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Tax 4022/5022 Federal Income Tax II Chapter 19

Tax 4022/5022 Federal Income Tax II Chapter 19. Dr. Robert R. Oliva Professor and Chairperson Department of Accounting University of Arkansas at Little Rock. Agenda. I. Dividends II. Redemptions. I. Dividends. Introduction . Tax effect of corporate distributions

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Tax 4022/5022 Federal Income Tax II Chapter 19

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  1. Tax 4022/5022 Federal Income Tax II Chapter 19 Dr. Robert R. Oliva Professor and Chairperson Department of Accounting University of Arkansas at Little Rock

  2. Agenda • I. Dividends • II. Redemptions

  3. I. Dividends

  4. Introduction • Tax effect of corporate distributions • Dividends • Return of Capital • Gain • IRC’s 301; 317; 316 • Earnings and Profits • Effect of IRC 243

  5. IRC 301(a): • Except as otherwise provided . . ., a distribution of property [as defined in . . . 317(a)] made by a corporation to a shareholder with respect to its stock shall be treated . . . [as provided in 301(c)]. . . .”

  6. IRC 301(c)(1): • That portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income.

  7. IRC 301(c)(2): • That portion . . . which is not a dividend shall be applied and reduce the adjusted basis of the stock . . . .

  8. IRC 301(c)(3): • That portion . . . which is not a dividend, to the extent that it exceeds the adjusted basis . . . shall be treated as gain from the sale or exchange of property. . . .

  9. IRC 317(a): • For purposes of this part, the term “property” means money, • securities, and any other property; except . . . stock in the • corporation making the distribution (or rights . . . .)

  10. EARNINGS AND PROFITS • AN INDICATION OF A CORPORATION’S ABILITY TO PAY A DIVIDEND • NO SPECIFIC DEFINITION IN IRC. • STARTS WITH TAXABLE INCOME

  11. T.I. + ITEMS EXCLUDED FROM INCOME • LIFE INSURANCE PROCEEDS • INTEREST FROM MUNICIPAL BONDS • COMPENSATORY INJURIES • FIT REFUNDS • IRC 243 • TIMING ADJUSTMENTS • REALIZED BUT UNRECOGNIZED GAINS

  12. T.I. - EXPENSES NOT DEDUCTED FROM T.I. • FIT PAID • EXPENSES IN CONNECTION W/CARRYING MUNIS • EXCESS CHARITABLE DEDUCTIONS • INS. PREMIUMS PAID BUT NOT DEDUCTIBLE • EXCESS CAPITAL LOSSES • ANY EXPENSES PAID BUT NOT DEDUCTIBLE

  13. EXAMPLE 1:INCOME • OPERATING INCOME: $30,000 • DIVIDEND INCOME: 20,000 • MUNICIPAL BOND INTEREST: 8,000 • LTCG: 6,000

  14. EXAMPLE 1: EXPENSES: • OPERATING EXPENSES: $17,000 • KICKBACKS: $5,000 • ACC. DEPRECIATION: $9,000 (SL:$3,000) • CAPITAL LOSSES: $7,000

  15. DETERMINE EP ASSUMING AN 80% DRD AND A 30% AGGREGATE TAX LIABILITY

  16. TAXABLE INCOME: • PLUS: OI ($30K) + DIV ($20K) + LTCG ($6K) = $56,000 • LESS: OE ($17K) + DEP ($9K) + LTCL ($6K) + DRD ($16K) = $48K • TAXABLE INCOME = $ 8,000

  17. EARNINGS AND PROFITS: • T.I. = $8,000 • PLUS: MUNI($8K) + DRD($16K) + DEP($6K) = $38K • LESS: KICKBACKS($5K) + EXCESS LOSS ($1K) + TAX ($2.4K) = $8.4K • EP = $38K - $8.4 = $29.6K

  18. DIVIDEND/EP RULES: IRC 316(a)

  19. IRC 316(a): DIVIDEND DEFINED • ANY DISTRIBUTION OF PROPERTY . . . OUT OF EP OF THE TAXABLE YEAR (COMPUTED AS OF THE CLOSE OF THE TAXABLE YEAR WITHOUT DIMINUTION BY REASON OF ANY DISTRIBUTIONS MADE DURING THE TAXABLE YEAR), WITHOUT REGARD TO THE AMOUNT OF EP AT THE TIME OF THE DISTRIBUTION . . . .

  20. IRC 316(a): CONT. • EXCEPT AS OTHERWISE PROVIDED . . ., EVERY DISTRIBUTION IS MADE OUT OF EP TO THE EXTENT THEREOF, AND FROM THE MOST RECENTLY ACCUMULATED EP . . . .”

  21. OTHER EP RULES: • DISTRIBUTIONS CANNOT CREATE/INCREASE EP DEFICITS • CONSIDER CEP + AEP, BUT CEP BEFORE AEP • CEP DEFICIT REDUCES AEP SURPLUS

  22. ALLOCATE CEP • IF > 1 DISTRIBUTION • ALLOCATE AS % OF TOTAL DISTRIBUTION • THEN OFFSET AEP AS NEEDED, AS IN FIFO. • IF > 1 SHAREHOLDER • ALLOCATE AS % OF OWNERSHIP.

  23. CEP DEFICIT: • ALLOCATED EVENLY THROUGHOUT YEAR • UNLESS IDENTIFIABLE TO SPECIFIC PART OF THE YEAR • CEP DEFICIT REDUCES AEP SURPLUS • A/O DISTRIBUTION DATE • OFFSET AEP AS IN FIFO

  24. THUS • POSITIVE CEP: PROPORTIONAL ALLOCATION • NEGATIVE CEP: DAILY ALLOCATION

  25. Cash Distribution Example A $20,000 cash distribution is made in each independent situation: 1 2 3* Accumulated E & P, beginning of year 100,000 (100,000) 15,000 Current E & P 50,000 50,000 (10,000) Dividend: 20,000 20,000 5,000 *Since there is a current deficit, current and accumulated E & P are netted before determining treatment of distribution.

  26. SINGLE DISTRIBUTION EXAMPLES: DISTRIBUTION OF $35K W/ AB = $10K • #2: CEP 100; AEP 0: DIV=35; AB=10 • #3: CEP 20; AEP 0: DIV=20; AB= 0; G=5 • #4: CEP 20; AEP (80): DIV=20; AB= 0; G=5

  27. MULTIPLE DISTRIBUTION EXAMPLE (#5): • 4 QTR. DIST. OF $25K; CEP=200K; AEP=0; AB=10 • ALLOCATE 25% OF CEP/QTR=$50K • ALL DIST. IS A DIVIDEND

  28. Multiple Dist.: • 1st Quarter: $35K • 2nd quarter: $15K • 3rd Quarter; $25K • 4th Quarter: $25K

  29. MULTIPLE DIST. EXAMPLE (#6):4 QTR DIST OF $25K; CEP $25K; AEP=$12K; AB=$10K • ALLOCATE 25% OF CEP/QTR=$6250/QTR • QTR 1: CEP + AEP USED UP IN QTR 1: • DIV = 6250+12000=18250 • OFSSET BALANCE OF DIST v. AB: 10000-6750=$3250 BAL ABEXAMPLE #6: LAST TWO QUARTERS: • QTR 2: 6250 CEP + 3250 AB = $6250 DIV; 3250 ROB; G=15.5 • QTRS 3 & 4: $6250/QTR AS DIV; 18750/QTR AS GAIN • TOTALS: • DIV= 25K+12K= 37K • ROB= 10K • GAIN= 53K

  30. EXAMPLE 7: SAME AS 6 BUT AEP DEFICIT: • NOTE: DISTRIBUTIONS CANNOT INCREASE EP DEFICIT • SAME RESULTS EXCEPT AEP IS NEITHER INCREASEDOR DECREASED.

  31. EXAMPLE 8: MULT. DIST.; NEGATIVE CEP • FOUR $5K QTR. DIST; CEP (50K); AEP=30K; AB=10K • ALLOCATE 25% CEP DEFICIT/DIST; OFFSET AEP AS NEEDED. • 1ST DIST: 30K-12.5K=$17.5 AEP AVAIL. • 17.5 - 5 DIST.= $5K DIV; 12.5 BAL IN AEP AGAINST 2ND DIST. • 2ND DIST.: $12.5 AEP - $12.5 CEP DEF. = 0 AEP

  32. EFFECT OF 2ND-4TH DISTS.: • SINCE AEP = 0 • 2D & 3D DIST. OF $5K= ROB OF $10K • 4TH DIST. = $5K GAIN

  33. CONSEQUENCES OF DIST. TO CORPORATION • AMOUNT DISTRIBUTED: • IRC 311(b)(2)/IRC 336(b): EFFECT OF DISTR. LIABILITY • GAIN/LOSS RECOGNIZED: • IRC 311(b): RECOGNIZE GAIN IF DIST. APP. PTY. • IRC 311(a): DONT RECOGNIZE LOSS IF DIST. LOSS PTY.

  34. CONSEQUENCES OF DIST. TO CORP.: EFFECT ON EP • INCREASE EP • BY GAIN RECOGNIZED IF DIST. APP. PTY. • REDUCE EP: • CASH • GREATER OF FMV PTY OR AB PTY • BUT ADJUST FOR THE AMOUNT OF LIAB. ASSUMED BY SHDR • FACE AMOUNT OF DIST CORP. DEBT

  35. Property Distribution Example Property is distributed (corporation’s basis = $20,000) in each of the following independent situations. Assume Current and Accumulated E & P are both $100,000 in each case: 1 2 3 Fair market value of distributed property 60,000 10,000 40,000 Liability on property -0- -0- 25,000 Gain(loss) recognized 40,000 -0- 20,000 E&P increased by gain 40,000 -0- 20,000 E & P decrease on dist. 60,000 20,000 15,000

  36. Situation #3 • Gain(loss) recognized: FMV - AB = 40-20 = 20 • Increase EP: FMV-AB = 40-20 = 20 • Reduce EP: F= FMV-Assumption = 40-25 = 15K

  37. CONSTRUCTIVE DISTRIBUTIONS • EXCESSIVE COMPENSATION • INTEREST ON SHDRS’ LOANS < FMV: IRC 7872 • PERSONAL OR BUSINESS?

  38. EXCESSIVE COMPENSATION • QUALIFICATIONS; SCOPE OF WORK; BUSINESS SIZE • COMPLEXITIES; DIV. HISTORY • SALARY v. GROSS v. NET • COMPARABLE PAY; SALARY POLICY; BOD APPROVAL

  39. HEDGE AGREEMENT • SHDR AGREES TO PAY BACK TO CORP DISALLOWED SALARY • PAYBACK DEDUCTIBLE BY SHDR UNDER IRC 162.

  40. LOANS TO SHAREHOLDERS • IS IT A LOAN? • WRITTEN; ADEQUATE i; SECURITY; PAYMENT SCH.; REPAYMENTS; DIV HISTORY; DEBT RATIO; PROPORTIONALITY OF LOANS TO EQUITY • IF A LOAN AND NO INTEREST: IRC 7872 • DEMAND LOAN • TERM LOAN

  41. DEMAND LOAN • NOT TRANSFERABLE; CONDITIONED ON SERVICES • LOAN OF $50K, NO i; FMV i = 10% (S/A i = 10.25%) • EACH YEAR: • SHDR DEEMED TO HAVE RECEIVED A $5,125 “DEEMED DISTRIBUTION” • SHDR DEEMD TO HAVE PAID $5,125 IN INTEREST TO CORP.

  42. NOT NECESARILY A “WASH”: • SHDR: DIV. INC. IF EP • SHDR: DEDUCT INTEREST DEEMED PAID TO CORP, AS LONG AS LOAN WAS USED FOR BUSINESS AND NOT PERSONAL. • CORP: RECOGNIZES INTEREST INCOME OF $5,125

  43. TERM LOAN: $50K, FOR 5 YEARS, NO i • PV OF $50K TO BE DELIVERED IN 5 YEARS, S/A AT 10.25% = $30,696 • DIFFERENCE: $50,000 - $30,696 = $19,304 IS A DEEMED DISTRIBUTION IN YEAR OF LOAN. • DIV. INC. OF $19,304 IF ENOUGH EP

  44. TERM LOAN/ DEEMED INTEREST PAYMENTS • YR 1: (.1025) ($30,696) = $3,146 • YR 2; (.1025) ($30,696 + $3,146) = $3, 469 • SAME AS BEFORE TO YR 5.

  45. CORPORATE SHAREHOLDERS • IRC 243 • BOOTSTRAP SALES • WATERMAN STEAMSHIP: DIV NOT RESPECTED • LITTON INDUSTRIES: DIV RESPECTED • IRC 1059: PENALIZES NOT HOLDING FOR => 2 YEARS BY REDUCING AB BY DRD

  46. Corporate Distribution Planning(slide 1 of 2) • Maintain ongoing records of E & P: • Ensures return of capital is not taxed as dividend • No statute of limitations on E & P, so IRS can redetermine at any time. • Accurate records minimize this possibility

  47. Corporate Distribution Planning(slide 2 of 2) • Adjust timing of distribution to optimize tax treatment: • If accumulated E & P deficit and current E & P loss, make distribution by end of tax year to achieve return of capital • If current E & P is likely, make distribution at beginning of next year to defer taxation

  48. Avoiding Constructive Dividends (slide 1 of 2) • Structure transactions at “arms’ length” rates: • Reasonable rent, compensation, interest rates, etc...

  49. Avoiding Constructive Dividends(slide 2 of 2) • Use mix of techniques to “Bail out” corporate earnings such as: • Shareholder loans to corporation at highest reasonable interest rates • Compensation paid to a shareholder-employee at the highest reasonable levels, plus “perks” such as health insurance • Rent property owned by shareholder to entity at highest reasonable rates • Make some dividend payments to minimize possibility that IRS considers disguised dividends

  50. II. IRC 302: REDEMPTIONS

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