Chapter 4 Nonliquidating Distributions
Dividends - i.e., “operating” distributions.
See IRC §301(a) - Subchapter C, Part A.
Alternative dividend classification systems:
1) Federal income tax– (a) income tax; & (b) e&p
2) Financial accounting – GAAP/SEC & intl. rules
3) Regulatory - utility rate-making
4) State income tax/franchise & TX margin tax
5) State corporate law/creditors’ protection rules
Dividend Payments - Alternatives for Corp.
A. Ordinary course of business
1. cash distribution
2. property – a) appreciated/depreciated
b) capital gain/ordinary income property
c) installment obligations
3. distribution of corporation's own notes
4. distribution of corporation's own stock
B. Extraordinary course of business
Tax Definition of a “Dividend” p.152
§301(c) Income Tax – Distribution 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.154
§1(h)(11) - taxation at capital gains rates (20%) to individual dividend recipient. “Permanent” rate.
Must be “qualified dividend income”, i.e., received from: (1) a domestic corporation, or
(2) a foreign corporation (if satisfying specified criteria). §1(h)(11)(C)(i)(II) & Notice 2011-64.
Must satisfy holding period requirement (60 of 121).
“Dividends” received from a “money market fund”? Not eligible for the 20% tax rate. Why?
Does the 20% dividends rate incentivize economy?
Corporate Dividend Policy
Why pay (or not pay) dividends?
- Retain earnings for future investments?
- Reduce borrowing costs through the retention of corporate earnings?
- Pay out earnings for a closely held corp. to shareholders, but only in a deductible form?
- Any effect on institutional shareholders?
Cf., better use of capital after corporate distributions have been made to shareholders?
Defining “Earnings and Profits” for Tax Purposes
P. 158. Code §312 concerns E&P concepts.
Objective: Identify a cash equivalent profits amount available for distribution to owners/shareholders; premised upon true economic results & not on the “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 (p.159)
- municipal bond income - §103
- life insurance proceeds (above tax basis?)
- federal tax refunds – this tax is not deductible
II. Deduction Addback Items to E&P (p.159)
- dividends to the corporate shareholder from another corp. when 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 (p.159)
- Federal income taxes paid by the corp.
- Disallowed losses - §265 and §267.
- Charitable contributions above the % limit.
- Disallowed T& E expense - §274.
These are “cash out of pocket” items but are not
deductible for FIT purposes.
E&P adjustments, continued §312(k)&(n)
IV Timing Adjustments for E&P (p.160).
A. Income components, e.g., §453 or the (if available?) “completed contract” method. P.160.
B. Depreciation components, e.g., §312(k)(3)(A) & §168(g)(2). Use alternative depreciation system & not ACRS. Also, §179 deduction amount to be amortized over 5 yrs. for E&P.
C. Inventory – FIFO method; not LIFO.
NOTE: (i) No statute of limitations on an E&P determination & (ii) No PLR re E&P status.
Income &E&P Determinations
I. Determining Taxable Income
Sales (gross) profits 20,000
Dividends from corp. 5,000
Long-term capital gain 2,500
Total gross income 27,500
Net Income Determination
Employee salaries 10,250
DRD - 70% of $5,000 (§243) 3,500
LTCL (limited to gain) 2,500
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 1,000) 1,800
(2,000 SL depreciation x ½ year)
Total increases to E&P 8,300
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.161 Income Tax Effects
1) Cash distribution to the shareholder is a “dividend,” but the dividend amount (ord. income for FedTax) is limited to the distributing corporation's “E&P” amount. See Code §301(c).
2) Result to the corporation: Reduction of E&P by the distribution amount, limited to the amount of E&P (i.e., cannot create a negative amount in E&P account).
3) What E&P allocation procedures (next slide)?
See Rev. Rul. 74-164 p.162
1) Current e&p is allocated proportionately to all current year distributions. Allocate first.
2) Accumulated e&p is allocated chronologically to distributions during the year (starting with the first distribution during the year).
3) Current loss is allocated pro rata against the accumulated e&p available on the date of the distribution, unless the date of the loss is specifically earmarked.
Multiple Share Purchases and Basis Recovery p.165
Shareholder might acquire shares of one corporation on several occasions and the purchase prices for each acquisition might be different.
For purposes of measuring tax basis recovery (under §301(c)(2) & (3)) each lot is treated separately (i.e., tax basis is not amalgamated) for purposes of determining capital gain (if any).
Cf., when only part of shares are sold: Determine basis for shares sold on FIFO, LIFO, averaging?
Problem (a) p.166
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 & distributes $17,500 .
Holding these shares more/less than one year?
Result: a) $5,000 dividend - §301(c)(1);
b) $10,000 return of capital - §301(c)(2); then, zero basis for the stock.
c) $2,500 capital gain- §301(c)(3). STCG? 39.6%?
Pelican's e&p is reduced to zero - §312(a)(1).
Problem (b) p.166
“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). §316(a)(2).
Pelican continues to have a $15,000 deficit in its e&p (i.e., no adjustments to e&p account).
No current e&p exists 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 allocation).
1) April 1 distribution of $10,000.
2,000 (pro rata portion of 4,000 current E&P); & then 8,000 of the 10,000 accumulated E&P (1st come/1st served) is 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 on April 1) allocated 1/2 (1,000) to each shareholder. Each has a $3,000 capital return (5,000 less 1,000 and less 1,000).
Zero E&P of corp. after these distributions.
Problem (c) continued
Stock sale results - p.166
3) On July 1 shareholder sells 1/2 of stock for 15k.
What basis, including any impact of the October transaction?
a) Original basis of $10,000 & sold ½ equals $5,000
tax basis allocated to this sale.
b) Also, less 1,500 basis (½ of the $3,000 tax basis return received on 10-1).
Equals: 15,000 less 6,500 (5,000 plus 1,500) or 8,500.
Problem (d) p.166
Current Year Deficit
Pelican has a $10,000 deficit in Year Two.
1) April 1 distribution of $10,000 to Ann
a) 1/4th of current 10,000 loss (2,500) is allocable to the April 1 distribution of 10,000 (no earmarking for the loss amount);
b) 7,500 dividend (reducing e&p from prior year to zero) & 2,500 return of capital to Ann.
Ann’s stock basis is reduced from 10,000 to 7,500.
Problem (d) p.166
Current Year Deficit
2) October distribution of $5,000 to Baker
(No e&p remaining & therefore, no dividend)
Purchase basis on July 1 15,000
Basis reduced – 10-1 distribution 5,000
Baker’s remaining basis 10,000
Problem (d), cont., p.166
Option One (dividends 1st)
2) October 1 distribution of $5,000 to Ann.
No current e&p & no acc. e&p. Ann’s results:
Option(s): Basis is: 7,500 3,750 (1/2?)
Less: distribution 5,000 5,000
Result: 2,500 1,250 (basis) (gain)
3) July 1 sale of 1/2 stock for 15k: (a) 11,250 gain (less 3,750 basis) or (b) 13,750 gain (15x less 1/2 of 2,500 or 1,250).
Problem (d), cont., p.166
Option Two (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 to Ann.
No current e&p & no accumulated e&p. Treatment to Ann:
Less: distribution 5,000
Basis is: 3,750
Result: 1,250 gain
Distributions of Property to Shareholders p.166
Prior history: General Utilities doctrine, i.e., no gain was to be recognized when appreciated property was distributed in a non-liquidating distribution to shareholders.
Earlier: Not treated as a sale, but certain limitations applied, such as the tax benefit rule and substance over form. See Code §311(a)(2).
Non-recognition was repealed in TRA-86.
Distributions of Property to Shareholders, cont. p.168
What corporate level tax effects?
Identifying current income tax issues to the corporation upon a property distribution:
1) Income (loss?) recognition to the distributing
corporation upon a distribution in kind?
Gain for the excess of FMV over tax basis is to be recognized. §311(b).
Cf., §311(a)(2) re no loss recognition.
Distributions of Property to Shareholders, cont. p.169
2) What effect on E&P from (a) this gain recognition to the corporation and (b) the distribution event? See §312(b). E&P is increased. 3) Effect when the distributed property is subject to a liability attached? See Reg. 1.312-3 re reduction of the E&P decrease - i.e., “proper adjustment.” Note (later): the dividend amount to the shareholder is limited to the net FMV of the property distributed.
Corporate Distributions of its Own Obligations p.170
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 - i.e., where the debt has OID). Code §312(a)(2).
Distributions of Property to the Shareholders p.170
Income tax issues to the shareholder upon a property distribution:
1) Dividend treatment to the shareholder receiving the property as a distribution (for the net fmv of the property)? Amount as reduced by any liabilities (assumed or attached to the property).
2) Tax basis to the shareholder for the property, not reduced by any assumed/attached debt; cf., Crane decireceived in the distribution? FMV of the property. butsion.
Corporation’s Own Obligations Received P.170
1) Dividend treatment to the shareholder receiving the corporation’s obligation property (for the net fmv of the property)?
2) Future income derived from this property can include interest income and original issue discount.
Problem (a) p.171
Zane purchased Sturdley stock for $8,000.
Sturdley has $25,000 accumulated e&p and no current e&p. Distribution of inventory is made:
$20,000 FMV and $11,000 basis for inventory.
1) Sturdley has recognized ordinary 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
4) Tax 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 Sturdley’s
Problem (b) p.171
No Pre-Distribution E&P
Sturdley has no accumulated e&p and no current e&p. Distribution of the appreciated 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 the shareholder - Distribution of the $20,000 inventory: 9,000 dividend, 8,000 tax basis recovery for shares, & 3,000 cap. gain. §301(c).
Problem (c) p.171
Distribution of land: $20,000 FMV; 11,000 basis; subject to 16,000 mortgage debt.
1) $9,000 income is realized by corporation on the land distribution. §311(b)(1).
2) E&P is increased by 9,000 - §312(b)(1).
3) Distribution to shareholder is $4,000 -
(20,000 FMV less the 16,000 debt). §301(b)(2).
Dividend income is 4,000 - adequate e&p exists.
FMV basis to the shareholder for the land.
Problem (d) p.171
$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 (property fmv) is made to the shareholder. §301(b)(1).
3) 20,000 tax basis to shareholder - §301(d).
4) E&P is reduced by $30,000 - §312(a)(3) & then 10,000 E&P for the future (25 + 15 less 30 = 10).
Problem (d), cont. p.171
Alternate: Property Sale
First, a sale of the depreciated property:
10,000 loss reduces corporation’s (1) taxable income and (2) current E&P (15 less 10 equals 5).
Distribution of 20,000 cash 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.171
Different E&P & FIT 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 seven year class life).
Purchased for $14,000 on July 1 of year one.
Distribution was made on January 1 of year 7.
Separate depreciation expense schedules for:
(i) income tax, and (ii) the E&P calculation.
Reg. §1.312-15(d). continued
Problem (e) cont., p.171
1) 10,000 ordinary income to Corp. 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) Dividend distribution of 10,000 to shareholder.
4) E&P is reduced by 10,000 - §311(a) & (b).
5) Remaining E&P? 25 + 8 less 10 = 23k.
6) 10,000 FMV basis for asset to shareholder.
Reg. §1.301-1(j) p.171
Types of disguised dividend distributions:
1) Excessive compensation paid to shareholders.
2) Personal expense reimbursements.
3) Excessive rent for corp. use of owner’s property.
4) Excessive interest paid on corp. debt, or interest is paid on debt which really constitutes equity.
5) Bargain sales of corp. property to shareholders.
6) Interest-free loans made to shareholders. §7872.
Nicholls, North, Buse Co.
v. Commissioner p.172
Corporate ownership of yacht and personal use of yacht by a son of the majority share 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 the tax year in issue.
& 20% Dividends Tax Rate
Taxation of dividends to the shareholder at the rate of 20% (after ATRA-2012).
Cf., maximum income tax rate of 39.6% for compensation income received (plus 3.8% ACA tax).
Better to have excess compensation treated as a constructive dividend rather than as compensation?
Consider also the social security tax (a 12.4% tax on maximum $118,500 for 2016), plus 2.9% unlimited medicare tax, and related considerations for compensation (in lower compensation ranges).
The Dividends Received Deduction - §243 p.177
Availability of the §243 “dividends received
deduction” to the recipient corporation:
1) 70% - corporate investment situations;
(10.5% effective tax rate, i.e., 30% x 35%)
2) 80% DRD if 20% to 80% corporate ownership of
another corporation’s stock;
3) 100% DRD if the dividend is paid to an
“affiliated group” member (i.e., above 80%).
Objective: reduce the cost of a 2nd corp. level tax.
on the DRD p.178
A) Limit on a corporation’s §243 “dividends received deduction”: 45 of 91 day holding period requirement - §246(c)(1)(A). Longer holding period (90 days of 181 day period) for preferred stock. Objective: must hold stock & have market risk to enable DRD availability.
Note re 2003 (2013) tax legislation for individuals:
A separate holding period rule limit (60 days in 120
day period) to enable the 20% (prior 15%)
dividend tax rate provided in §1(h)(11)(B)(iii)(I).
cont. §1059 p.179
B. Treatment to corp. of extraordinary dividends, i.e., “dividend stripping” transactions:
1) tax basis reduction (for nontaxed portion) and gain recognition after tax basis recovery. §1059.
2) “extraordinary dividend” occurs when 10% plus of tax basis (or FMV) amount (5% for preferred stock) is received in an 85 day (or shorter) period. Not in the 100% DRD situation.
Note: 2003 (2013) tax legislation - extraordinary dividend rule for individuals. §1(h)(11)(D)(ii).
C. Debt financed portfolio stock limitation on the dividends received deduction - §246A. Are interest expense deduction + DRD both acceptable?
Debt incurred must be attributable to “portfolio
stock” (i.e., less than a 50% ownership interest).
Proportionate disallowance occurs if portfolio
debt only partially finances the stock acquisition.
Reduction in DRD is limited to the amount of
interest expense deduction allocable to the dividend.
Direct attribution to debt (what if “indirect” debt?)
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 (cf., the usual §§167/168 depreciation formula), or
2) installment sale recognition occurs for E&P but
not for taxable income purposes (i.e., postponed).
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 12, and sells the stock for $14,000 on June 15.
Anticipation: 1,000 dividend & 70% DRD = 300 net ordinary dividends (100x tax?), plus 1,000 STCL.
Problem (a): §246(c) results in denial of the DRD.
1) $1,000 ordinary income (not $300 with DRD), and
2) $1,000 STCL on sale of stock.
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.184, cont.
(c) Publicly Held pays a second $1 per share dividend ($1,000) on August 15 (60 days later).
§1059(c)(3) becomes applicable and a $2,000 total dividend is treated as having been received.
The total dividends exceed 10 percent of the tax basis for the stock (since tax basis is $15,000 and the total dividends are $2,000).
Tax basis is reduced by the nontaxed portion of the extraordinary dividend (i.e., $1,400 – 70% DRD).
Problem p.184 cont.
(d) Dividends received total $2 per share but stock is held for 25 months before being sold.
Under §1059(a) stock must be held for more than two years before the dividend announcement date to avoid §1059 application.
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.184 cont.
(e) Investor (i) purchases stock for $15,000 by (ii) borrowing $15,000 secured by the stock, (iii) paid $1,200 interest expense during the year (40% tax effect deduction) and (iv) received $1,000 dividends (20% tax if individual).
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.184 cont.
Partial Portfolio Debt
(f) Investor borrowed only $7,500 of the $15,000 total cost (i.e., 1/2) to acquire the stock.
The “average indebtedness percentage" would then be only 50% of purchase price. §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.184
TSN Liquidating Corp. v. U.S., p.184
Assets are distributed by the subsidiary to parent corp. immediately prior to the sale of stock of sub.
Issue: (i) dividend (& DRD available)? or
(ii) sale of stock proceeds (if stock sale - §453 installment sales treatment was not then available because of then applicable 30 percent limit on the initial payment in installment sales)?
Held: DRD is available (dividend before the sale).
Problem, p.196 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 then sell X stock to Boot for $400,000.
Problem, p. 196
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.
Problem p.196, cont.
If Strap is an individual: Would IRS 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 20% rate for capital gains). But, also a 20% rate for dividends received by individuals.
Planning in this context: have the individual redeem $100,000 worth of stock immediately before the sale to Boot?