Chapter 5 Corporations: Earnings & Profits and Dividend Distributions

1. 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
2. Calculating Earnings & Profits
 E & P represents:
Upper limit on amount of dividend income recognized on corporate distributions
Corporation's economic ability to pay dividend without impairing capital
 Calculation generally begins with taxable income, plus or minus certain adjustments
[1] Add previously excluded income items and certain deductions to taxable income including:
o Muni bond interest
o Excluded life insurance proceeds
o Federal income tax refunds
o Dividends received deduction
o Domestic production activities deduction
[2] Subtract certain nondeductible items:
o Nondeductible portion of meal and entertainment expenses
o Related-party losses
o Expenses incurred to produce tax-exempt income
o Federal income taxes paid
o Key employee life insurance premiums (net of increase in cash surrender value)
o Fines, penalties, and lobbying expenses
[3] 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:
o Charitable contribution carryovers
o NOL carryovers
o Capital loss carryovers
o 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
[4] Other adjustments: Accounting methods for E & P are generally more conservative than for taxable income:
o Installment method is not permitted: recognized the gain no matter when the money is received.
o Alternative depreciation system required
o §179 expense (tangible depreciable personalty 250,000/125,000, limitation, over 800,000) must be deducted
over 5 years, so add back 80%, 60%, 40%, 20%.
o Percentage of completion must be used (no completed contract method)
o Not allow the amortization of organizational expenses
o LIFO vs. FIFO?
 o E & P rules also specify that intangible drilling costs and mine exploration and development costs be
amortized over a period of 60 months and 120 months, respectively, which are deducted in the current year.
3. Current vs Accumulated E & P
[1] Current E & P: Taxable income as adjusted
[2] Accumulated E & P: Total of all prior years’ current E & P (since February 28, 1913) reduced by
distributions from E & P
[3] Distinction between current and accumulated E & P is important
o Taxability of corporate distributions depends on how current and accumulated E & P are allocated to each
distribution made during year
4. Allocating E & P to Distributions
[1] If positive balance in both current and accumulated E&P, distributions are deemed made first from current
E&P, then accumulated E&P
o If distributions exceed current E&P, must allocate current and accumulated E & P to each distribution
o Allocate current E&P pro rata (using dollar amounts) to each distribution; apply accumulated E&P in
chronological order, beginning with the earliest distribution
[2] If current E&P is positive and accumulated E&P has a deficit, accumulated E&P IS NOT netted against
current E&P
o Distribution is deemed to be taxable dividend to extent of positive current E&P balance
[3] If accumulated E&P is positive and current E&P is a deficit, net both at date of distribution
o If balance is zero or a deficit, distribution is a return of capital
o If balance is positive, distribution is a dividend to the extent of the balance
[4] Any current E&P loss is allocated ratably during the year unless the parties can show otherwise
5. Qualified Dividends
[1] For individual taxpayers, qualified dividends are subject to a max 15% tax rate
o Beginning in 2008, qualified dividends are exempt from tax for taxpayers in the 10% or 15% rate brackets
o The lower rates on dividend income apply to both the regular income tax and the alternative minimum tax
[2] Corporations treat dividends as ordinary income and are permitted a dividends received deduction
[3] To qualify for lower rates, dividends must be:
o Paid by domestic or certain qualified foreign corps
o Qualified foreign corps include those traded on a U.S. stock exchange or any corp. located in a country that:
 Has a comprehensive income tax treaty with the U.S.
 Has an information-sharing agreement with the U.S. and
 Is approved by the Treasury
o Paid on stock held > 60 days during the 121-day period beginning 60 days before the ex-dividend date
o Dividends paid to shareholders who hold both long and short positions in the stock do not qualify
[4] Qualified dividends are not considered investment income for purposes of determining the investment
interest expense deduction
o An election is available to treat qualified dividends as ordinary income (taxed at regular rates) and include
them in investment interest income
o Thus, taxpayers subject to an investment interest expense limitation must compare relative benefits of low
tax on qualifying dividends vs. increased amount of deductible investment interest expense
6. Property Dividends
[1] Effect on shareholder:
 o 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
 Reduce amount distributed by liabilities assumed by shareholder
 Basis of distributed property = fair market value
[2] Effect on corporation:
o Corp. is treated as if it sold the property for fair market value
 Corp. recognizes gain, but not loss
o 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
[3] Effect on corporation’s E & P:
o Increases E & P for excess of FMV over basis of property distributed (i.e., gain recognized)
o Reduces E & P by FMV of property distributed (or basis, if greater) less liabilities on the property
o 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
7. Constructive Dividend
[1] Any economic benefit conveyed to a shareholder may be treated as a dividend for tax purposes, even though
not formally declared
o Need not be pro rata
[2] Usually arises with closely held corporations
[3] Payment may be in lieu of actual dividend and is presumed to take form for tax avoidance purposes
[4] Benefit conveyed is recharacterized as a dividend for all tax purposes
o Corporate shareholders are entitled to the dividends received deduction
o Other shareholders receive preferential tax rates
Examples of Constructive Dividends
o Shareholder use of corporate property at reduced cost or no cost (e.g., company car to non-employee
shareholder)
o Bargain sale of property to shareholder (e.g., sale for $1,000 of property worth $10,000)
o Bargain rental of corporate property
o Payments on behalf of shareholder (e.g., corporation makes payments to satisfy obligation of shareholder)
o Unreasonable compensation
o Below market interest rate loans to shareholders
o High rate interest on loans from shareholder to corporation
8. Avoiding Unreasonable Compensation
Documentation of the following attributes will help support payments made to an employee-shareholder:
o Employee’s qualifications
o Comparison of salaries with dividends made in past
o Comparable salaries for similar positions in same industry
o Nature and scope of employee’s work
o Size and complexity of business
o Corporation’s salary policy for other employees
9. Stock Dividends
 [1] Excluded from income if pro rata distribution of stock, or stock rights, paid on common stock
o Five exceptions to nontaxable treatment deal with various disproportionate distribution situations
[2] Effect on E & P
o If nontaxable, E & P is not reduced
o If taxable, treat as any other taxable property distribution
[3] Basis of stock received
If nontaxable
o If shares received are identical to shares previously owned, basis = (cost of old shares/total number of
shares)
o If shares received are not identical, allocate basis of old stock between old and new shares based on relative
fair market value
o Holding period includes holding period of formerly held stock
If taxable, basis of new shares received is fair market value
o Holding period starts on date of receipt
10. Stock Rights : Tax treatment of stock rights is same as for stock dividends
[1] If stock rights are taxable
Income recognized = fair market value of stock rights received
Basis = fair market value of stock rights
If exercised, holding period begins on date rights are exercised
Basis of new stock = basis of rights plus any other consideration given
[2] If stock rights are nontaxable
If value of rights received < 15% of value of old stock, basis in rights = 0
Election is available which allows allocation of some of basis of formerly held stock to rights
If value of rights is 15% or more of value of old stock, and rights are exercised or sold, must allocate some of basis in
formerly held stock to rights
11. Corporate Distribution Planning
[1] Maintain ongoing records of E & P:
o Ensures return of capital is not taxed as dividend
o No statute of limitations on E & P, so IRS can redetermine at any time
 Accurate records minimize this possibility
[2] Adjust timing of distribution to optimize tax treatment:
o If accumulated E & P deficit and current E & P loss, make distribution by end of tax year to achieve return
of capital
o If current E & P is likely, make distribution at beginning of next year to defer taxation
12. Avoiding Constructive Dividends
[1] Structure transactions on “arms’ length” basis:
Reasonable rent, compensation, interest rates, etc...
[2] Use mix of techniques to “bail out” corporate earnings such as:
Shareholder loans to corporation
Salaries to shareholder-employee
Rent property to corporation
Pay some dividends
Overdoing any one technique may attract attention of IRS