As corporations operate, they can share their economic successes with shareholders by making distributions. However distributions are not necessarily required and different firms have different incentives and disincentives. From a tax perspective, it is necessary to classify distribution as:
- Taxable dividends
- Nontaxable return of capital
- Gain from the sale of stock
The term non-liquidating distribution implies that the distributions are not in an effort to wind up the affairs of the corporation. Under §301(c), distributions are classified as
| Dividends | Code §316(a) defines a dividend as any distribution of property made by a corporation to its shareholders out of its earnings and profits. Dividends are treated as gross income for 1. Non-corporate shareholders, taxed at preferential long-term rates 2. Corporate shareholders, taxed at ordinary rates, after any allowable dividends received deduction. |
| Non-dividends | Non-dividends are first treated as recovery of shareholder basis. Any excess then is treated as a gain from the sale or exchange of the stock. |
Earnings and Profits
Earnings & Profits (E&P) refers to a C corporation’s economic ability to pay dividends to its shareholders without encroaching its capital. E&P captures a C corporation’s accumulated prior and current capital. It defines the tax treatment of corporation distributions. It is purely a tax concept, it does not refer to taxable income, net profit, or any other common performance metric.
The Code does not define E&P, instead, instead legislators have enacted adjustments to taxable income that ultimately determine E&P. These adjustments include elements of both taxable and non-taxable income, consistent with the concept of E&P capturing a corporation’s ability to make a distribution of after-tax economic profits. For this reason, a shareholder may be taxed on a distribution of income not subject to tax at the corporate level, even though the shareholder would not have been taxed on such income if it were earned directly.
Adjustments to taxable income fall into four main categories:
| Increases to taxable income | By all income items that were excluded from taxable income, for instance: Tax-exempt interest on municipal bonds Tax-exempt life insurance proceeds Federal income tax refunds in prior years etc. They are just not taxable for various reasons. |
| Decreases to taxable income | By all expenses that were disallowed from taxable income, for instance: 1. Non-deductible portion of meals and entertainment 2. Related-party losses 3. Federal income tax expense 4. Fines and penalties etc. |
| Timing issues | Shift the effect of a particular transaction from the year of its inclusion or deduction from taxable income to the year in which it had an economic effect on the corporation and its ability to make a distribution. For instance: 1. Net operating losses 2. Charitable contributions 3. Capital losses etc. No adjustments for deferred gain or loss. |
| Accounting method issues | Calculating E&P are generally more conservative than those used for determining taxable income. The Alternative Depreciation System (ADS) is used for E&P purposes instead of Modified Accelerated Cost Recovery System (MACRS). 1. ADS uses straight line depreciation with a half-year convention over pre-defined recovery periods. 2. ADS also prohibits bonus depreciation and imposes limitations on immediate expensing of assets under section 179. 3. Installment method is not permitted. 4. Percentage depletion is not allowed. 5. Intangible drilling costs are amortized. 6. Organizational expenses are not amortized. 7. Adjust for income deferred under LIFO. |
Examples
Example: Corporation A reported taxable income of $625,000, and paid $200,000 in federal income taxes. Not included in the computation were non-deductible meals of $3,000, tax-exempt income of $7,000, and deferred gain on an installment sale of $12,000. Determine the current E&P.
Taxable Income 625000
Fed Income Taxes -200000
Non-deductible -3000
Tax-exempt income +7000
Deferred install +12000
Current E&P =441000Example: Corporation B is an accrual basis taxpayer, who had E&P $74000 last year. The following information is pertain to this tax year:
| Taxable income on tax return | $304000 |
| Charitable contributions in excess of 10% limitation | $9000 |
| Interest paid for tax-exempt bonds | $5000 |
| Tax-exempt interest received | $8000 |
| Federal income tax | $97000 |
| MACRS depreciation in excess of ADS depreciation | $3500 |
Determine its current E&P:
Taxable income 304000
Tax-exempt interest +8000
Excess depreciation +3500
Excess charitable -9000
Interest paid -5000
Federal income tax -97000
Current E&P =278500Cash Distributions
Once E&P is determined, you will use it to determine the taxation of cash distributions. Taxation of the cash distribution is relatively straightforward once E&P is known. Certainly, the amount of the distribution equals the amount of cash received by the shareholder.
According to §301(c) and 316(a), a distribution of cash is a dividend for tax purposes to the extent of the corporation’s current and accumulated E&P. In other words, the cash distributed is a dividend to the extent the corporation had economic wherewithal to pay a dividend. And dividends in general are gross income of the shareholders.
Accumulated E&P =
Total of all prior current year E&P - Distributions from E&P in prior years§316(a) presumes that:
- Every cash distribution is made out of the E&P to the extent that E&P exists.
- Every cash distribution is made from the most recently accumulated E&P.
The distributing corporation reduces its E&P by the amount of cash distributed, as long as sufficient current and accumulated E&P exist. In other words, negative E&P can result from that operating losses, but a deficit in the E&P cannot be created or increased by distribution. Therefore, when there is insufficient current E&P available to cover cash distributions made during the tax year, E&P is allocated to the distributions to determine dividend status.
| Negative current E&P | Positive current E&P | |
| Positive accumulated E&P | Net current and accumulated E&P. If the sum ≤ 0, the distribution is return of capital. If the sum > 0, the distribution is treated as a dividend to the extent of positive balance. | Distributions made first from current E&P, then accumulated E&P. If distributions exceed current E&P, then current and accumulated E&P are allocated to each distribution. Current E&P is applied first to distributions on a pro rata basis, then accumulated E&P is applied beginning with the earliest distribution. |
| Negative accumulated E&P | Distributions are treated as dividends to the extent of current E&P. |
Amounts distributed in excess of current and accumulated E&P are NOT dividends:
- They first reduce the shareholder stock basis
- Any additional excess treated as a gain from the sale or exchange of the stock.
Examples
Example: Corporation A had $50000 of accumulated E&P on Jan 1. During the current year, it had a $40000 operating loss for the first 6 months, but ended up with $15000 in E&P. The corporation made a $25000 cash distribution to its shareholders at year-end. What is the amount accumulated E&P at the end of the year?
We first need to determine if the cash distribution was a dividend. The cash distribution comes from current E&P, then accumulated E&P:
Cash distribution $25000
= Current E&P $15000
+ Accumulated E&P $10000Meaning at the end of the year, $50000 - $10000 = $40000 accumulated E&P remains available.
Example: Person A holds all of the stock of Corp B with a basis of $8000, Assume the Corp B has $15000 of current E&P and it distributes $25200 cash to Person A. What are the tax effects of the cash distribution?
We must first focus on how much is a dividend. Then we can then move on to cost recovery or basis reduction and everything else that remains is treated as a gain on the sale of stock.
Cash distribution $25200
- Dividend $15000
- Basis reduction $8000
- Gain from sale $2200Example: Person A holds all of the stock of Corp B with a basis of $8000, Assume the Corp B has $15000 deficit in accumulated E&P, $20000 of current year E&P. It distributes $20000 cash to Person A. What are the tax effects of the cash distribution?
The distribution first comes from current E&P, leaving current E&P become zero. The distribution will become taxable dividend to Person A. The accumulated E&P remains $15000 deficit.
Example: Corporation B has accumulated E&P of $200k a the beginning of the year, and a deficit in current E&P of $100k at year-end. The corp distributed $300k cash to its sole shareholder in current year. What amount of the distribution is treated as a dividend if it was made in December?
First we need to net the accumulated E&P and the current E&P, leaving us with $100k E&P available. Since this number is positive, any distributions of cash in this case, is going to be dividends to the extent of this positive amount of E&P.
Cash distribution $300k
- Dividend $100k
- Basis and gain $200kOr if the distribution was made in January? Current E&P does not exist.
Cash distribution $300k
- Dividend $200k
- Basis and gain $100kProperty Distributions
Recall that gains from the sale of appreciated property are taxed twice:
- First, at the corporate level when property is sold
- Second, at the shareholder level when the proceeds are distributed as dividends
What if, instead of selling appreciated property, a corporation distributes appreciated property directly to shareholders?
Brief History
The case General Utilities & Operating Company v. Helvering (1935) was the first time the US Supreme Court considered the corporate level tax effects of a non-liquidating distribution of appreciated property.
The Supreme Court held that the corporation should not recognize a gain, because the distribution was not a sell and the corporation did not discharge indebtedness with appreciated assets. Then many courts and practitioners interpreted it as implying that a distributing corporation does not recognize a gain or loss when making a property distribution with respect to its stock.
The General Utilities decision directly threatened the double-tax regime by creating a tax law distinction between:
- A distribution of appreciated property
- The corporation recognizes a gain and correspondingly increases E&P
- The sale of that same property by the corporation followed by a distribution of the proceeds to shareholders.
- The shareholders receive taxable dividends to the extent of corporate E&P
Despite the criticism, Congress codified the General Utilities decision in the Internal Revenue Code of 1954. Code §311(a)2 stipulates that, as a general rule, a corporation recognizes no gain or loss on the non-liquidating distribution of property.
Despite codification, the courts frequently applied common law doctrines such as Substance over Form to override the statute and attribute income to the corporation.
Finally In 1986, Congress repealed the General Utilities rule in the context of both non-liquidating and liquidating distributions of appreciated property.
General Rules
Code §311(b) provides that if a corporation distributes appreciated property other than its own obligations and a non-liquidating distribution, it must recognize gain in an amount equal to the excess of the fair market value of the property over its adjusted basis.
Recognized gain = Fair market value - Adjusted basisIf the property is subject to a liability or if the shareholder assumes a liability in connection with the distribution, the fair market value of the distributed property is treated as not less than the amount of the liability.
Fair market value ≥ Amount of liabilityNotice that the General Utilities rule still applies to disallow recognition of loss on the distribution of property that has declined in value.
The non-liquidating distribution of property has several effects on the corporation’s E&P:
- Gain recognized by the corporation on the distribution of property increases current E&P
Current E&P = Current E&P + Recognized gain
- The distribution itself reduces accumulated E&P by
- The Adjusted basis of the distributed property if depreciated
Accumulated E&P = Accumulated E&P - Adjusted basis
- The Fair market value of the distributed property if appreciated
Accumulated E&P = Accumulated E&P - Fair market value
- The Adjusted basis of the distributed property if depreciated
The net result is the same as if the corporation had sold the property and then distributed cash equal to the fair market value of the property. In other words, the corporation would have increased Current E&P by the Recognized gain and then decreased Accumulated E&P by the same amount.
To summarize, the rules governing distributing corporation:
| Appreciated Property | Depreciated Property | |
| Taxation | Increase taxable income by Recognized gain | No effect, loss is not recognized |
| Current E&P | Increased by Recognized gain | No effect |
| Accumulated E&P | Decreased by Fair market value (Net of liability, distributions can not create a deficit) | Decreased by Adjusted basis (Net of liability, distributions can not create a deficit) |
| Concept | Same position as if sold property and distributed cash | E&P reflects loss on distribution via adjusted basis decrease to E&P, but regular loss disappears |
The rules governing the shareholders are basically the same as those for cash distributions:
- The amount of the distribution is the fair market value of the distributed property reduced by any liabilities assumed by the shareholder or to which the property is subject.
- The shareholder’s basis of the distributed property is its fair market value as of the date of the distribution.
Examples
Example: Person A has $8000 basis in 100% of the stock of Corp B. If at the beginning of current year, Corp B had $25000 of accumulated E&P, what are the tax effects of a distribution of inventory worth $20000 (basis of $11000) if Corp B has no current E&P?
Fair market value $20000
- Adjusted basis $11000
= Built-in gain $ 9000The build-in gain must be recognized by Corp B, which has an immediate effect on current E&P, which now from $0 becomes $9000. Given the Accumulated E&P of $25000, there is $25000 + $9000 = $34000 now for distribution.
Because the distributed inventory is appreciated property, so we focus on its Fair market value $20000:
Fair market value $20000
- Current E&P $ 9000 #taxable dividend
- Accumulated E&P $11000 #taxable dividendPerson A on the other side takes basis as Fair market $20000 value in the inventory received. In that year-end, Corp B will have Accumulated E&P $25,000 – $11,000 = $14,000.
What are the tax effects of a distribution of inventory worth $20000 (basis of $11000) if Corp B has no current and accumulated E&P?
Fair market value $20000
- Current E&P $ 9000 #taxable dividend
- Return of capital $ 8000
- Gain of sale of stock $ 3000Example: Corp B distributed a building to its only shareholder, Person A. The building was worth $189000 with basis $154000, and subject to a $24500 liability that Person A assumed. How much gain (if any) does Corp B recognize?
When we go to figure out the gain on this property, we have to use the debt as the fair market value because the debt exceeds adjusted basis.
Debt liability $245000
- Adjusted basis $154000
= Recognized gain $ 91000Example: Corp B distributed a building to its only shareholder Person A. The building was worth $20000 with basis of $30000, and subject to a $6000 liability that Person A assumed. Before considering this distribution, Corp B had current E&P of $30000 and accumulated E&P of $0. Compute the current E&P after the property distribution.
This property has depreciated in value. So the Corp B is not allowed to recognize this loss, which has no effect on E&P. But the distribution of property does affect E&P. Because it’s depreciated property, we decrease E&P by the adjusted basis of the distributed property, net of liabilities.
Current E&P $30000
- Adjust basis net of liability $24000 = $30000 - $6000
= E&P after distribution $ 6000Stock Distributions
A corporation can distribute stock, or rights to acquire stock, to some or all of its shareholders. Stock distribution and stock split are similar but with fundamental differences:
| Stock distribution | Does not have to be from the same class as the shareholders’ existing ownership interest. Requires a corporation to transfer an amount from retained earnings to paid-in capital. Public corporations typically distribute stock to provide shareholders with something of value while retaining cash and property in the business. In a closely-held corporation, a distribution of stock is often used to facilitate a shift in corporate control. |
| Stock split | Has to be from the same class as the shareholders’ existing ownership interest. Simply increases the number of outstanding shares with no adjustment to capital accounts. Increase the number of outstanding shares, are often used to reduce the price per share in hopes of increasing the marketability of the stock on an exchange. |
Pro Rata vs Non-Pro Rata
A distribution of stock is non-taxable to shareholders if:
- it is paid on (not in) common stock, and
- it is pro rata
such that the shareholders’ proportionate ownership interests are maintained.
- If the shares received are identical to the shares owned (in terms of class or voting rights, the shareholder’s basis in each share is computed as:
Basis of the old shares / Total number of shares owned- If the shares received are not identical to the shares owned, the shareholder must allocate the basis of the old stock between the old and new shares based on the relative fair market value.
Basis of the old shares * (Fair market value received / Total fair market value)Holding period is tacked such that it includes the holding period of the previously owned stock. Corporation does not reduce E&P.
A non-pro rata stock distribution is generally taxable as a dividend. The basis of the new shares received by the shareholder is the fair market value, and the holding period begins on the date of receipt. The corporation adjusts E&P as it would for any taxable property distribution.
Stock Rights
The tax treatment of stock rights is the same as for stock dividends.
If the stock rights are non-taxable, the basis depends on the fair market value of the rights received.
- If the value of the rights ≤ 15% of the value of the stock already owned, the shareholder receives zero basis in the rights.
- If the value of the rights ≥ 15% of the value of the stock already owned, and the rights are exercised or sold, the shareholder must allocate some of its basis in its formerly held stock to the rights. Allocation of stock’s original basis between the stock and rights is based on fair market value at distribution. Portion allocated to the stock rights is the ratio of the fair market value of the rights to the total fair market value of the rights and stock.
If the stock rights are taxable, the fair market value of the stock rights received is recognized as income. The basis in rights is also fair market value. When exercised to acquire new stock, the holding period begins on the date rights are exercised. The basis of the new stock is then the basis of the stock rights plus any other consideration given to acquire the stock.
Examples
Example: In January, Person A bought one share of Corp B for $300. On March 1, the Corp B distributed one share of a new class of preferred stock for each share of common stock held. This distribution was non-taxable. On March 1, the fair market value of Person A’s common and preferred share are $450 and $150 respectively. After the distribution, what is Person A’s basis in each share?
Common stock $300 × $450 / ($450 + $150) = $225
Preferred stock $300 × $150 / ($450 + $150) = $75When does the holding period begin for the preferred stock? The holding period will be tacked, meaning it will begin in January.
Example: Person A owns 100 shares of common stock of Corp B. During the year, he received:
- a dividend of $3,000 in cash
- 50 additional shares of common stock (value $2,000)
- The right to purchase 50 additional shares (value $1,000)
The distributions were not disproportionate, and Person A was not given an option to receive cash instead of stock or rights. What amount, if any, does Person A include in gross income?
The dividend is paid out of E&P, therefore it should be included in gross income. Both stock and stock right distributions are non-taxable. So overall only $3000 is included in gross income.
Example: In January, Person A receives a non-taxable distribution of stock rights from Corp B. Each right entitles the holder to purchase one share of stock for $40. One right is issued for every share of stock owned. Person A owns 100 shares, purchased several years ago for $4,000, but now worth $5,000. Upon distribution, the rights are worth $1,000, that is 100 rights at $10 per right. On December 1, Person A sells all 100 stock rights for $12 per right. How much gain, if any, does Person A recognize?
Amount realized $12 * 100 = $1200
Value of rights / Value of Stocks = $1000/$5000 = 20% > 15%
Rights basis
= Stock basis * (FMV of rights / Total FMV)
= $4000 * ($1000 / $6000)
= $667
Recognized gain
= Amount realized - Rights basis
= $1200 - $667
= $533Constructive Distributions
Dividend distributions are fully taxable to non-corporate shareholders at the highest ordinary tax rates and non-deductible to the corporation. To avoid double taxation, some closely-held corporations attempt to distribute earnings in a form that is deductible at the corporate level. However, these distributions risk being reclassified by the IRS as constructive or presumed dividends.
Generally speaking, there are six common types of disguised dividend distributions:
- Excessive compensation
- Expenses paid for personal benefit
- Excessive rent for corporate use of shareholder property
- Excessive interest on debt
- Bargain sales of property
- Interest free loans
While reasonableness standards exist in some situations, the ultimate resolution of the constructive dividends issue requires an evaluation of all facts and circumstances, as well as consideration of the intent of the corporation and its shareholders.
Qualified Dividends
In general, the tax treatment of dividends depends on whether the shareholder receiving them is another corporation or not:
- If corporation, ordinary rates after dividends received deduction.
- If individual, preferential rates for qualified dividends, ordinary rates otherwise.
To be considered qualified, a dividend must:
- First be paid by a domestic corporation. If the dividend is paid by foreign corporation, it is permitted if they meet several tax treaty and information sharing agreements with the U.S. government.
- Also be paid on stock that has been held greater than 60 days during the 121-day period beginning the 60 days before the ex-dividend date.
- Not be paid to a shareholder who owns both long and short positions in the stock.
Qualified dividends are exempt from tax for taxpayers in the 10% or 15% individual income tax brackets. Taxpayers pay a 20% tax rate if they are in the 39.6% tax bracket. Other taxpayers with qualified dividends generally pay a 15% tax rate.
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