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Property Distributions

Property Distributions. General rule: A corporate distribution of cash or property with respect to stock is a taxable dividend to extent distribution comes out of earning and profits (E&P) ---to be explained below. Property does not include the distributing company’s own stock

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Property Distributions

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  1. Property Distributions General rule: A corporate distribution of cash or property with respect to stock is a taxable dividend to extent distribution comes out of earning and profits (E&P) ---to be explained below. Property does not include the distributing company’s own stock E&P refers to the corporation’s accumulated or current year’s E&P.

  2. To extent such distribution exceeds the distributing corporation’s E&P, it is • first applied against (and reduces) the receiving shareholder’s stock basis, and • Then any excess is treated as gain from the sale of property, at capital gains rate.

  3. Illustration of corporate distribution with respect to shareholder

  4. Example • Corporate X with E&P of $10 makes distribution of $50 to sole sh whose stock basis is $20. • Question: How is the $50 distribution treated or characterized by sh? • Answer: 1st $10 is taxable dividend to extent of E&P (which is reduced to $0), next $20 offsets basis (which is reduced to $0) and last $20 is treated as capital gain income from sale or exchange.

  5. Tax Distinction Between Capital Gain and “Qualified” Dividend Distribution • The top tax rate for both is 20% for individual tps in the 39.6% tax bracket (and 15% for most others), but big difference remains. • The entire amount of qualified dividend (to extent of E&P) is taxable, whereas capital gain distribution is taxable only to extent it exceeds basis of stock. Also, capital losses can only be offset against capital gains, not dividends.

  6. What are “Qualified” Dividends • Dividends received BY INDIVIDUALS from “domestic corporations” or “qualified foreign corporations”. • “Qualified foreign corporations” are those incorporated in a possession of the United States or which are eligible for benefits of comprehensive income tax treaty with U.S. and meet other requirements

  7. Problem 1 • B&E Revised Study Problems, Lesson 5A, Problem (1)

  8. Amount Distributed • The amount of money, plus FMV of other property received • Corporate and individual shareholders view dividends differently. Why? • The corporate dividend received deduction eliminates most if not all of the tax sting. Either 70, 80 or 100 % is deductible. • After applying deduction, the top rate for corporate dividends received is 35%. • For individuals, the top tax rate for qualified dividends is the capital gains rate of 20% (plus 3.8%).

  9. Dividend Received Deduction • General rule: Corporation entitled to 70% deduction for dividends received from domestic corporation • 80% deduction: Corporation that owns 20% or more (by vote and value) of second corporation is entitled to 80% deduction for dividends received from corporation • 100% deduction: Corporation that is member of affiliated group is entitled to 100% deduction for dividends received from affiliated member

  10. Basis Reduction for Extraordinary Dividends • Special basis reduction rule that requires corporate shareholder to reduce basis in stock to extent of non-taxed portion of “extraordinary dividend”. • Applies generally where corporate shareholder has not held stock for more than 2 years before dividend announcement date and the amount of the dividend exceeds 10% of shareholder’s basis in any stock that is not “preferred as to dividends”.

  11. Another effect of 2013 tax law • Consider this: In 2012, for a corporate shareholder at top income tax bracket of 35% holding less than 20% ownership, the tax on $100 dividend is $10.50, whereas the tax for individual in the top tax bracket was $15. • Starting in 2013 (and still true in 2016) the difference is more than double: $10.50 for corporations and $20 (plus another $3.80) for individuals. • Implications? See investor activists like Carl Icahn, John Paulson or William Ackman

  12. The Meaning of the Term “Dividend” • It’s all about whether there is enough current and/or accumulated E & P to cover distribution amount. If yes, then a dividend; if not, either recovery of basis or gain from sale of property. • First, see whether enough current year E&P. Caution: Determination is made at the end of current year---not at time of distribution • If not, next see whether enough accumulated, that is, pre-current year E & P determined at end of immediately preceding year. • General rule: Determine separately current and accumulated E & P.

  13. Tracing Rules Where Distribution(s) Exceed Amount of Current Year E&P • Proportionate amount of current year E&P applied against each distribution • Next, accumulated E&P applied to extent available on the date of distribution, that is, on a first-dollar-out basis. • To understand the interplay of these concepts, read --- and then read again ---and again--- Treas. Reg. Sec. 1.316-2 (b) and (c ) Examples. Also, see Rev. Rul. 74-164.

  14. Examples • Go through EXAMPLES 1 through 4 on page 8-15 of B&E treatise • See Example 4. Where the Current E&P is negative, that negative amount is pro-rated throughout the year, UNLESS it can be specifically allocated to a part of the year. • of B & E’s treatise. • Planning tip: See difference in tax result between EXAMPLE 1 and EXAMPLE 2 simply by delaying distribution of dividend. • EXAMPLES 3 and 4 illustrate two situations where accumulated E&P is “co-mingled” with current E & P. Another planning opportunity presents itself in EXAMPLE 4. What is it?

  15. Problem 2 • Assume Corp had $12M of accumulated E & P and $30M of current year E & P. Also, assume that Corp made quarterly payments of $15M to its shareholders during current year. How much of each payment would be a dividend? • What answer if facts are the same as above, except Corp’s current year E&P is negative (not positive) $30,000? Would answer change if it could be shown that negative E&P was incurred entirely before 1st quarter of current year?

  16. The Make-Up of Earnings and Profits • Similar to, but different from, income tax, tax accounting, or calculation of surplus rules. Start with calculating corporation’s taxable income and make adjustments from there. • Add: tax-exempt income and income equal to dividend received deduction. • Subtract: taxes paid (for cash basis taxpayer) or accrued (for accrual basis taxpayer); non-capital, non-deductible business expenses; and excess capital losses. Also, watch out for depreciation: for E&P purposes, only allowed to deduct on straight line basis, regardless of what is used for income tax purposes.

  17. Problem 3 • B&E Revised Study Problems, Lesson 5A, Problem (2) • Hint: First calculate E&P. Distributions cannot be treated as dividend income except to extent there is E&P at end of year to cover such amount.

  18. Problem 4 • B&E Revised Study Problems, Lesson 5A, Problem (3). • Hint: Remember corporate dividend received deduction and how that deduction varies depending on corporate shareholder’s % ownership.

  19. Problem 5 • B&E Revised Study Problems, Lesson 5A, Problem (4). • Alternative to problem: What if facts the same except that distribution made in the next taxable year, i.e., the year after current and two years after preceding taxable year, and there is no current E&P in the next taxable year?

  20. E & P Rules for Subchapter S Corporations • For post-1982 years S corporations do not generate current E & P. • The source of accumulated E & P comes from (1) prior status as a C Corporation; (2) pre-1983 E & P; and (3) merger with a C Corporation. • The situation arises more than one might think --- especially with recent liberalization of Sub S qualifying rules. A lot of companies are organized as C corps and then decide to switch to S.

  21. S Corporation With Accumulated E & P • First, up to the amount of S Corporation’s accumulated adjustments account (AAA), distributions are treated same as S Corporation’s distributions without accumulated E & P. • AAA generally consists of S Corporation’s net income, reduced by prior tax-free distributions • Any excess amount is taxable, to extent of accumulated E & P. • Rules intended to ensure accumulated E & P “inherited” from C Corp eventually will be taxed

  22. Priority of Distributions from S Corp with Accumulated E&P • 1st: Applied against S Corp’s Accumulated Adjustment Account. Also reduces S Corp sh’s stock basis by same amount. • 2nd: Applied against S Corp’s Accumulated E&P and treated as taxable dividend to that extent. But does not reduce S Corp sh’s stock basis. • 3rd: Applied against S Corp sh’s basis • 4th: Excess taxed as capital gain.

  23. S Distribution With No Accumulated E & P • First, reduces sh’s basis in stock, and • Then, to the extent of any excess, is treated as capital gain from sale or exchange of property.

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