Corporations: Earnings & Profits and Dividend Distributions

Chapter 5
Corporations: Earnings & Profits and

Dividend Distributions
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Learning Objective (1 of 2)
• LO.1: Explain the role that earnings and profits play in determining the
tax treatment of distributions.
• LO.2: Compute a corporation’s earnings and profits (E & P).
• LO.3: Determine taxable dividends paid during the year by correctly
allocating current and accumulated E & P to corporate distributions.
• LO.4: Describe the tax treatment of dividends for individual
shareholders.
• LO.5: Evaluate the tax impact of property dividends by computing the
shareholder’s dividend income, basis in the property received, and the
effect on the distributing corporation’s E & P and taxable income.
Learning Objective (2 of 2)
• LO.6: Recognize situations when constructive dividends exist and
compute the tax resulting from such dividends.
• LO.7: Determine the tax implications arising from receipt of stock
dividends and stock rights and the shareholder’s basis in the stock and
stock rights received.
• LO.8: Structure corporate distributions in a manner that minimizes the
tax consequences to the parties involved.
The Big Picture (1 of 3)
• Plainwell Ice Cream Corporation (Plainwell),a premium ice cream
manufacturer, has had a very profitable year
o To share its profits with its two shareholders, it distributes the following:
 Cash of $200,000 to Waffle Cone Corporation
 Real estate worth $300,000 (adjusted basis of $20,000) to Luis
o The real estate is subject to a mortgage of $100,000, which Luis assumes
• The distribution is made on December 31, Plainwell’s year-end
• Plainwell Corporation has had both good and bad years in the past
o More often than not, however, it has lost money
o Despite this year’s record profits, the GAAP-based balance sheet for
Plainwell indicates a year-end deficit in retained earnings
• Consequently, the distribution of cash and land is treated as a
liquidating distribution for financial reporting purposes, resulting in a
reduction of Plainwell’s paid-in capital account
• The tax consequences of the distributions to the corporation and its
shareholders depend on a variety of factors
o Identify these factors
• Explain the tax effects of the distributions to both Plainwell Ice Cream
Corporation and its two shareholders
• Read the chapter and formulate your response
Corporate Distributions
• Distributions from corporate earnings and profits (E & P)
o Treated as a dividend distribution
 Taxed as ordinary income or as preferentially taxed dividend income
• Distributions in excess of E & P
o Nontaxable to extent of shareholder’s basis (that is, a return of capital)
o Exceeding the shareholder’s basis is taxable as a gain from sale or
exchange
Earnings & Profits—§ 312
• No definition of E & P in Code
• Similar to Retained Earnings (financial reporting), but often not the
same
• E & P represents:
o Upper limit on amount of dividend income recognized on corporate
distributions
o Corporation's economic ability to pay dividend without impairing capital
Computation of Earnings & Profits (1 of 5)
• Calculation generally begins with taxable income, plus or minus certain
adjustments
o Add previously excluded income items and certain deductions to taxable
income including:
 Municipal bond interest
 Life insurance proceeds (in excess of cash surrender value)
 Federal income tax refunds
 Dividends received deduction
• Calculation generally begins with taxable income, plus or minus certain
adjustments
o Subtract certain nondeductible items:
 Portion of meals
 Entertainment expenses
 Related-party losses
 Expenses incurred to produce tax-exempt income
 Federal income taxes paid
 Key employee life insurance premiums (net of increase in cash surrender
value)
 Fines, penalties, and lobbying expenses
• 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:
o Charitable contribution carryovers
o Net operating loss carryovers
o Capital loss carryovers
• Gains and losses from property transactions
o Generally affect E & P only to extent recognized for tax purposes
o Thus, gains and losses deferred under the like-kind exchange provision and
deferred involuntary conversion gains do not affect E & P until recognized
• Other adjustments
o Accounting methods for E & P are generally more conservative than for
taxable income, for example:
 Installment method is not permitted
 Alternative depreciation system must be used
o Also, ADS prohibits additional first-year depreciation
 § 179 expense must be deducted over 5 years
 Percentage of completion must be used (no completed contract method)
 Others
• Other adjustments
o Accounting methods for E & P are generally more conservative than for
taxable income, for example:
 Cost depletion must be used rather than percentage depletion
 Amortization of organizational expenses is not allowed
 Adjustment is required for changes in LIFO recapture amount
 Intangible drilling costs must be amortized over a period of 60 months
 Mine exploration and development costs must be amortized over a period of
120 months
Summary of E & P Adjustments (1 of 2)
Summary of E & P Adjustments (2 of 2)
Current versus Accumulated E & P
• Current E & P
o Taxable income as adjusted
• Accumulated E & P
o Total of all prior years’ current E & P (since February 28, 1913) reduced
by distributions from E & P
• Distinguishing between current and accumulated E & P is important
o Taxability of corporate distributions depends on how current and
accumulated E & P are allocated to each distribution made during year
Allocating E & P to Distributions (1 of 4)
• If positive balance in both current and accumulated E & P
o Distributions are deemed made first from current E & P, then accumulated
E&P
o If distributions exceed current E & P, must allocate current and
accumulated E & P to each distribution
 Allocate current E & P pro rata (using dollar amounts) to each distribution
 Apply accumulated E & P in chronological order
• When the tax years of the corporation and its shareholders are not the
same
o May be impossible to determine the amount of current E & P on a timely
basis
o Allocation rules presume that current E & P is sufficient to cover every
distribution made during the year until the parties can show otherwise
• If current E & P is positive and accumulated E & P has a deficit
o 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
The Big Picture—Positive Current E & P, Deficit
in Accumulated E & P
• Return to the facts of The Big Picture
• Plainwell Corporation had a deficit in G AAP-based retained earnings at
the start of the year and record profits during the year
o Assume that this translates into an $800,000 deficit in accumulated E & P at
the start of the year and current E & P of $600,000
• In this case, current E & P would exceed the total cash and property
distributed to the shareholders
o The distributions are treated as taxable dividends
o They are deemed to be paid from current E & P even though Plainwell still
has a deficit in accumulated E & P at end of year
• If accumulated E & P is positive and current E & P is a deficit, net both at
the date of distribution
o If balance is zero or a deficit, distribution is a return of capital to the extent of
basis; any excess results in a taxable gain
o If balance is positive, distribution is a dividend to the extent of the balance
o A deficit in current E & P is allocated ratably during the year unless the
parties can show otherwise
Cash Distribution Example
A $20,000 cash distribution is made at year end 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
Rationale for Reduced Tax Rates on Dividends
• All corporations treat dividends as ordinary income and are permitted a
dividend received deduction
• Economic distortions leading to reduced tax rates on dividends:
o Incentive to invest in noncorporate rather than corporate entities
o Incentive for corporations to finance operations with debt rather than with
equity because interest payments are deductible
 This increases the vulnerability of corporations in economic downturns because
of higher leverage
o Incentive for corporations to retain earnings and structure distributions of
profits to avoid the double tax
Qualified Dividends (1 of 3)
• For most individual taxpayers, qualified dividends are subject to a 15%
tax rate
o High-income taxpayers are subject to a 20% rate
 In 2020, the 20% rate applies to married taxpayers filing jointly with taxable
income greater than $496,600 ($441,450 for single taxpayers)
o A 0% tax rate applies to lower-income taxpayers
 In 2020, the 0% rate applies to married taxpayers filing jointly with taxable
income of $80,000 or less ($40,000 for single taxpayers)
• Corporations treat dividends as ordinary income and are permitted a
dividends received deduction
• To qualify for lower rates, dividends must be:
o Paid by domestic or certain qualified foreign corporations
 Qualified foreign corporations include those traded on a U.S. stock exchange or
any corporation located in a country that:
o Has a comprehensive income tax treaty with the U.S.
o Has an information-sharing agreement with the U.S. and
o Is approved by the Treasury
o Paid on stock held >60 days during the 121-day period beginning 60 days
before the ex-dividend date
o Dividends paid to shareholders who hold both long and short positions in the
stock do not qualify
• Qualified dividends are not considered investment income when
determining the investment interest expense deduction
o An election is available to treat qualified dividends as ordinary income (taxed
at regular rates) and include them in investment interest income
o Thus, taxpayers subject to an investment interest expense limitation must
compare relative benefits of low tax on qualifying dividends vs. increased
amount of deductible investment interest expense
Property Dividends (1 of 3)
• Effect on shareholder:
o 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
o Reduce amount distributed by liabilities assumed by shareholder
o Basis of distributed property = fair market value
• Effect on corporation:
o Corporation is treated as if it sold the property for fair market value
 Corporation recognizes gain, but not loss
o 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
• Effect on corporation’s E & P:
o Increases E & P for excess of FMV over basis of property distributed (that is,
gain recognized)
o Reduces E & P by FMV of property distributed (or basis, if greater) less
liabilities on the property
o 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
The Big Picture—Property Dividends—Effect on
the Shareholder
• Plainwell Corporation distributed property to Luis, one of its shareholders
o Fair market value $300,000
o Adjusted basis $20,000
o Subject to a $100,000 mortgage, which Luis assumed
• As a result, Luis has a taxable dividend of $200,000
o $300,000 (fair market value) − $100,000 (liability)
o The basis of the property to Luis is $300,000
The Big Picture—Property Dividends—Effect
on the Corporation
• Plainwell Corporation distributed property to Luis, one of its shareholders
o Fair market value of $300,000
o Adjusted basis of $20,000
• As a result, Plainwell recognizes a $280,000 gain on the distribution
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– 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
Constructive Dividend (1 of 2)
• Any economic benefit conveyed to a shareholder may be treated as a
dividend for tax purposes, even though not formally declared
o Need not be pro rata
Constructive Dividend (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
o Corporate shareholders are entitled to the dividends received deduction
o Other shareholders receive preferential tax rates
Examples of Constructive Dividends (1 of 3)
• Shareholder use of corporate property at reduced cost or no cost
(example: company car to non-employee shareholder)
• Bargain sale of property to shareholder (example: sale for $1,000 of
property worth $10,000)
• Bargain rental of corporate property
• Payments on behalf of shareholder (example: corporation makes
payments to satisfy obligation of shareholder)
• Unreasonable compensation (example: salary payment to a
shareholder-employee)
• Below market interest rate loans to shareholders
• High rate interest on loans from shareholder to corporation
Unreasonable Compensation
• Documentation of the following attributes will help support payments
made to an employee-shareholder:
o Employee’s qualifications
o Comparison of salaries with dividends made in past
o Comparable salaries for similar positions in same industry
o Nature and scope of employee’s work
o Size and complexity of business
o Corporation’s salary policy for other employees
Loans to Shareholders
• Factors considered in determining whether an advance to shareholder is
bonafide:
o Time span for which the advance has been outstanding
o Any repayments made by the shareholder
o Shareholder’s ability to repay advance
o Shareholder’s use of funds
o Corporation’s salary policy for other employees
o Regularity of advances
o Dividend-paying history of corporation
Stock Dividends (1 of 2)
• Excluded from income if pro rata distribution of stock, or stock rights,
paid on common stock
o Five exceptions to nontaxable treatment deal with various disproportionate
distribution situations
• Effect on E & P
o If nontaxable, E & P is not reduced
o If taxable, treat as any other taxable property distribution
Stock Dividends (2 of 2)
• Basis of stock received
o 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
o If taxable, basis of new shares received is fair market value
 Holding period starts on date of receipt
Stock Rights (1 of 2)
• Tax treatment of stock rights is same as for stock dividends
o If stock rights are taxable
 Income recognized = fair market value of stock rights received
 Basis = fair market value of stock rights
 If exercised, holding period begins on date rights are exercised
 Basis of new stock = basis of rights plus any other consideration given
Stock Rights (2 of 2)
• If stock rights are nontaxable
o If value of rights received < 15% of value of old stock, basis in rights = 0
 Election is available which allows allocation of some of basis of formerly held
stock to rights
o If value of rights is 15% or more of value of old stock, and rights are
exercised or sold, must allocate some of basis in formerly held stock to
rights
Corporate Distribution Planning (1 of 2)
• Maintain ongoing records of E & P:
o Ensures return of capital is not taxed as dividend
o No statute of limitations on E & P, so IRS can redetermine at any time
 Accurate records minimize this possibility
Corporate Distribution Planning (2 of 2)
• Adjust timing of distribution to optimize tax treatment:
o If accumulated E & P deficit and current E & P loss, make distribution by end
of tax year to achieve return of capital
o If current E & P is likely, make distribution at beginning of next year to defer
taxation
Planning for Qualified Dividends (1 of 3)
• Retirement plans
o Reduced tax rates are not available when stock is held in retirement
accounts
o Distributions from these plans are taxed at ordinary rates
• Individual alternative minimum tax
o Lower rates on dividends and long-term capital gains apply under both the
regular income tax and the alternative minimum tax
o Appropriately managing the mix of ordinary income, dividend income, and
capital gain can minimize the alternative minimum tax
• Closely held corporations
o They have considerable discretion regarding their dividend policies
o Shareholders might prefer dividends, because of the preferential treatment
Avoiding Constructive Dividends (1 of 2)
• Structure transactions on “arms’ length” basis:
o Reasonable rent, compensation, interest rates, etc...
Avoiding Constructive Dividends (2 of 2)
• Use mix of techniques to “bail out” corporate earnings such as:
o Shareholder loans to corporation
o Salaries to shareholder-employee
o Rent property to corporation
o Pay some dividends
• Overdoing any one technique may attract attention of I RS
Refocus on The Big Picture (1 of 4)
• A number of factors affect the tax treatment of Plainwell Corporation’s
distributions
• The amount of current and accumulated E & P (which differ from
retained earnings) partially determines the tax effect on the shareholders
o Given that Plainwell Corporation has had a highly profitable year, it is likely
that there is sufficient current E & P to cover the distributions
 If so, they are dividends to the shareholders rather than a return of capital
• Waffle Cone Corporation receives $200,000 of dividend income that is
mostly offset by the dividends received deduction
o It would appear that each shareholder owns 50% of Plainwell
o As a result, Waffle Cone’s dividends would be offset by a 65% dividends
received deduction
• Luis has $200,000 of dividend income
 $300,000 value of the land less the $100,000 mortgage
o Assuming that Plainwell is a domestic corporation and that Luis has held his
stock for the entire year, the land is a qualified dividend
 As such, since Luis is married filing jointly in 2020,
o There will be no tax on the dividend if his taxable income is $80,000 or less,
o A 20% tax if his taxable income is greater than $496,600, or
o A 15% tax if his taxable income is between these two figures
o Luis’s basis in the land is its fair market value at distribution, or $300,000
• From Plainwell Corporation’s perspective, the distribution of appreciated
property creates a deemed gain of $280,000
 $300,000 fair market value of the land less its $20,000 adjusted basis
o Although the gain increases Plainwell’s E & P, the distributions to the
shareholders reduce it by $200,000 for the cash and $200,000 for the land
($300,000 fair market value reduced by the $100,000 mortgage)
What If?
• What if current E & P is less than the cash and land distributed to the
shareholders?
• Current E & P is applied pro rata to the cash and the land
o Since the amounts received by the two shareholders are equal ($200,000 each),
the current E & P applied is taxed as a dividend
o To the extent that the distributions are not covered by current E & P, accumulated
E & P is then applied in a pro rata fashion
• However, Plainwell probably has a deficit in accumulated E & P
• As a result, the remaining amounts distributed to the two shareholders are:
o First a tax-free recovery of stock basis, and
o Any excess is taxed as a sale of the stock (probably classified as capital gain)

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