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CCH Federal Taxation Comprehensive Topics Chapter 15 Corporate Nonliquidating Distributions

CCH Federal Taxation Comprehensive Topics Chapter 15 Corporate Nonliquidating Distributions. ©2006 , CCH, a Wolters Kluwer business 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 www.CCHGroup.com. Chapter 15 Exhibits.

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CCH Federal Taxation Comprehensive Topics Chapter 15 Corporate Nonliquidating Distributions

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  1. CCH Federal TaxationComprehensive TopicsChapter 15Corporate Nonliquidating Distributions ©2006, CCH, a Wolters Kluwer business 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 www.CCHGroup.com

  2. Chapter 15 Exhibits 1. Effect of Operations on Owners—Comparison Among Entities 2. Effect of Nonstock Distributions on Owners—Comparison Among Entities 3. Effect of Nonstock Distributions on Entities—Comparison Among Entities 4. Effect of Taxable Stock Distributions on Shareholders 5. Effect of Identical, Nontaxable Stock Distributions on Shareholders 6. Effect of Nonidentical, Nontaxable Stock Distributions on Shareholders 7. Effect of Stock Redemptions on Shareholders 8. Effect of Stock Redemptions on Corporations 9. Effect of Complete Liquidations on Shareholders 10. Effect of Complete Liquidations on Corporations Chapter 15, Exhibit Contents A CCH Federal Taxation Comprehensive Topics

  3. Chapter 15 Exhibits 11. Nonstock Distributions—Effect on Shareholders 12. Earnings and Profits of C Corporations 13. Nonstock Distributions—Effect on Corporation 14. Nonstock Distributions—Examples 15. Stock Distributions 16. Redemptions (Including Partial Liquidations)—Overview 17. Redemptions (Including Partial Liquidations)—Tax Effect on Shareholders 18. Redemptions (Including Partial Liquidations)—Example on Shareholder Effect 19. Redemptions (Including Partial Liquidations)—Tax Effect on Corporations 20. Redemptions (Including Partial Liquidations)—Example on Corporate Effect Chapter 15, Exhibit Contents B CCH Federal Taxation Comprehensive Topics

  4. Effect of Operations on Owners—Comparison Among Entities Chapter 15, Exhibit 1a CCH Federal Taxation Comprehensive Topics

  5. Effect of Operations on Owners—Comparison Among Entities Chapter 15, Exhibit 1b CCH Federal Taxation Comprehensive Topics

  6. Effect of Nonstock Distributions on Owners—Comparison Among Entities Chapter 15, Exhibit 2a CCH Federal Taxation Comprehensive Topics

  7. Effect of Nonstock Distributions on Owners—Comparison Among Entities Chapter 15, Exhibit 2b CCH Federal Taxation Comprehensive Topics

  8. Effect of Nonstock Distributions on Owners—Comparison Among Entities Chapter 15, Exhibit 2c CCH Federal Taxation Comprehensive Topics

  9. C and S Corporations Partnerships Does an entity recognize gain or loss on the distribution of: i) Cash or its own bonds to owners? ii) Other property (other than its own stock)? No Gains: Yes (compute gain in the same way as if the property were sold) Losses: No (except in complete liquidation) No No gain or loss, unless it is part of a disguised sale. In a disguised sale, the partnership’s recognized gain or loss = (a) – (b), where: (a) = FMV of property dist’d. (b) = AB of property dist’d. Effect of Nonstock Distributions on Entities—Comparison Among Entities Chapter 15, Exhibit 3a CCH Federal Taxation Comprehensive Topics

  10. Effect of Nonstock Distributions on Entities—Comparison Among Entities Chapter 15, Exhibit 3b CCH Federal Taxation Comprehensive Topics

  11. Effect of Taxable Stock Distributions on Shareholders Rules for Taxable Stock Dividends: 1. Upon receipt: Stock dividends are taxable as ordinaryincome at their fair market value (FMV). 2.  Upon sale: Basis of taxable stock dividends = same amount as in (a) above; holding period begins on the day AFTER receipt (i.e., consistent with the general rule for holding period). Chapter 15, Exhibit 4a CCH Federal Taxation Comprehensive Topics

  12. Effect of Taxable Stock Distributions on Shareholders Chapter 15, Exhibit 4b CCH Federal Taxation Comprehensive Topics

  13. Effect of Taxable Stock Distributions on Shareholders Solution: March 31, 20x1 receipt: $4,000 taxable dividend income. $4,000 = $20/share x (1,000 old x 20%); June 30, 20x2 sale: $2,000 short-term capital gain. $2,000 = $6,000 sales proceeds - $4,000 basis of new shares. (The beginning holding period date is October 1, 20x1, the day AFTER receipt of the stock dividend. A June 30, 20x2 sale results in a short-term holding period.) Chapter 15, Exhibit 4c CCH Federal Taxation Comprehensive Topics

  14. Effect of Identical, Nontaxable Stock Distributions on Shareholders Rules for Identical, Nontaxable Stock Dividends: 1.  Upon receipt: Stock dividends are not taxable. 2. Upon sale: Allocate old basis over old and new shares using the following formula: Basis per share = old basis  (# old shares + # new shares) (Holding period of original and new shares begins on day AFTER original acquisition.) Chapter 15, Exhibit 5a CCH Federal Taxation Comprehensive Topics

  15. Effect of Identical, Nontaxable Stock Distributions on Shareholders Chapter 15, Exhibit 5b CCH Federal Taxation Comprehensive Topics

  16. Effect of Identical, Nontaxable Stock Distributions on Shareholders Solution: March 31, 20x1 receipt: The stock dividends are not taxable. June 30, 20x2 sale: $4,000 long-term capital gain (6,000 – 2,000). $2,000 basis of new shares = $10/share x 200 new shares, where $10/share = [$12,000  (1,000 old shares + 200 new shares)]; (The beginning holding period date is 4/1/x1, the day AFTER receipt of the original stock. A 6/30/x2 sale results in a long-term holding period.) Chapter 15, Exhibit 5c CCH Federal Taxation Comprehensive Topics

  17. Effect of Nonidentical, Nontaxable Stock Distributions on Shareholders Rules for Nonidentical, Nontaxable Stock Dividends: 1. Upon receipt: Stock dividends are not taxable. 2.  Upon sale: Allocate the original common stock (C/S) basis between the number of original C/S shares and the number of new preferred stock shares (P/S) using relative fair market values as of the date of receipt. 3.  The holding period of the original C/S does not change (i.e., it begins on the day AFTER original acquisition). The holding period of the new P/S shares is the same as the C/S. Chapter 15, Exhibit 6a CCH Federal Taxation Comprehensive Topics

  18. Effect of Nonidentical, Nontaxable Stock Distributions on Shareholders Chapter 15, Exhibit 6b CCH Federal Taxation Comprehensive Topics

  19. Effect of Nonidentical, Nontaxable Stock Distributions on Shareholders Solution: March 31, 20x1 receipt: The stock dividends are not taxable. June 30, 20x2 sale of common stock: $14,000 long-term capital gain 1. $14,000 capital gain: = (20,000 sales price – 8,000 adjusted basis). 2.  $8,000 AB = $12,000 x [(1,000 C/S shares x 16 per share]  [16,000 + (100 P/S shares x 80 per P/S share)] 3.  Long-term HP: The beginning holding period date is April 1, 20x1, the day AFTER receipt of the original stock. A June 30, 20x2 sale results in a long-term holding period. June 30, 20x2 sale of preferred stock: $6,000 long-term capital gain 1. $6,000 capital gain: = 10,000 sales price – 4,000 adjusted basis). 2.  $4,000 AB = 12,000 x [(100 P/S shares x 80 per share]  [16,000 + 8,000] 3.  Long-term HP: The beginning holding period date is April 1, 20x1, the same as the common stock. A June 30, 20x2 sale results in a long-term holding period. Chapter 15, Exhibit 6c CCH Federal Taxation Comprehensive Topics

  20. Stock Redemptions Corporations What is the tax effect of redemptions on shareholders? If dividend treatment: Same as non-stock distributions, i.e., C Corps 1. Ord. up to curr. E&P; 2.  Ord. up to accum. E&P; 3.  Tax-free up to outside basis 4.  Capital gain on remainder Effect of Stock Redemptions on Shareholders Chapter 15, Exhibit 7a CCH Federal Taxation Comprehensive Topics

  21. Effect of Stock Redemptions on Shareholders Chapter 15, Exhibit 7b CCH Federal Taxation Comprehensive Topics

  22. Effect of Stock Redemptions on Shareholders Chapter 15, Exhibit 7c CCH Federal Taxation Comprehensive Topics

  23. Effect of Stock Redemptions on Shareholders Chapter 15, Exhibit 7d CCH Federal Taxation Comprehensive Topics

  24. Does a corporation recognize gain or loss on redemption? (a)  If it distributes cash or its own bonds to owners? (b)  If it distributes other property to its owners? No Gains: Yes, computed as if the property were sold; Losses: No. Effect of Stock Redemptions on Corporations Chapter 15, Exhibit 8 CCH Federal Taxation Comprehensive Topics

  25. Does an owner recognize gain or loss in a complete liquidation? 1. Parent owns less than 80% of subsidiary: Yes, gains and losses are recognized, using the same formula as for redemptions with sales treatment, i.e., capital gain/loss = (a) – (b) – (c): (a) = Fair market value of property received (b) = Corporate debt assumed (c) = Basis of stock given up 2. Parent owns 80% or more of subsidiary: No gain or loss Effect of Complete Liquidations on Shareholders Chapter 15, Exhibit 9 CCH Federal Taxation Comprehensive Topics

  26. Effect of Complete Liquidations on Corporations Chapter 15, Exhibit 10 CCH Federal Taxation Comprehensive Topics

  27. Nonstock Distributions—Effect on Shareholders What is the amount of distributions other than stock? The amount of distribution other than stock of the corporation is: (a) – (b), where, (a) = The fair market value of all property received (other than the common stock of the distributing corporation) (b) = Liabilities of the distributing corporation, both recourse and nonrecourse, assumed by the shareholder Chapter 15, Exhibit 11a CCH Federal Taxation Comprehensive Topics

  28. Nonstock Distributions—Effect on Shareholders Chapter 15, Exhibit 11b CCH Federal Taxation Comprehensive Topics

  29. Nonstock Distributions—Effect on Shareholders What is a shareholder’s basis in the nonstock property distributed by the corporation? Basis = Fair market value of the asset. The assumption of a liability does not affect basis. Chapter 15, Exhibit 11c CCH Federal Taxation Comprehensive Topics

  30. Earnings and Profits of C Corporations Chapter 15, Exhibit 12 CCH Federal Taxation Comprehensive Topics

  31. Nonstock Distributions—Effect on Corporation Does a corporation recognize a gain or loss on the distribution of cash or its own bonds? No. Chapter 15, Exhibit 13a CCH Federal Taxation Comprehensive Topics

  32. Nonstock Distributions—Effect on Corporation Does a corporation recognize a gain or loss on the distribution of an asset? Yes for gains (unlike partnerships), no for losses (similar to partnerships). A corporation is considered to have sold the property to the shareholder at the larger of FMV of the asset or the debt associated with the asset. Gain is computed as follows: Gain = [greater of (a) or (b)], minus (c), where, (a) = FMV of property distributed (b) = corporation’s debt relief (if any) (c) = corporations adjusted basis in the property distributed The character of the gain is based on the character of the assets distributed. However if the shareholder owns > 50% of the o/s stock, the corporation’s gain is ordinary, regardless of the character of the assets. Chapter 15, Exhibit 13b CCH Federal Taxation Comprehensive Topics

  33. Nonstock Distributions where Mortgage > Fair Market Value of Property Facts: 1.  X Corp. distributed land to Fred, a shareholder. The land had been held as investment by X for five years. At the time of the distribution, the land had a FMV of $60, a basis to X of $5, and was subject to a mortgage of $70. 2.  X Corp.’s current and accumulated E&P was $2 and $18, respectively. Questions: 1 What is the amount and character of the recognized gain to X Corp. as a result of this distribution? 2 If Fred the stockholder has a $20 basis in his X stock, what is the amount and character of his recognized gain? 3 What is Fred’s basis in the land? Nonstock Distributions—Examples Chapter 15, Exhibit 14a CCH Federal Taxation Comprehensive Topics

  34. Nonstock Distributions—Examples Chapter 15, Exhibit 14b CCH Federal Taxation Comprehensive Topics

  35. Nonstock Distributions—Examples Chapter 15, Exhibit 14c CCH Federal Taxation Comprehensive Topics

  36. Example 2, Question 2 Computation Amount of distribution = $50 [(Land FMV: 60) - (Mortgage on Land: 10) = 50] Distributions to the Extent of: Tier Tax Treatment to Shareholder Current E&P 2 1. Ordinary income based on FMV Accumulated E&P 18 2. Ordinary income based on FMV Shareholder’s basis in the stock 3. Nontaxable return of capital 20 Any balance remaining 10 4. Capital gain 50 Total amount distributed Nonstock Distributions—Examples Chapter 15, Exhibit 14d CCH Federal Taxation Comprehensive Topics

  37. Stock Distributions What types of stock distributions are taxable to shareholders? Stock dividends are usually tax-free to the shareholder unless any one of the following exceptions occurs under Code Sec. 305(b): 1. In lieu of cash. Shareholders could have opted for cash, but instead chose stock. 2.  Disproportionate distributions. (e.g., some shareholders receive property, others receive stock.) 3.  Common/preferred. (e.g., some shareholders receive C/S dividends, others receive P/S.) 4.  Dividends “of” convertible preferred stock. 5.  Dividends “of” preferred stock “on” preferred stock. Chapter 15, Exhibit 15a CCH Federal Taxation Comprehensive Topics

  38. Stock Distributions Exceptions 1 - 4(from previous slide) are taxable because they allow the proportionate ownership mix of the shareholders to change. (Economic benefit doctrine applies.) Exception 5 (from previous slide) is taxable because the recipients of preferred stock dividends get an increase in their priority claims (vis-à-vis common shareholders) against corporate net assets in event of liquidation. (Again, the economic benefit doctrine applies.) Chapter 15, Exhibit 15b CCH Federal Taxation Comprehensive Topics

  39. What is the tax effect of stock dividends on the corporation and its shareholders? It depends on whether stock dividends are taxable or nontaxable: Corporate Treatment Taxable Nontaxable Tax effect Never a gain or loss on distribution Never a gain or loss on distribution E&P Reduce E&P by market value No effect on E&P Shareholder treatment Taxable Nontaxable Tax effect Ordinary income based on market value at date of receipt Not taxable until sold Basis in new stock Market value at date of receipt Allocate old basis over old and new shares Stock Distributions Chapter 15, Exhibit 15c CCH Federal Taxation Comprehensive Topics

  40. Redemptions (Including Partial Liquidations)—Overview What is a stock redemption? Stock is redeemed when a corporation acquires its own stock from a shareholder in exchange for cash or other property. Redemptions occur for numerous reasons, including: 1. To allow current shareholders to retain complete control of the corporation when one of them wishes to terminate her interest in the corporation. 2.  To allow a shareholder to terminate her interest in the corporation when it is difficult to find an outside buyer (i.e., the corporation stock is not publicly traded). 3.  To allow the corporation to “invest in itself” when future stock appreciation is anticipated. 4.  To build up treasury stock for later distribution to employees as a performance incentive. Chapter 15, Exhibit 16a CCH Federal Taxation Comprehensive Topics

  41. Redemptions (Including Partial Liquidations)—Overview What is the tax effect of redemptions to the shareholder? The tax effect depends on whether the shareholder is required to treat the distribution as: 1. Dividend treatment. Receipt of nonstock distributions treatment (i.e., cash or other property), and stock dividends other than those qualifying for sales treatment (discussed below); or, 2.  Sale treatment. Sale of stock to the corporation. Chapter 15, Exhibit 16b CCH Federal Taxation Comprehensive Topics

  42. Redemptions (Including Partial Liquidations)—Overview A shareholder gets dividend treatment unless the redemptions cause one of the following 5 conditions to occur: 1. Terminate the shareholder’s entire interest. 2. Are substantially disproportionate between shareholders. This condition exists if the shareholder: (i) gives up over 20% of his voting and nonvoting common stock; AND (ii) owns less than 50% of total corporate voting stock after the redemption. 3.  Are NOT essentially equivalent to a dividend. Congress is vague on this condition. The courts have held that this condition exists if there is a “business contraction”—a corporation liquidating a “segment” of an existing business, such as a product line. Distribution of “excess” inventory or unwanted assets does not count (i.e., IS essentially equivalent to a dividend). 4. Are from a shareholder, other than a corporation, in partial liquidation. This condition occurs if the corporation was actively engaged in two or more businesses over the past five years and decided to shut one down and distribute its assets. (Note that “3” above referred to a “segment” of a business, while “4” refers to an entire business.) 5. Are received by an estate to the extent of death taxes and administrative expenses. If one of these 5 conditions occurs, then the shareholder gets sale treatment. Chapter 15, Exhibit 16c CCH Federal Taxation Comprehensive Topics

  43. Redemptions (Including Partial Liquidations)—Tax Effect on Shareholders Chapter 15, Exhibit 17a CCH Federal Taxation Comprehensive Topics

  44. Redemptions (Including Partial Liquidations)—Tax Effect on Shareholders Chapter 15, Exhibit 17b CCH Federal Taxation Comprehensive Topics

  45. Redemptions (Including Partial Liquidations)—Tax Effect on Shareholders Chapter 15, Exhibit 17c CCH Federal Taxation Comprehensive Topics

  46. Redemptions (Including Partial Liquidations)—Tax Effect on Shareholders Chapter 15, Exhibit 17d CCH Federal Taxation Comprehensive Topics

  47. Redemptions (Including Partial Liquidations)—Example on Shareholder Effect Facts: 1. In 20x1, X Corporation has current E&P of $1,000,000. 2.  Emad owns 100 shares of X Corporation’s 1,000 shares outstanding. His basis in the 100 shares is $100,000 and the shares had been held long-term. 3.  On December 31, 20x1, X distributes land held for investment to Emad, and as part of the exchange, redeems 10 of Emad’s 100 shares. 4.  On the date of redemption, the land had a FMV of $50,000 and a basis to X of $15,000. Also, the land was subject to a $20,000 mortgage that Emad assumed. Questions: What are the tax consequences to Emad if the redemption is treated as a dividend? What if the redemption were treated as a sale? Chapter 15, Exhibit 18a CCH Federal Taxation Comprehensive Topics

  48. Redemptions (Including Partial Liquidations)— Example on Shareholder Effect Chapter 15, Exhibit 18b CCH Federal Taxation Comprehensive Topics

  49. Redemptions (Including Partial Liquidations)—Tax Effect on Corporations What is the tax effect of redemptions to the corporation? Gain or loss recognition: Under Code Sec. 311, losses are NOT recognized. However, gains are recognized based on: [Greater of (a) or (b)], less (c), where, (a) = FMV of property transferred, (b) = Debt relief, and (c) = Adjusted basis of property transferred by the corporation to a shareholder to redeem her shares. This formula applies to both the Dividend Treatment Method and the Sales Treatment Method. Of course, if the corporation pays cash, and has no debt relief, it recognizes no gain, since [FMV – AB of cash = 0]. Chapter 15, Exhibit 19a CCH Federal Taxation Comprehensive Topics

  50. Redemptions (Including Partial Liquidations)—Tax Effect on Corporations Character of gainThe character of gain is based on the character of the property distributed (e.g., an inventory distribution creates OI if FMV > AB). Chapter 15, Exhibit 19b CCH Federal Taxation Comprehensive Topics

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