Chapter 13 Corporations: Earnings & Profits and Distributions Essentials of Taxation © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Big Picture (slide of 3) • Lime Corporation, an ice cream manufacturer, has had a very profitable year – To share its profits with its two shareholders, it distributes the following: • Cash of $200,000 to Orange Corporation, and • Real estate worth $300,000 (adjusted basis of $20,000) to Gustavo – The real estate is subject to a mortgage of $100,000, which Gustavo assumes • The distribution is made on December 31, Lime’s year-end The Big Picture (slide of 3) • Lime Corporation has had both good and bad years in the past – More often than not, however, it has lost money – Despite this year’s banner profits, the GAAP-based balance sheet for Lime 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 Lime’s paid-in capital account The Big Picture (slide of 3) • The tax consequences of the distributions to the corporation and its shareholders depend on a variety of factors – Identify these factors • Explain the tax effects of the distributions to both Lime Corporation and its shareholders • Read the chapter and formulate your response 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 Earnings & Profits (slide of 2) • No definition of E & P in Code • Similar to Retained Earnings (financial reporting), but often not the same Earnings & Profits (slide 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 Calculating Earnings & Profits (slide of 4) • Calculation generally begins with taxable income, plus or minus certain adjustments – Add previously excluded income 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 Calculating Earnings & Profits (slide of 4) • Calculation generally begins with taxable income, plus or minus certain adjustments (cont’d) – Subtract certain nondeductible items: • • • • • Nondeductible portion of meal and 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 Calculating Earnings & Profits (slide 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 not affect E & P until recognized Avoiding Unreasonable Compensation • Documentation of the following attributes will help support payments made to an employeeshareholder: – Employee’s qualifications – Comparison of salaries with dividends made in past – Comparable salaries for similar positions in same industry – Nature and scope of employee’s work – Size and complexity of business – Corporation’s salary policy for other employees Stock Dividends (slide 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 Stock Dividends (slide 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 Stock Redemptions (slide 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 Stock Redemptions (slide 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 Stock Redemptions (slide 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 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 Accumulated Earnings Tax • Imposes a 20% 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 selfinsurance Personal Holding Company (PHC) Tax (slide of 2) • Enacted to discourage sheltering income in corporations owned by individuals with high marginal tax rates • Imposes a 20% 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 Personal Holding Company (PHC) Tax (slide 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) Refocus On The Big Picture (slide of 4) • A number of factors affect the tax treatment of Lime Corporation’s distributions • The amount of current and accumulated E & P (which differ from retained earnings) partially determines the tax effect on the shareholders – Given that Lime 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 • Orange Corporation receives $200,000 of dividend income that is mostly offset by the dividends received deduction – The amount of the offsetting deduction depends on the ownership percentage that Orange has in Lime Refocus On The Big Picture (slide of 4) • Gustavo has $200,000 of dividend income (i.e., $300,000 value of the land less the $100,000 mortgage) – Assuming that Lime is a domestic corporation and that Gustavo has held his stock for the entire year, the land is a qualified dividend • As a result, the dividend is either tax-free (if Gustavo has a marginal rate of 10% or 15%) or subject to a 15% (or 20%) tax rate (depending on Gustavo’s marginal tax rate) – Gustavo’s basis in the land is its fair market value at distribution, or $300,000 Refocus On The Big Picture (slide of 4) • From Lime 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 – While the gain increases Lime’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) Refocus On The Big Picture (slide of 4) 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 – Since the amounts received by the two shareholders are equal ($200,000 each), the current E & P applied is taxed as a dividend – 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, Lime probably has a deficit in accumulated E & P • As a result, the remaining amounts distributed to the two shareholders are: – First a tax-free recovery of stock basis, and – Any excess is taxed as a sale of the stock (probably classified as capital gain) 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 © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 50 ... excess of E & P – Nontaxable to extent of shareholder’s basis (i.e., a return of capital) • Excess distribution over basis is capital gain Earnings & Profits (slide of 2) • No definition of E &... Percentage of completion must be used (no completed contract method) Examples of E & P Adjustments (slide of 2) Examples of E & P Adjustments (slide of 2) Current vs Accumulated E & P (slide of 3)... treatment of distribution Property Dividends (slide 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