Corporations: Earnings & Profits and Taxable Dividends

1. Chapter 10 Corporations: Earnings & Profits and Distributions

2. Taxable Dividends • Distributions from corporate earnings and profits (E & P) • Treated as a dividend distribution • Taxed as ordinary income or as preferentially taxed dividend income • Distributions in excess of E & P • Nontaxable to extent of shareholder’s basis (i.e., a return of capital) • Excess distribution over basis is capital gain

3. Earnings & Profits(slide 1 of 2) • No definition of E & P in Code • Similar to Retained Earnings (financial reporting), but often not the same

4. Earnings & Profits(slide 2 of 2) • E & P represents: • Upper limit on amount of dividend income recognized on corporate distributions • Corporation's economic ability to pay dividend without impairing capital

5. Calculating Earnings & Profits(slide 1 of 4) • Calculation generally begins with taxable income, plus or minus certain adjustments • Add previously excluded items and certain deductions to taxable income including: • Muni bond interest • Excluded life insurance proceeds • Federal income tax refunds • Dividends received deduction • Domestic production activities deduction

6. Calculating Earnings & Profits(slide 2 of 4) • Calculation generally begins with taxable income, plus or minus certain adjustments (cont’d) • Subtract certain nondeductible items: • Related-party losses • Expenses incurred to produce tax-exempt income • Federal income taxes paid • Key employee life insurance premiums (in excess of increase in cash surrender value) • Fines, penalties, and lobbying expenses

7. Calculating Earnings & Profits(slide 3 of 4) • Certain E & P adjustments shift effect of transaction from the year of inclusion in or deduction from taxable income to year of economic effect, such as: • Charitable contribution carryovers • NOL carryovers • Capital loss carryovers • Gains and losses from property transactions • Generally affect E & P only to extent recognized for tax purposes • Thus, gains and losses deferred under the like-kind exchange provision and deferred involuntary conversion gains do not affect E & P until recognized

8. Calculating Earnings & Profits(slide 4 of 4) • Other adjustments • Accounting methods for E & P are generally more conservative than for taxable income, for example: • Installment method is not permitted • Alternative depreciation system required • § 179 expense must be deducted over 5 years • Percentage of completion must be used (no completed contract method)

9. Effect on taxable income for E & P: TransactionAddSubtract Tax-exempt income X Life insurance proceeds X Deferred installment gain X Excess charitable contribution X Ded. of prior excess contribution X Federal income taxes X Officer’s life insurance premium X Accelerated depreciation X Examples of E & P Adjustments

10. Current vs Accumulated E & P(slide 1 of 3) • Current E & P • Taxable income as adjusted

11. Current vs. Accumulated E & P(slide 2 of 3) • Accumulated E & P • Total of all prior years’ current E & P as of first day of tax year, reduced by distributions from E & P

12. Current vs. Accumulated E & P (slide 3 of 3) • Distinction between current and accumulated E & P is important • Taxability of corporate distributions depends on how current and accumulated E & P are allocated to each distribution made during year

13. Allocating E & P to Distributions (slide 1 of 4) • If positive balance in both current and accumulated E & P • Distributions are deemed made first from current E & P, then accumulated E & P • If distributions exceed current E & P, must allocate current and accumulated E & P to each distribution • Allocate current E & P pro rata to each distribution • Apply accumulated E & P in chronological order

14. Current vs. Accumulated E & P(slide 2 of 4) • When the tax years of the corporation and its shareholders are not the same • May be impossible to determine the amount of current E & P on a timely basis • Allocation rules presume that current E & P is sufficient to cover every distribution made during the year until the parties can show otherwise

15. Allocating E & P to Distributions (slide 3 of 4) • If current E & P is positive and accumulated E & P has a deficit • Accumulated E & P IS NOT netted against current E & P • Distribution is deemed to be taxable dividend to extent of positive current E & P balance

16. Allocating E & P to Distributions (slide 4 of 4) • If accumulated E & P is positive and current E&P is a deficit, net both at date of distribution • If balance is zero or a deficit, distribution is a return of capital • If balance is positive, distribution is a dividend to the extent of the balance • Any current E & P is allocated ratably during the year unless the parties can show otherwise

17. 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. Cash Distribution Example

18. Property Dividends(slide 1 of 4) • Effect on shareholder: • Amount distributed equals FMV of property • Taxable as dividend to extent of E & P • Excess is treated as return of capital to extent of basis in stock • Any remaining amount is capital gain

19. Property Dividends(slide 2 of 4) • Effect on shareholder (cont’d): • Reduce amount distributed by liabilities assumed by shareholder • Basis of distributed property = fair market value

20. Property Dividends(slide 3 of 4) • Effect on corporation: • Corp. is treated as if it sold the property for fair market value • Corp. recognizes gain, but not loss • If distributed property is subject to a liability in excess of basis • Fair market value is treated as not being less than the amount of the liability

21. Property Dividends(slide 4 of 4) • Effect on corporation’s E & P: • Increases E & P for excess of FMV over basis of property distributed (i.e., gain recognized) • Reduces E & P by FMV of property distributed (or basis, if greater) less liabilities on the property • Distributions of cash or property cannot generate or add to a deficit in E & P • Deficits in E & P can arise only through corporate losses

22. 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- 15,000 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 25,000 Property Distribution Example

23. Constructive Dividend(slide 1 of 2) • Any economic benefit conveyed to a shareholder may be treated as a dividend for tax purposes, even though not formally declared • Need not be pro rata

24. Constructive Dividend(slide 2 of 2) • Usually arises with closely held corporations • Payment may be in lieu of actual dividend and is presumed to take form for tax avoidance purposes • Benefit conveyed is recharacterized as a dividend for all tax purposes • Corporate shareholders are entitled to the dividends received deduction • Other shareholders receive preferential tax rates

25. Examples of Constructive Dividends (slide 1 of 3) • Shareholder use of corporate property at reduced cost or no cost (e.g., company car to non-employee shareholder) • Bargain sale of property to shareholder (e.g., sale for $1,000 of property worth $10,000) • Bargain rental of corporate property

26. Examples of Constructive Dividends (slide 2 of 3) • Payments on behalf of shareholder (e.g., corporation makes payments to satisfy obligation of shareholder) • Unreasonable compensation

27. Examples of Constructive Dividends (slide 3 of 3) • Below market interest rate loans to shareholders • High rate interest on loans from shareholder to corporation

28. Stock Dividends (slide 1 of 2) • Excluded from income if pro rata distribution of stock, or stock rights, paid on common stock • Five exceptions to nontaxable treatment deal with various disproportionate distribution situations • Effect on E & P • If nontaxable, E & P is not reduced • If taxable, treat as any other taxable property distribution

29. Stock Dividends (slide 2 of 2) • Basis of stock received • If nontaxable • If shares received are identical to shares previously owned, basis = (cost of old shares/total number of shares) • If shares received are not identical, allocate basis of old stock between old and new shares based on relative fair market value • Holding period includes holding period of formerly held stock • If taxable, basis of new shares received is fair market value • Holding period starts on date of receipt

30. Stock Redemptions(slide 1 of 3) • Generally result in dividend income for shareholder whose stock is redeemed unless shareholder surrenders significant control • Section 302 allows sale or exchange treatment where either: • All of the shareholder’s stock is redeemed • After redemption, investor is a minority shareholder and owns less than 80% of the interest owned in the corporation before the redemption

31. Stock Redemptions(slide 2 of 3) • When transaction is treated as a dividend, investor’s basis in redeemed shares does not disappear but attaches to remaining shares owned • Other provisions also allow sale or exchange treatment for a stock redemption • In measuring the investor’s stock holdings before and after the redemption, shares owned by related taxpayers also are counted

32. Stock Redemptions(slide 3 of 3) • The tax consequences for the redeeming corporation are summarized as follows • If noncash property is used to acquire redeemed shares, the corporation recognizes realized gain (but not loss) on distributed assets • E & P of redeeming corporation disappears to extent of the number of shares redeemed as a percentage of the shares outstanding before the buyback

33. Liquidations—In General • Corporation winds up affairs, pays debts, and distributes remaining assets to shareholders • Produces sale or exchange treatment to shareholder • Liquidating corporation recognizes gains and losses upon distribution of its assets, with certain exceptions

34. Accumulated Earnings Tax • Imposes a 15% tax on current year’s corporate earnings accumulated without a reasonable business need • Most businesses are allowed a $250,000 minimum credit • Beyond the minimum credit, earnings can be accumulated for: • Working capital needs • Retirement of debt incurred in connection with the business • Investment or loans to suppliers or customers , or • Realistic business contingencies, including lawsuits or self-insurance

35. Personal Holding Company (PHC) Tax (slide 1 of 2) • Enacted to discourage sheltering income in corporations owned by individuals with high marginal tax rates • Imposes a 15% tax • Designed to force a corporation to distribute earnings to shareholders • In any single year, the IRS cannot impose both the PHC tax and the accumulated earnings tax

36. Personal Holding Company (PHC) Tax (slide 2 of 2) • A company is considered a PHC if: • More than 50% of the value of the outstanding stock was owned by five or fewer individuals at any time during the last half of the year, and • A substantial portion (60% or more) of corporation’s income is comprised of passive types of income (dividends, interest, rents, royalties, or certain personal service income)

37. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: • Dr. Donald R. Trippeer, CPA • trippedr@oneonta.edu • SUNY Oneonta