property Dividends (slide 1 of 4) Effect on shareholder: –Amount distributed equals FMV of property Taxable as dividend to extent of E & P Excess is treated as return of capital to extent of basis in stock Any remaining amount is capital gain

25. Property Dividends (slide 2 of 4) Effect on shareholder (cont’d): –Reduce amount distributed by liabilities assumed by shareholder –Basis of distributed property = fair market value

26. Property Dividends (slide 3 of 4) Effect on corporation: –Corp. is treated as if it sold the property for fair market value Corp. recognizes gain, but not loss –If distributed property is subject to a liability in excess of basis Fair market value is treated as not being less than the amount of the liability

27. Property Dividends (slide 4 of 4) Effect on corporation’s E & P: –Increases E & P for excess of FMV over basis of property distributed (i.e., gain recognized) –Reduces E & P by FMV of property distributed (or basis, if greater) less liabilities on the property –Distributions of cash or property cannot generate or add to a deficit in E & P Deficits in E & P can arise only through corporate losses

28. The Big Picture – Example 15 Property Dividends - Effect on the Shareholder Return to the facts of The Big Picture on p. 5–1. Lime Corporation distributed property to Gustavo, one of its shareholders. –Fair market value $300,000. –Adjusted basis $20,000. –Subject to a $100,000 mortgage, which Gustavo assumed. As a result, Gustavo has a taxable dividend of $200,000 –$300,000 (fair market value) – $100,000 (liability). –The basis of the property to Gustavo is $300,000.

29. The Big Picture – Example 17 Property Dividends - Effect on the Corporation Return to the facts of The Big Picture on p. 5–1. Lime Corporation distributed property to Gustavo, one of its shareholders. –Fair market value of $300,000 –Adjusted basis of $20,000 As a result, Lime recognizes a $280,000 gain on the distribution.

30. Property Distribution Example Property is distributed (corporation’s basis = $20,000) in each of the following independent situations. Assume Current and Accumulated E & P are both $100,000 in each case: 1 2 3. Fair market value of distributed property60,00010,00040,000 Liability on property -0- -0- 15,000 Gain(loss) recognized40,000 -0-20,000 E&P increased by gain40,000 -0-20,000 E & P decrease on dist.60,00020,00025,000

31. Constructive Dividend (slide 1 of 2) Any economic benefit conveyed to a shareholder may be treated as a dividend for tax purposes, even though not formally declared –Need not be pro rata

32. Constructive Dividend (slide 2 of 2) Usually arises with closely held corporations Payment may be in lieu of actual dividend and is presumed to take form for tax avoidance purposes Benefit conveyed is recharacterized as a dividend for all tax purposes –Corporate shareholders are entitled to the dividends received deduction –Other shareholders receive preferential tax rates

33. Examples of Constructive Dividends (slide 1 of 3) Shareholder use of corporate property at reduced cost or no cost (e.g., company car to non-employee shareholder) Bargain sale of property to shareholder (e.g., sale for $1,000 of property worth $10,000) Bargain rental of corporate property

34. Examples of Constructive Dividends (slide 2 of 3) Payments on behalf of shareholder (e.g., corporation makes payments to satisfy obligation of shareholder) Unreasonable compensation

35. Examples of Constructive Dividends (slide 3 of 3) Below market interest rate loans to shareholders High rate interest on loans from shareholder to corporation

36. Avoiding Unreasonable Compensation Documentation of the following attributes will help support payments made to an employee- shareholder: –Employee’s qualifications –Comparison of salaries with dividends made in past –Comparable salaries for similar positions in same industry –Nature and scope of employee’s work –Size and complexity of business –Corporation’s salary policy for other employees

37. Stock Dividends (slide 1 of 2) Excluded from income if pro rata distribution of stock, or stock rights, paid on common stock –Five exceptions to nontaxable treatment deal with various disproportionate distribution situations Effect on E & P –If nontaxable, E & P is not reduced –If taxable, treat as any other taxable property distribution

38. Stock Dividends (slide 2 of 2) Basis of stock received –If nontaxable If shares received are identical to shares previously owned, basis = (cost of old shares/total number of shares) If shares received are not identical, allocate basis of old stock between old and new shares based on relative fair market value Holding period includes holding period of formerly held stock –If taxable, basis of new shares received is fair market value Holding period starts on date of receipt

39. Stock Redemptions (slide 1 of 3) Generally result in dividend income for shareholder whose stock is redeemed unless shareholder surrenders significant control Section 302 allows sale or exchange treatment where either: –All of the shareholder’s stock is redeemed –After redemption, investor is a minority shareholder and owns less than 80% of the interest owned in the corporation before the redemption

40. Stock Redemptions (slide 2 of 3) When transaction is treated as a dividend, investor’s basis in redeemed shares does not disappear but attaches to remaining shares owned Other provisions also allow sale or exchange treatment for a stock redemption –In measuring the investor’s stock holdings before and after the redemption, shares owned by related taxpayers also are counted

41. Stock Redemptions (slide 3 of 3) The tax consequences for the redeeming corporation are summarized as follows –If noncash property is used to acquire redeemed shares, the corporation recognizes realized gain (but not loss) on distributed assets –E & P of redeeming corporation disappears to extent of the number of shares redeemed as a percentage of the shares outstanding before the buyback

42. Liquidations—In General Corporation winds up affairs, pays debts, and distributes remaining assets to shareholders –Produces sale or exchange treatment to shareholder –Liquidating corporation recognizes gains and losses upon distribution of its assets, with certain exceptions

43. Accumulated Earnings Tax Imposes a 20% tax on current year’s corporate earnings accumulated without a reasonable business need –Most businesses are allowed a $250,000 minimum credit –Beyond the minimum credit, earnings can be accumulated for: Working capital needs Retirement of debt incurred in connection with the business Investment or loans to suppliers or customers, or Realistic business contingencies, including lawsuits or self- insurance

44. Personal Holding Company (PHC) Tax (slide 1 of 2) Enacted to discourage sheltering income in corporations owned by individuals with high marginal tax rates Imposes a 20% tax –Designed to force a corporation to distribute earnings to shareholders –In any single year, the IRS cannot impose both the PHC tax and the accumulated earnings tax

45. Personal Holding Company (PHC) Tax (slide 2 of 2) A company is considered a PHC if: –More than 50% of the value of the outstanding stock was owned by five or fewer individuals at any time during the last half of the year, and –A substantial portion (60% or more) of corporation’s income is comprised of passive types of income (dividends, interest, rents, royalties, or certain personal service income)

46. Refocus On The Big Picture (slide 1 of 4) A number of factors affect the tax treatment of Lime Corporation’s distributions. The amount of current and accumulated E & P (which differ from retained earnings) partially determines the tax effect on the shareholders. –Given that Lime Corporation has had a highly profitable year, it is likely that there is sufficient current E & P to cover the distributions. If so, they are dividends to the shareholders rather than a return of capital. Orange Corporation receives $200,000 of dividend income that is mostly offset by the dividends received deduction. –The amount of the offsetting deduction depends on the ownership percentage that Orange has in Lime.

47. Refocus On The Big Picture (slide 2 of 4) Gustavo has $200,000 of dividend income (i.e., $300,000 value of the land less the $100,000 mortgage). –Assuming that Lime is a domestic corporation and that Gustavo has held his stock for the entire year, the land is a qualified dividend. As a result, the dividend is either tax-free (if Gustavo has a marginal rate of 10% or 15%) or subject to a 15% (or 20%) tax rate (depending on Gustavo’s marginal tax rate). –Gustavo’s basis in the land is its fair market value at distribution, or $300,000.

48. Refocus On The Big Picture (slide 3 of 4) From Lime Corporation’s perspective, the distribution of appreciated property creates a deemed gain of $280,000. –$300,000 fair market value of the land less its $20,000 adjusted basis. –While the gain increases Lime’s E & P, the distributions to the shareholders reduce it by $200,000 for the cash and $200,000 for the land ($300,000 fair market value reduced by the $100,000 mortgage).

49. Refocus On The Big Picture (slide 4 of 4) What If? What if current E & P is less than the cash and land distributed to the shareholders? Current E & P is applied pro rata to the cash and the land. –Since the amounts received by the two shareholders are equal ($200,000 each), the current E & P applied is taxed as a dividend –To the extent that the distributions are not covered by current E & P, accumulated E & P is then applied in a pro rata fashion. However, Lime probably has a deficit in accumulated E & P. As a result, the remaining amounts distributed to the two shareholders are: –First a tax-free recovery of stock basis, and –Any excess is taxed as a sale of the stock (probably classified as capital gain).

50. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 50 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta