Dividends - i.e., “operating”
IRC §301(a) - Subchapter C,
1) Federal income tax– income
2) Financial accounting –
3) Regulatory - utility
4) State income
5) State corporate
Dividend Payment Alternatives
A. Ordinary course of
2. property -
gain/ordinary income property
corporation's own notes
corporation's own stock
B. Extraordinary course
Tax Definition of a
§301(c) Income Tax Ordering
1) §301(c)(1) - dividend
2) §301(c)(2) - recovery of
3) §301(c)(3) - realization
of capital gain.
§316 - Dividend distribution sourcing:
“earnings & profits,” or
2) current “earnings
(i.e., the "nimble
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
corporation (if satisfying specified criteria).
Must satisfy a holding
“Dividends” from “money
market fund”? No.
Corporate Dividend Policy
Why pay (or not pay)
- Retain earnings for
- Reduce borrowing costs
Pay out earnings for closely held corp. shareholders only in a
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
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
1) Taxable 2)
E&P 3) Earned surplus;
Adjustments to Taxable Income
for E&P Amount
I. E&P Additions for
- 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
E&P adjustments, continued
Nondeductible amounts which do reduce the E&P amount
- Federal income
- Disallowed losses
- §265 and §267.
contributions above % limit.
- Disallowed T&
E expense - §274.
These are “cash out of
IV Timing Adjustments
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.
C. Inventory – FIFO method; not
of limitations on E&P determination.
Income &E&P Determinations
I. Determining Taxable
Sales profits 20,000
Net Income Determination
Employee salaries 10,250
DRD - 70% of $5,000
LTCL (limited to gain)
Total deductions 19,050
Total taxable income 8,450
(27,500 less 19,050)
Taxable income 8,450
Increases to E&P:
Tax-exempt interest 3,000
Dividends received deduction 3,500
Depreciation (2,800 less
(2,000 SL depreciation x
Total increases to
Decreases to E&P Amount
Estimated federal taxes
Earnings and profits total 13,450
(8,450 + 8,300 less 3,300)
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
Rev. Rul. 74-164 p.170
e&p is allocated proportionately to all current year
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
Distribution Exceeding E&P
$10,000 tax basis to Ann for
Pelican has $5,000 of current
e&p and no accumulated e&p and distributes $17,500.
Result: a) $5,000 dividend -
return of capital - §301(c)(2); zero basis for the
capital gain - §301(c)(3).
Pelican's e&p is reduced to
zero - §312(a)(1).
“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
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
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.
Problem (c) continued
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
Current Year Deficit
Pelican has a $10,000 deficit
in Year Two.
1) April 1 distribution
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.
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
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
Less: distrib. 5,000
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
Distributions of Property to
Income tax issues upon property
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?
Zane purchased Sturdley stock
Sturdley has $25,000
accumulated e&p and no current e&p. Distribution of inventory
$20,000 FMV and $11,000
1) Sturdley has recognized gain
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
4) Basis to Zane for the
$20,000 (FMV) -
§301(d). Holding period?
5) Remaining E&P is
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.
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
1) Distribution produces to the
$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).
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
3) Distribution to shareholder
is $4,000 -
20,000 less the 16,000 debt. §301(b)(2).
Dividend income is 4,000 -
$25,000 acc. e&p and 15,000
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
Problem (d), cont.
Alternate: Property Sale
First a sale of the depreciated
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
But, shareholder might want the
land for other (e.g., sentimental) reasons.
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.
(i) income tax, and (ii)
Problem (e) cont., p.178
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
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
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.
Distribution of OID Obligation
Shareholder stock basis is
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.
Reg. §1.301-1(j). p.180
Types of disguised dividend
1) Excessive compensation to
2) Personal expense
3) Excessive rent for use of
4) Excessive interest on debt,
or interest paid on debt which really constitutes equity.
5) Bargain sales of property to
6) Interest-free loans to
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
2) Use was imputed to the
father (not son).
3) Amount of the dividend (to
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
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.
& 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
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;
effective tax rate)
DRD if 20% to 80% corporate ownership;
DRD if the dividend is paid to an affiliated group member.
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).
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)
Note: 2003 tax legislation -
extraordinary dividend rule for individuals. §1(h)(11)(D)(ii).
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.
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.
D. §301(e) – downward
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.
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.
§246(c) results in denial of DRD.
1) $1,000 of ordinary
2) $1,000 STCL on sale of
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.
(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).
(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
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).
(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
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
Dividends Paid in Bootstrap
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 (&
(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).
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
Boot willing to purchase X
stock from Strap for $500,000. X has $100,000 cash.
X will distribute $100,000 to
Strap will sell X stock to Boot
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
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
Planning in this context: have
the individual redeem $100,000 worth of stock immediately before the
sale to Boot?