Education Inc Publishing as Prentice Hall NONLIQUIDATING DISTRIBUTIONS 1 of 2 Nonliquidating distributions in general Earnings and profits EampP Nonliquidating property distributions ID: 193905
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Slide1
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide2
NONLIQUIDATING
DISTRIBUTIONS (1 of 2)
Nonliquidating distributions in generalEarnings and profits (E&P)Nonliquidating property distributionsStock dividends and stock rightsStock redemptionsPreferred stock bailoutsStock redemptions by related corps
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide3
NONLIQUIDATING
DISTRIBUTIONS (2 of 2)
Tax planningCompliance and procedural considerations©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide4
Nonliquidating Distributions in General
(1 of 2)
Dividend distributionsA distribution of property based upon a corporation’s earnings & profits (E&P)Property includesMoney, securities and other assets
Does not include stock or stock rights of distributing
corp
Dividends treated as ordinary income by shareholder
(taxed
at 15
% in 2010)
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide5
Nonliquidating Distributions in General
(2 of 2)
Earnings and profits (E&P)E&P not defined in the CodeE&P consists of current & accumulatedDistributions are based upon current E&P first & accumulated E&P secondDistributions in excess of E&P are considered a return of capital
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide6
Earnings and Profits
Current E&P (1 of 2)
E&P computed on annual basis at end of tax yearGenerally E&P based on corp’s economic income instead of taxable incomeAdjustments to taxable income for permanent & timing differences including use of different depreciation methodsRefer to Table
1
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide7
Earnings and Profits
Current E&P (2 of 2)
Taxable income+ Excluded taxable income + Taxable income deferred to another year
+/-
Inc & deduct recomputed under E&P rules
+
Deductions disallowed for E&P
-
Nondeductible items that reduce E&P
=
Current E&P (or current E&P deficit)
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide8
Earnings and Profits
Current vs. Accumulated E&P (1 of 3)
Current E&P (CE&P) computed on last day of the corp’s tax yearDistributions first from CE&PDistributions greater than CE&PCE&P allocated to distributions pro rata regardless of payment dateThen AE&P (only if positive) allocated to distributions in chronological order
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide9
Earnings and Profits
Current vs. Accumulated E&P (2 of 3)
Distributions greater than E&PCannot create an E&P deficitDistributions in excess of all E&P is a return of capital to shareholders and reduce shareholders’ basis in stockDistributions in excess of basis result in a gain (usually capital gain)
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide10
Earnings and Profits
Current vs. Accumulated E&P (3 of 3)
If CE&P is positive and beginning AE&P is a deficitDistributions will produce ordinary income to shareholder until CE&P reaches zeroCE&P allocated on a pro-rata basisDeficit in CE&P transferred to AE&P before classifying distributions
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide11
Nonliquidating Property Distributions
Shareholder consequences
Corporation’s consequencesExample 15Example 16Distribution’s effect on E&PConstructive dividends
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide12
Shareholder Consequences
In non-cash distributions, amount of income equal to FMV of property received minus liabilities assumed
Amount of distribution cannot be <$0Shareholder’s basis in non-cash property is FMV on distribution dateHolding period of property begins day after distribution date
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide13
Corporation’s Consequences
Appreciated non-cash property produces gain as if corp sold property for FMV on distribution date
Loss recognition NOT permittedIf liabilities exceed FMV, then FMV is assumed to be no less than amount of the liability©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide14
Example
15
Corporate Gain/Loss on Property DistributionFMV of land $60,000Adjusted basis 20,000Capital Gain 40,000
FMV of land $12,000
Adjusted Basis 20,000
No loss recognition by corporation
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide15
Example
16
Corporate Gain and Shareholder BasisFMV of land $25,000Mortgage 35,000Adjusted basis 20,000
Capital Gain 15,000
FMV cannot be less than liability
Shareholder’s basis $35,000
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide16
Distribution’s Effect on E&P
(1 of 2)
Gain on non-cash distribution increases Current E&PE&P is reduced by Amount of cash distributedGreater of FMV or adjusted basis of property distributed minus liability assumed by shareholderTax liability on gain recognized
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide17
Distribution’s Effect on E&P
(2 of 2)
E&P is reduced by (continued)Principal amount of the corporation’s own notes, bonds, debentures or other obligations distributed to shareholders
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide18
Constructive Dividends
(1 of 3)
IRS or courts recharacterize payments to shareholder where substance of transaction is a dividendAll or part of income recharacterized as a dividendNeed not be pro-rata distribution
May be intentional way to bail out E&P without triggering dividend treatment
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide19
Constructive Dividends
(2 of 3)
Tax consequencesCorporation denied deduction on benefit given to shareholderDividend income to shareholder for benefit receivedExcessive compensationOrdinary income to
shareholder
May not treated as a dividend
due to maximum 15% tax rate on dividends
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide20
Constructive Dividends
(3 of 3)
Examples“Loans” to shareholdersExcessive rent paid to shareholderPayments for shareholder’s benefitBargain purchaseUse of corporate property
Excessive compensation
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide21
Stock Dividends & Stock Rights
Nontaxable Stock Dividends
Tax-free distribution of additional shares of stock to existing shareholderIf shares identical, basis allocated by dividing old basis by total shares heldIf shares different, basis allocated between old and new shares in proportion to FMV on distribution date
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide22
Stock Dividends & Stock Rights
Nontaxable Stock Rights
Tax-free distribution of right to purchase add’l shares of stock unless proportionate interest changes or could changeIf the value of right <15% of underlying stock, basis of right is zeroIf value
15% of underlying stock, basis allocated based on relative FMV
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide23
Stock Dividends & Stock Rights
Taxable Stock Dividends and Stock Rights
Distribution amount = FMV of stock or rights on distribution dateDividend to extent of E&PRecipient takes FMV as basisTopic Review 3Illustrates tax consequences to shareholders and distributing corporation
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide24
Stock Redemptions
(1 of 2)
Acquisition by a corporation of its own stock in exchange for propertyShareholder consequencesAttribution rulesSubstantially disproportionate redemptionsComplete termination of shareholder’s interest
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide25
Stock Redemptions
(2 of 2)
Redemptions not essentially equivalent to a dividendPartial liquidationsRedemptions to pay death taxesRedeeming corporation consequences
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide26
Shareholder Consequences
Sale treatment produces capital gain or loss
Dividend treatment produces ordinary income on entire distributionGenerally taxed at 15% (through 2010)
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide27
§318 Attribution Rules
(1 of 2)
Family attributionSpouse, children, grandchildren, & parentsStock cannot be reattributed to another family member
Attribution from entities
Proportionate ownership for stock owned by or for partnership, estate, or trust
Proportionate ownership for stock owned by C corp only for s/h owning
50%
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide28
§318 Attribution Rules
(2 of 2)
Attribution to entitiesStock owned by partners or beneficiaries considered owned by partnership, estate, or trustStock owned by 50% shareholder of C corp considered owned by corp
Option attribution
Option owner treated as owning stock
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide29
Substantially Disproportionate Redemptions
(1 of 2)
After the redemption, the s/hOwns < 50% of voting power of all classes of stockOwns < 80% of his/her percentage ownership of voting stock before the redemptionOwns < 80% of his/her percentage ownership of common stock before the redemption
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide30
Substantially Disproportionate Redemptions
(2 of 2)
Redemptions receiving sale treatmentComplete termination of interestNot essentially equivalent to dividendPartial liquidation of corp to a non-corporate shareholder
Made in order to pay death taxes
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide31
Complete Termination
of Interest
Redemption of shareholder’s entire interest corporation consisting of nonvoting stockNormally would not qualify because no reduction in voting power occursFamily attribution rules may be waived to allow complete termination to qualify
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide32
Redemptions not Essentially Equivalent to a Dividend
(1 of 2)
Facts and circumstances testNo safe harbor or mechanical testGenerally applies to Redemptions of nonvoting preferred stock if no common stock owned
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide33
Redemptions not Essentially Equivalent to a Dividend
(2 of 2)
Generally applies to (continued)Redemptions resulting in substantial reduction in shareholder’s right to vote and exercise control, participate in earnings, or share in assets upon liquidation
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide34
Partial Liquidations
(1 of 2)
Corp discontinues one line of business Distributes assets to shareholdersContinues other line(s) of businessDetermined at corporate levelMust be bona fide business contraction
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide35
Partial Liquidations
(2 of 2)
Tax consequences to shareholdersNoncorp shareholder treats redemption as a saleCorp treats as a dividend unless redemption meets one of other tests for sale treatement.
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide36
Effect of Redemptions on Distributing Corporation
Sale treatment may produce gains but no losses
E&P must be reduced by Full amount for dividends (if dividend) ORProportionate amount for sale treatment after adjusting for gains net of taxes
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide37
Preferred Stock Bailouts
§306 in general
Dispositions of §306 stockRedemptions of §306 stockExceptions to §306 treatment©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide38
§306 in General
(1 of 2)
§306 stock definedStock other than common stockIssued on a tax free basisSubstantially same as a stock dividend
Sale results in ordinary income equal to FMV of stock
Limited by corporation’s E&P at distribution date
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide39
§306 in General
(2 of 2)
If no Current or Accumulated E&P in issue year, §306 does not apply
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide40
Dispositions of §306 stock
Dividend income to the extent of E&P in year of redemption
Amounts in excess are considered a return of capitalAmounts recovered in excess of basis are capital gainsAny unrecovered basis is added to remaining common stock
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide41
Redemptions of §306 stock
Same dividend treatment as sale of §306 stock
Corporation’s E&P reduced by amount realized©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide42
Exceptions to §306
§306 does not apply in the following circumstances
Complete termination of interestComplete redemption of all holdingsRedemption in a partial liquidation Gift transfer (stock remains tainted)No tax avoidance as a principal purpose
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide43
Stock Redemptions by
Related Corporations
A sale of a corp’s stock by controlling shareholder to a second corp controlled by same shareholder treated as a redemption§304 applies to bothbrother-sister andparent-subsidiary controlled groups
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide44
Brother-Sister Controlled Groups
Redemption is by the corp buying stock from the shareholder
If a dividend, E&P of acquiring corp and then the issuing corp (if necessary) is reducedBasis of redeemed stock added to basis of stock held in acquiring corp©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide45
Parent-Subsidiary Controlled Group
Sale of parent stock by shareholder to subsidiary
If a dividend, E&P of sub and then parent are both availableShareholder’s basis in remaining parent stock increased by basis of stock redeemed by subsidiary©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide46
Tax Planning
(1 of 2)
Avoiding unreasonable compensationHedge agreementS/h-employee agrees to repay any portion of salary IRS disallows as unreasonableBootstrap acquisitionsS/h sells part of stock to purchaser, then has
corp
redeem seller’s remaining shares
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide47
Tax Planning
(2 of 2)
Timing of distributionsMake distributions when corp has little or no E&P so distributions treated as return of capital
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide48
Compliance and Procedural Considerations
Corporate reporting of
nondividend distributionsAgreement to terminate interest under §302(b)(3)
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide49
©2011 Pearson
Education, Inc. Publishing as Prentice Hall