Chapter 4     Nonliquidating                                                                                   Distributions

Dividends - i.e.,  “operating” distributions

IRC §301(a) - Subchapter C,  Part A.

Alternative dividend classification systems:

 1) Federal income tax– income tax;  e&p

 2) Financial accounting – GAAP/SEC

 3) Regulatory - utility rate-making

 4) State income taxation/franchise taxation

 5) State corporate law/creditors’ protection

Dividend Payment Alternatives

A. Ordinary course of business

    1.  cash

    2.  property - appreciated/depreciated

            capital gain/ordinary income property

            installment obligations

     3.  distributing corporation's own notes

     4.  distributing corporation's own stock

B.  Extraordinary course of business

Tax Definition of a “Dividend”                   p.160

§301(c) Income Tax Ordering Rules

   1) §301(c)(1) - dividend distributions.

   2) §301(c)(2) - recovery of tax basis.

   3) §301(c)(3) - realization of capital gain.

§316 - Dividend distribution sourcing:

   1) accumulated “earnings & profits,”  or

   2) current “earnings and profits”

      (i.e.,  the "nimble dividend" rule).

Dividend Taxation to the Individual Shareholder   p.162

§1(h)(11) - taxation at capital gains rates (15%) to the individual dividend recipient.

Must be “qualified dividend income”, i.e.,  received from:   (1) domestic corporation, or

    (2) foreign corporation (if satisfying specified criteria).

Must satisfy a holding period requirement.

“Dividends” from “money market fund”? No.

Corporate Dividend Policy
p.164

Why pay (or not pay) dividends?

-  Retain earnings for future investments?

-  Reduce borrowing costs through retention?

-           Pay out earnings for closely held corp. shareholders only in a deductible form?

-           Institutional shareholders do not pay taxes.

Cf., better use of capital after distributions have been made to shareholders?

Defining “Earnings and Profits” for Tax Purposes

Code §312 concerns E&P concepts.

Objective:  Identify a cash equivalent amount available for distribution to owners/shareholders; premised upon true economic results, not on taxable income base.

Choices for identifying “dividend” status:

1) Taxable        2) E&P      3) Earned surplus;

     income                                        GAAP concepts

 

Adjustments to Taxable Income for E&P Amount

I.      E&P Additions for Income Items

  - municipal bond income

  - life insurance proceeds (above tax basis?)

  - federal tax refunds

II.        Deduction Addback Items to E&P 

  - dividends to the corporate shareholder previously protected by a dividends received deduction (DRD) for FIT purposes.

E&P adjustments, continued

III.  Nondeductible amounts which do reduce the E&P amount  

     - Federal income taxes paid.

     - Disallowed losses - §265 and §267.

     - Charitable contributions above % limit.

     - Disallowed T& E expense - §274.

These are “cash out of pocket” items.

E&P adjustments, continued         §312(k)&(n)

IV        Timing Adjustments for E&P

A. Income components, e.g., §453 or the “completed contract” method.

B. Depreciation components, e.g., §312(k)(3)(A) &  §168(g)(2). Use the alternative depreciation system. Also, §179.

C. Inventory – FIFO method; not LIFO

No statute of limitations on E&P determination.

Problem                           p.169
Income &E&P Determinations

I.         Determining Taxable Income

   Gross income       

            Sales   profits                                               20,000

            Dividends                                                          5,000

            Long-term capital gain                     2,500

                   Total  gross  income              27,500

           

Net Income Determination
continued,                  p.169

Deductions

   Employee salaries                         10,250

   DRD - 70% of $5,000 (§243)     3,500

   Depreciation                                               2,800

   LTCL (limited to gain)                    2,500

Total deductions                                19,050 Total taxable income                                   8,450

     (27,500 less 19,050)

E&P Determination
Adjustments

Taxable income                                              8,450

Increases to E&P:

   Tax-exempt interest                                3,000

   Dividends received deduction                 3,500

   Depreciation (2,800 less 1,000)            1,800

     (2,000 SL depreciation x  ½ year)    

Total increases           to E&P                         8,300

 

E&P Determination
adjustments, cont.

Decreases to E&P Amount

   Excess LTCL                                                       2,500

   Estimated federal taxes paid                    800

Total decreases                                                      (3,300)

 

Earnings and profits total                             13,450

(8,450 + 8,300 less 3,300)

 

Cash Distributions           p.169        Income Tax Effects

1) Cash distribution to the shareholder is a “dividend,” but the dividend amount is limited to the distributing corporation's “earnings and profits” amount.  Code §301.

2) Result to the corporation:  Reduction of E&P by the amount of the distribution, limited to the amount of E&P (i.e., cannot create a negative amount in E&P account).

3) What allocation procedures (next slide)?

Allocation Procedures
Rev. Rul. 74-164         p.170

1)  Current e&p is allocated proportionately to all current year distributions.

2)  Accumulated e&p is allocated chronologically to distributions during the year (starting with the first distribution).

 3) Current loss is allocated pro rata against accumulated e&p available on the date of the distribution, unless the date of the loss is specifically earmarked.

 

Problem (a)                      p.173
Distribution Exceeding E&P

$10,000 tax basis to Ann for Pelican stock.

Pelican has $5,000 of current e&p and no accumulated e&p and distributes $17,500.

Result: a) $5,000 dividend - §301(c)(1)

                b) $10,000 return of capital -                         §301(c)(2);  zero basis for the stock.

                c) $2,500 capital gain - §301(c)(3).

Pelican's e&p is reduced to zero - §312(a)(1).

Problem (b)                      p.173
“Nimble Dividend” Rule Effect

$15,000 accumulated deficit in e&p from prior year and $10,000 of current e&p & corp. distributes $10,000 currently.

Result:  the entire $10,000 distribution is a dividend to Ann under the "nimble dividend" rule (sourced from current e&p).

Pelican continues to have a $15,000 deficit in its e&p (i.e., no adjustments to e&p account). 

No current e&p (after the distribution).

 

Problem (c)     Distributions &                Mid-Year Stock Partial Sale

Facts:  (i) $10,000 of accumulated e&p before year two (to be allocated chronologically) and (ii) $4,000 of current e&p (pro-rated).

1)  April 1 distribution of $10,000.

2,000 (pro rata portion of 4,000 current E&P); & then 8,000 of 10,000 accumulated E&P received as a dividend distribution.

                                             continued

Problem (c) continued  
p. 173

2)  October 1 distributions of $5,000 & $5,000 to (now) two shareholders.  

$2,000 current E&P (1,000 each shareholder).   $2,000 remaining accumulated E&P (10,000 less 8,000) allocated 1/2 (1,000) to each shareholder.  Each has $3,000 capital return. 3)  On July 1 shareholder sells 1/2 of stock for 15k  (impact on/of the October transaction?)

Zero E&P of corp. after these distributions.

Problem (d)                      p.173
Current Year Deficit

Pelican has a $10,000 deficit in Year Two.

1)  April 1 distribution of $10,000

1/4th of 10,000 loss (2,500) is allocable to the April 1 distribution of 10,000 (no earmarking);  7,500 dividend  (reducing e&p to zero) & 2,500 return of capital.

Stock basis is reduced from 10,000 to 7,500.

                                                      continued

Problem (d), cont.,      p.173
Option One (chronological)

2) July 1 - Ann sells 1/2 of stock for 15k.

 (15,000 less 3,750 (1/2 basis) = 11,250 gain)

3)  October 1 distribution of $5,000 & $5,000 to two shareholders - No current e&p & no accumulated e&p.    Treatment to Ann:

Less: distribution       5,000

Basis is:                                  3,750

Result:                                   1,250 gain                                                 

Problem (d), cont.,      p.173
Option Two  (dividends 1st)

2)  October 1 distribution of $5,000 & $5,000. No current e&p & no acc. e&p.    Option(s): Basis is:                                 7,500           3,750 (1/2?)

Less: distrib.               5,000           5,000

Result:                                   2,500           1,250                                                                   (basis)               (gain)

3) July 1 sale of 1/2 stock for 15k:  11,250 gain or  13,750 gain (15x less 1/2 of 2,500 or 1,250).

Distributions of Property to Shareholders              p.173

Income tax issues upon property distribution:

1) Income (loss?) recognition to distributing corporation upon a distribution in kind?

2) Effect on E&P from the distribution event and the gain recognition to the corporation?

3) Dividend treatment to the shareholder receiving the property as distribution (fmv)?

4) Tax basis to the shareholder for the property received in the distribution?

Problem (a)                      p.177
Appreciated Inventory

Zane purchased Sturdley stock for $8,000.

Sturdley has $25,000 accumulated e&p and no current e&p.  Distribution of inventory made:

        $20,000 FMV and $11,000 basis. 

1) Sturdley has recognized gain of $9,000.

2) $9,000 gain = current e&p for Sturdley.

3) The entire $20,000 is dividend to Zane.

 9,000 current e&p and 11,000 of acc. e&p.                                                                                                           cont.                                           

Problem (a), continued 
p.178

4) Basis to Zane for the inventory received:

     $20,000 (FMV) - §301(d).   Holding period?

5)  Remaining E&P is $14,000:

     25,000 prior E&P, plus 9,000 current E&P, less 20,000 distribution, equals 14,000.  §312(b)(2).  Not considering the impact of the federal income tax liability on the $9,000 gain realized on asset distribution.

Problem (b)                      p.178
No Pre-Distribution E&P

Sturdley has no accumulated e&p and no current e&p.     Distribution of inventory:

   $20,000 FMV and $11,000 basis.

1) Distribution produces to the corporation

$9,000 gain (ord. income) & $9,000 current e&p (less any income tax on the $9,000 gain).

2) Result to shareholder - Distribution of the $20,000 inventory:  9,000 dividend, 8,000 basis recovery & 3,000 cap. gain. §301(c).

Problem (c)                      p.178
Mortgaged Property

Distribution of land:  $20,000 FMV; 11,000 basis; 16,000 mortgage debt.

1) $9,000 income is realized by corporation on the distribution.  §311(b)(1).

2)  E&P increased by 9,000 - §312(b)(1).

3)  Distribution to shareholder is $4,000 -

20,000 less the 16,000 debt.  §301(b)(2).

Dividend income is 4,000 - adequate e&p.

Problem (d)                      p.178
Depreciated Property

$25,000 acc. e&p and 15,000 current e&p.

Corp. distributes depreciated land with a 20,000 fmv and a 30,000 tax basis.

1) §311(a) - no recognition of loss occurs.

2) 20,000 dividend distribution made to the shareholder.

3) 20,000 tax basis to shareholder - §301(d).

4) E&P is reduced by $30,000 - §312(a)(3).

Problem (d), cont.            p.178
Alternate: Property Sale

First a sale of the depreciated property:

10,000 loss reduces taxable income and current E&P.

Distribution of 20,000 produces 20,000 dividend;  acc. E&P is reduced to 10,000 (25,000 plus 5,000 current less 20,000).

But, shareholder might want the land for other (e.g., sentimental) reasons.

Problem (e)                      p.178
Different tax bases

Assume $25,000 acc. e&p and distribution of used machinery - 10,000 fmv;  zero income tax basis; 2,000 E&P tax basis (five year property and 7 year class life).

Purchased for $14,000 on July 1 of year one.

Distribution made on January 1 of year 7.

Separate depreciation schedules for:

(i) income tax,  and (ii) E&P calculation. 

Reg. §1.312-15(d).                       continued

Problem (e) cont.,       p.178
Distribution effects

1) 10,000 ordinary income for taxable income purposes - §311(b)(1) & §1245.

2) 8,000 income for e&p purposes upon the distribution of the asset.  E&P tax basis is 2,000 (14,000 cost less 12,000  depreciation).

3) Distribution of 10,000 to the shareholder.

4) E&P is reduced by 10,000 - §311(a) & (b).

5) Remaining E&P?  25 + 8 less 10 = 23k.

Corporate Distributions of its Own Obligations    p.178

Treatment of the corporation:

1)  §311(b)(1)(A) - gain recognition is required by a corporation on the distribution of appreciated property "other than an obligation of such corporation”.

2)  The corporation's e&p is reduced by the principal amount of the obligation (or, alternatively, the “issue price,” if a lesser value). Code §312(a)(2).

 

Corporation’s Own Obligations Received, cont.

Shareholder distributee treatment:

1)  dividend to the shareholder for the fair market value of the obligation received (i.e., not the "face value" of the instrument).

2)  tax basis to the shareholder for the obligation received as a dividend is the fair market value of that obligation when received by the shareholder.

Problem                           p.179
Distribution of OID Obligation

Shareholder stock basis is $100,000.

Corp's e&p is $100,000; Corporation distributes its own $100,000  30 yr. no interest note -  $5,000 FMV for the promissory note.   No corp. gain on this distribution.

On Feb. 1 Corp. also distributes 100x cash

Results:  1) Jan. 1 distribution of note reduces e&p by its $5,000 issue price. 2)  Feb. 1 distribution is a $95,000 ordinary dividend.

Constructive Dividends
Reg. §1.301-1(j).         p.180

Types of disguised dividend distributions:

1) Excessive compensation to shareholders.

2) Personal expense reimbursements.

3) Excessive rent for use of owner’s property.

4) Excessive interest on debt, or interest paid on debt which really constitutes equity.

5) Bargain sales of property to shareholders.

6) Interest-free loans to shareholders. §7872.

Nicholls, North, Buse Co.
v. Commissioner              p.181

Corporate ownership of yacht and personal use of yacht by a son of the majority owner.

1) Constructive dividend for personal use.

2) Use was imputed to the father (not son).

3)  Amount of the dividend (to father):

  a) Not the purchase price of the yacht.

  b) But, value of the personal use of the yacht for one year.

 

Rev. Rul. 69-630,        p.184
Triangular Dividend

Two corporations wholly owned by the same individual shareholder & §482 reallocation:

1) Increased income of X (since X should have received more income for the property).

2) Increased basis of property to Y (should have paid more for the purchased asset).

3) Distribution from X to Controlling Shareholder A (upstream dividend).

4) Contribution by A to the capital of Y.

Constructive Dividends
& 15% Dividends Tax Rate

Taxation of dividends to the shareholder at the rate of 15% in 2003 (through 2010).

Cf., maximum income tax rate of 35% for compensation income received.

Better to have excess compensation treated as a constructive dividend rather than as compensation?

Consider also the social security tax and related considerations for compensation.

The Dividends Received Deduction - §243             p.187

Availability of  the §243  “dividends received deduction” to the recipient corporation:

              1) 70% - corporate investment situations;

                         (10.5% effective tax rate)      

                2) 80% DRD if 20% to 80% corporate ownership;

                3)  100% DRD if the dividend is paid to an affiliated group member.

Anti-Avoidance Limitations
on the DRD                       p.187

A.  Limits on the §243 “dividends received deduction”:    45 of 91 day holding period requirement - §246(c)(1)(A).  Longer holding period (90 days) for preferred stock.

Note re 2003 tax legislation: separate holding period rule limit (60 days in 120 day period) to enable the 15% dividend tax rate. §1(h)(11)(B)(iii)(I).

 

Anti-Avoidance Limitations
cont.     §1059                  p.188

B.   Treatment of extraordinary dividends, i.e., “dividend stripping”:

   1)  tax basis reduction and then gain recognition after the basis recovery.  §1059.

   2)  “extraordinary dividend” occurs when 10% plus of tax basis (or FMV) received in an 85 day (or shorter) period.

Note: 2003 tax legislation -  extraordinary dividend rule for individuals. §1(h)(11)(D)(ii).

Anti-Avoidance Limitations
cont.                                p.190

C.  Debt financed portfolio stock limitation on the deduction - §246A.

Debt must be attributable to “portfolio stock”, i.e., less than a 50 percent interest.

Proportionate disallowance if portfolio debt is only partially financed.

Reduction in DRD is limited to amount of interest expense deduction allocable to the dividend.  Direct attribution to debt.

 

Anti-Avoidance Limitations
cont.                                 p.192

D. §301(e) – downward e&p adjustments.  

Objective:  To limit the DRD (for 20% plus corporate shareholders), e.g.:

    1)  when E&P is increased because of slower depreciation schedules for E&P purposes (than usual §167 formula), or

    2) installment sale recognition for E&P but not for taxable income purposes.

Problem                           p.193
DRD Eligibility - 45 day rule

Investor corporation purchases 1,000 shares of publicly held common stock for $15,000 on June 3, collects $1,000 dividend on June 10, and sells stock for $14,000 on June 15. 

Anticipation:  1,000 dividend & 70% DRD = 300 ordinary dividends, plus  1,000 STCL.

Problem (a):  §246(c) results in denial of DRD.

 1) $1,000 of ordinary income, and

 2) $1,000 STCL on sale of stock.

 

Problem                           p.192
Stock Held Longer

(b)  Stock is retained until December 1 (rather than being sold on June 15):

The §246(c) DRD limitation would not apply since the 45 day minimum holding period requirement (during the specified 90 day period) has been satisfied in this situation.

Problem                 p.193, cont.
Dividend Stripping?

(c) Publicly Held pays second $1 per share dividend ($1,000) on August 15.  

§1059(c)(3) becomes applicable and a $2,000 dividend is treated as received.

The total dividends exceed 10 percent of tax basis for the stock (since tax basis is $15,000 and the total dividends are $2,000).

Basis is reduced by the nontaxed portion of the extraordinary dividend (i.e., by $1,400).

Problem                  p.193 cont.
Extraordinary Dividend?

(d)       Dividends received total $2 per share but stock is held for 25 months before sold.

Under §1059(a) stock must be held for more than two years before the dividend announcement date to avoid §1059. 

The $2,000 dividend would be an extraordinary dividend under §1059(c).

Basis is to be reduced by the nontaxed portion (2,000 less 600 (taxed) = $1,400).

Problem                  p.193 cont.
Portfolio Debt?

(e) Investor purchases stock for $15,000 by borrowing $15,000 secured by the stock and paid $1,500 interest expense during the year and received $1,000 dividends.

Under §246A(d)(3) the $15,000 is “portfolio indebtedness” with respect to the stock.

Under §246A(a) the §243 deduction is 70 percent of zero (100% less 100% = 0).

The $1,000 dividend is fully taxable.

 

Problem                  p.193 cont.
Partial Portfolio Debt

(f) Investor borrowed only $7,500 of the $15,000 total cost to acquire the stock.

  The ”average indebtedness percentage" would then be only 50%.  §246A(d).

  Under §246A(a) the dividends received deduction is 70% times 50%, or 35%.

  Of the $1,000 dividend received the DRD would be available for 35 percent of the total $1,000 dividend (or $350).

Dividends Paid in Bootstrap Sales                           p.194

TSN Liquidating Corp. v. U.S.,  p.194

Assets distributed by subsidiary to parent immediately prior to the sale of stock of sub.

Issue: (i) dividend (& DRD),  or

   (ii) sale of stock   (if stock sale - §453 installment sales treatment not available because of then applicable 30 percent limit on initial payment in installment sales).  

Held: DRD is available (dividend before sale).

Problem,  p.207         Dividend
Substance vs. Form

Strap Corp as the sole shareholder of X, Inc.

X stock held more than two years.   Therefore, no §1059 applicability.

Strap basis of $150,000 in X stock.

Boot willing to purchase X stock from Strap for $500,000.   X has $100,000 cash.

X will distribute $100,000 to Strap.

Strap will sell X stock to Boot for $400,000.

                                                            continued

 

Problem,  p. 207

Strap would receive a 100% DRD  -  if the form of the transaction is respected.

Strap’s LTCG would then be $250,000 (400 less 150 tax basis).

Here: the unwanted asset is fungible cash -  and is the distribution part of the sale?

Stronger step transaction argument for IRS?

Dividend excluded if a consolidated return.

                                                            continued

 

 

Problem            p.207, cont.

If Strap is an individual: IRS  would argue for dividend treatment since the $100,000 dividend would be treated as ordinary income (subject to tax at ordinary income tax rate, rather than the 15% rate for capital gains);  but compare impact after 2003 Act?

Planning in this context:  have the individual  redeem $100,000 worth of stock immediately before the sale to Boot?