To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER CORPORATIONS: EARNINGS & PROFITS AND DIVIDEND DISTRIBUTIONS SOLUTIONS TO PROBLEM MATERIALS Question/ Problem Learning Objective *1 LO LO LO LO 5 LO LO LO *9 10 LO LO 1, 2, 3, 4, LO 11 LO 12 13 LO LO 14 LO 15 LO *16 LO 17 LO Topic Definition of earnings and profits Taxation of corporate distributions Effect of selected transactions in adjusting taxable income (for determining E & P) Effect of selected situations in adding to or generating a deficit Comparison of accounting methods under E & P and income tax Effect of distribution, taxable dividend or return of capital, in selected situations Planning corporate distributions: beginning or end of tax year Rationale for reduced tax rate on dividends Factors affecting tax treatment of distribution to shareholder Factors affecting tax treatment of distribution to distributing corporation Purpose of property dividend versus cash dividend Property distribution: choice of property Impact of property distributions on corporation Effect of property distributions on corporation Necessity of dividend distribution to meet state legal requirements in determining tax treatment Reasonable compensation and constructive dividends Selected factors in determining reasonableness of compensation Status: Present Edition Q/P in Prior Edition Unchanged Unchanged Modified Unchanged Unchanged Unchanged Unchanged Unchanged Modified New Unchanged 11 Modified Unchanged 12 14 Unchanged 13 Unchanged 15 Modified 16 Unchanged 17 Instructor: For difficulty, timing, and assessment information about each item, see p 5-4 5-1 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-2 2012 Corporations Volume/Solutions Manual Question/ Problem Learning Objective 18 LO 4, 19 20 LO 6, LO 6, 21 LO 22 LO 23 LO 24 25 26 LO 1, LO LO 1, 2, *27 *28 LO LO *29 30 LO LO 1, 31 32 33 *34 LO 1, LO 1, LO 1, LO 1, 35 LO 1, 36 LO 37 LO 38 LO 1, 39 LO 1, 40 LO 1, 41 LO 1, 42 LO 1, Topic Choice between dividend and deductible payment Unreasonable compensation Unreasonable compensation; ways to draw funds from corporation Election to receive common or preferred stock dividend Rationale underlying tax treatment of stock distributions Explain tax effects of nontaxable stock rights; taxable stock rights Amount of dividend income Amount of taxable income; balance in E & P Deficit in E & P followed by sale on installment method; taxation of dividend distribution Compute E & P Effect of specified transactions on taxable income; on E & P Effect of income tax refund on E & P Amount of dividend income; deficit in current E & P with positive balance in accumulated E & P Dividend distribution; effect on E & P Dividend distribution; effect on E & P Dividend distribution; effect on E & P Cash distributions; determination of taxable amount Cash distributions; determination of taxable amount Choosing low tax on dividend or investment interest expense deduction Holding period requirement for qualified dividend Property distribution; effect of gain, loss, liability, and differing basis Tax treatment to shareholder and to corporation on distribution of property subject to liability in excess of basis Tax treatment to individual shareholder and to distributing corporation of property subject to a liability Taxation of dividend when E & P has positive balance but corporation has current loss Property distribution where FMV is less than adjusted basis Status: Present Edition Q/P in Prior Edition Unchanged 18 Modified Unchanged 19 20 Unchanged 21 Unchanged 22 Unchanged 23 Modified Modified Modified 24 25 26 Modified Unchanged 27 28 Modified Modified 29 30 Unchanged Modified Modified Unchanged 31 32 33 34 Modified 35 Unchanged 36 Modified 37 Modified 38 Modified 39 Unchanged 40 Modified 41 Modified 42 Instructor: For difficulty, timing, and assessment information about each item, see p 5-4 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions Question/ Problem *43 *44 45 46 47 48 49 *50 51 52 Status: Present Edition Q/P in Prior Edition Effect of distributions Unchanged 43 Property dividend; liability assumed by shareholder; determination of E & P; distribution of loss property Property distribution to corporate shareholder, basis in excess of FMV; liability assumed by shareholder Bona fide loan to shareholder Constructive dividends Basis of taxable preferred stock dividend Stock dividend; basis allocation; gain on sale Stock rights; basis allocation; gain on sale Choosing between a dividend and a deductible payment Source of dividend distribution Unchanged 44 Modified 45 Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged 46 47 48 49 50 51 Unchanged 52 Learning Objective LO 1, 2, 3, 4, LO 1, 2, LO LO LO LO LO LO LO 4, LO 1, 3, 5-3 Topic *The solution to this problem is available on a transparency master Instructor: For difficulty, timing, and assessment information about each item, see p 5-4 Research Problem Topic Status: Present Edition Q/P in Prior Edition Salary reimbursement (Oswald) agreement Dividend in anticipation of corporate sale Effect of large dividend on corporate shareholder Effect of a change in accounting method on E & P Internet activity Internet activity Internet activity Unchanged Modified Modified Modified Unchanged Unchanged Unchanged © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-4 2012 Corporations Volume/Solutions Manual Question/ Problem Est’d completion time Difficulty Easy Easy Easy Easy Medium Medium Easy Easy Medium 5 10 10 10 5 10 10 Medium 11 12 Easy Medium 10 13 14 15 16 Easy Easy Easy Medium 5 10 17 18 Medium Medium 10 10 19 Medium 10 20 Medium 10 21 Medium 15 22 23 Easy Easy 5 24 Easy 25 Medium 10 26 Medium 10 27 Medium 10 28 Medium 10 29 Easy 30 Easy 10 Assessment Information AICPA* AACSB* Core Comp Core Comp FN-Measurement FN-Reporting FN-Measurement FN-Measurement FN-Reporting FN-Reporting FN-Reporting FN-Measurement FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Reporting FN-Measurement | FNReporting FN-Measurement FN-Reporting FN-Reporting FN-Measurement | FNReporting FN-Reporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Reporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic | Reflective Thinking Analytic | Reflective Thinking Analytic Analytic | Reflective Thinking Analytic Analytic Analytic Analytic | Reflective Thinking Analytic Analytic | Reflective Thinking Analytic | Reflective Thinking Analytic | Reflective Thinking Communication | Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic *Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB core competencies in assessment © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions Question/ Problem Difficulty Est’d completion time 31 Medium 10 32 Easy 33 Easy 10 34 Medium 10 35 Medium 10 36 Medium 10 37 38 Easy Medium 15 39 Medium 10 40 Medium 10 41 Easy 42 Easy 43 Hard 15 44 Hard 15 45 Easy 10 46 Medium 10 47 Medium 15 48 49 Easy Medium 20 50 Medium 10 51 Medium 10 52 Hard 20 5-5 Assessment Information AICPA* AACSB* Core Comp Core Comp FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting Analytic Analytic Analytic Analytic Analytic Analytic | Reflective Thinking Analytic Analytic Analytic Analytic Analytic Analytic Analytic | Reflective Thinking Analytic Analytic Analytic | Reflective Thinking Analytic Analytic Communication | Analytic Analytic Analytic | Reflective Thinking Communication | Analytic *Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB core competencies in assessment © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-6 2012 Corporations Volume/Solutions Manual CHECK FIGURES 24 25.a 25.b 26 27 28.a 28.b 28.c 28.d 28.e 28.f 28.g 28.h 28.i 29 30 31 32 33.a 33.b 34.a 34.b 34.c 34.d 34.e 35 37 38.a Dividend income $200,000 each, Mason reduces basis in stock to $12,000, Sarah reduces stock basis to zero and capital gain $12,000 $1,380,000 $2,240,000 $500,000 taxable dividend; $300,000 capital gain $331,133 $20,000; no effect ($36,000); $33,900 No effect; $140,000 $9,000; $21,000 ($60,000); $60,000 ($60,000); $48,000 No effect; ($12,000) ($90,000); ($10,000) No effect; ($50,000) Subtract $12,000 in 2011; add $7,000 in 2012 $100,000 taxable dividend, $60,000 capital gain Return of capital $75,000 Taxable dividend $80,000 and return of capital $40,000 Taxable dividend $30,000 each ($145,000) accumulated E & P balance $70,000; $60,000 $140,000; $70,000 $150,000; $0 $80,000; $50,000 $100,000; $30,000 Mike dividend income $237,500, $62,500 reduces basis in stock and capital gain $112,500 on sale; Steve dividend $42,500 and $57,500 reduction in basis $1,000 ordinary income Silver $12,000 gain; Heather $54,000 dividend, $54,000 land basis; ending E & P $34,000 38.b 38.c 38.d 38.e 39.a 39.b 40 41 42 44.a 44.b 44.c 44.d 45.a 45.b 48 49 50 51.a 51.b 51.c 51.d Silver $12,000 gain; Heather $12,000 dividend, $54,000 land basis; ending E & P $0 Silver $12,000 gain; Heather $8,000 dividend; ending E & P $80,000; Heather land basis $54,000 Heather $54,000 dividend and $54,000 land basis; Silver ending E & P $14,000 Silver $12,800 taxable gain; Heather $14,000 dividend and $14,000 furniture basis; ending E & P $70,800 $150,000 $0 Green reduces E & P by $210,000; Michael taxable dividend $170,000 and land basis $300,000 $33,000 dividend and $10,000 return of capital Holly dividend $65,000 and basis in land $65,000; Penguin $0 loss recognized and E & P reduced $80,000 $60,000 $98,500 $140,000 $118,500 taxable dividend; E & P is $98,500 Dividend income $20,000, dividends received deduction $16,000, basis $100,000 in land $80,000 Preferred stock basis is $40,000; holding period starts at receipt $7,000 long-term capital gain Long-term capital gain on sale $1,935 and new stock basis $7,560 $1,950 $5,100 Ivana is better off with bonus; Robin is better off with bonus Pay bonus © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions 5-7 DISCUSSION QUESTIONS “Earnings and profits” is the factor that fixes the upper limit on the amount of dividend income shareholders recognize as a result of a distribution from the corporation It represents the corporation’s economic ability to pay a dividend without impairing its capital ‘‘Earnings and profits” is similar to the accounting concept of “retained earnings.” However, E & P and retained earnings differ because E & P is computed using tax rules while retained earnings is computed using financial accounting rules For example, a stock dividend that decreases the retained earnings account does not decrease E & P E & P is increased for all items of income It is decreased for deductible and nondeductible items, such as capital losses, income taxes, and expenses incurred to produce tax-exempt income p 5-3 and Concept Summary 5.1 At least six factors impact the tax treatment of corporate distributions These factors are: • The availability of earnings to be distributed • The basis of the stock in the hands of the shareholder • The character of the property being distributed • Whether the shareholder gives up ownership in return for the distribution • Whether the distribution is liquidating or nonliquidating in character • Whether the assets distributed are subject to any liabilities or whether the shareholder assumes any liabilities in the distribution • Whether the distribution is a “qualified dividend” for purposes of the reduced tax rate on dividend income p 5-2 a Taxable income for 2011 is increased by the amount of the capital loss carryover because the loss reduced E & P in 2010 b Taxable income is reduced by the nondeductible meal expenses c To determine current E & P for 2011, taxable income is increased by the interest received on municipal bonds d Taxable income is reduced by the nondeductible lobbying expenses e Taxable income is reduced by the loss on sale between related parties f Taxable income is increased by the Federal income tax refund when computing E & P for 2011 pp 5-3 to 5-6 and Concept Summary 5.1 a An operating loss can both generate and add to a deficit in E & P Deficits can only arise through corporate losses b A dividend distribution cannot generate or add to a deficit in E & P p 5-15 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-8 2012 Corporations Volume/Solutions Manual The accounting methods employed when computing E & P are considerably more conservative than the methods allowed when computing taxable income First, rather than allowing the taxpayer to carry forward NOLs, capital losses, and charitable contributions, these deductions are accelerated to the year realized Second, the computation of E & P does not allow use of the installment method Third, more conservative depreciation methods are used—in particular, ADS depreciation rather than MACRS is mandated A portion of § 179 expense is deferred when computing E & P (only 20% of the expense is allowed as a deduction each year over a five-year period) A variety of other more conservative accounting methods are required when computing E & P (e.g., cost depletion, percentage of completion for long-term contracts, and capitalization and amortization of mining exploration and development costs and intangible drilling costs) pp 5-4 to 5-6 a If a distributing corporation has a deficit in accumulated E & P and a positive amount in current E & P, a distribution during the year is a taxable dividend to the extent of current E & P b If the corporation has a positive amount in accumulated E & P and a deficit in current E & P, a distribution either is a taxable dividend or a return of capital, depending on the resulting balance in E & P when current and accumulated E & P are netted The accounts are netted at the date of distribution If the resulting balance is zero or a deficit, the distribution results in a tax-free recovery of basis or capital gain If a positive balance results, the distribution represents a dividend to that extent For netting purposes, current E & P is determined as of the date of the distribution by ratably allocating the loss over the entire year, unless the loss can be shown to have otherwise occurred c If there is a deficit in both current and accumulated E & P, a corporate distribution is treated as a return of capital to the extent of the shareholder’s basis in his or her stock Any excess is a capital gain d If there is a positive amount in both current and accumulated E & P, to the extent of the positive balance in both amounts, the distribution is a taxable dividend pp 5-8 to 5-10 and Concept Summary 5.2 This is not a valid statement Any current E & P (determined at the end of the year) is deemed to be available when the distribution occurs, on January p 5-9 The reduced tax on dividends is intended to lessen the effect of several existing distortions and to stimulate the economy The distortions arise from the double tax on corporate income and include (1) an incentive to invest in non-corporate businesses rather than corporations, (2) an incentive for corporations to finance operations through debt rather than equity, and (3) an incentive to retain more earnings than necessary It has been estimated that reducing the tax on dividends will stimulate the economy significantly, leading to gains of up to $25 billion annually (if the tax were dropped completely) Because debt financing would not be as heavily relied upon, the reduced tax on dividends should make the economy more robust in economic downturns The competitiveness of the U.S in the international markets should also be improved This comes about because most of our trading partners not impose a double tax on corporate source earnings pp 5-11 and 5-11 A variety of factors should be considered, including: • What is the E & P of Red Corporation? © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions • Has E & P been accurately determined for tax purposes? • How much E & P is allocated to each shareholder’s distribution? • How will the distribution affect Red Corporation’s E & P? • Is the distribution in partial or complete liquidation of Red Corporation? • Does the distribution qualify as a stock redemption for tax purposes? • What is the tax basis to the shareholders of Red Corporation stock? 5-9 Also important is the nature of the shareholder In the case of a corporate shareholder (Orange Corporation in this situation), a dividends received deduction is available In contrast, an individual shareholder may qualify for a reduced tax rate pp 5-2 to 5-15 and Chapter 10 A variety of factors should be considered, including: • Is the distributed property appreciated or depreciated? • What is the character of the property being distributed? • Is the distributed property secured by debt? • Is the distribution in complete liquidation of Red Corporation? • Does the distribution qualify as a stock redemption for tax purposes? pp 5-2, 5-14, and 5-15 11 A corporation may distribute a property dividend for various reasons The shareholders could want a particular property that is held by the corporation The corporation may be strapped for cash but does not want to forgo distributing a dividend to its shareholders p 5-13 12 Distributing machine C triggers taxable gain of $8,000 for Seagull Corporation, while distributing A produces a nondeductible loss of $7,000 To preserve the loss on A and avoid recognizing gain on C, Seagull should consider selling A and then distributing cash to the second shareholder Seagull should also distribute machine B because there will be no gain on the distribution and no nondeductible loss p 5-14 13 All distributions of appreciated property generate gain to the distributing corporation In effect, the corporation is treated as if it had sold the property to the shareholder for its fair market value The distributing corporation does not recognize loss on distributions of property If the distributed property is subject to a liability in excess of basis or the shareholder assumes such a liability, a special rule applies For purposes of determining gain on the distribution, the fair market value of the property is treated as not being less than the amount of the liability © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-10 2012 Corporations Volume/Solutions Manual Further, corporate distributions reduce E & P by the amount of money distributed or by the greater of the fair market value or the adjusted basis of property distributed, less the amount of any liability on the property E & P is increased by gain recognized on appreciated property distributed as a property dividend Under no circumstances can a corporate distribution create/generate a deficit in E & P or add to an existing deficit in E & P pp 5-13 to 5-15 and Examples 15 to 21 14 Probably not, unless the corporation has some capital losses that it cannot use In the case of corporations, capital gains are taxed the same as ordinary income See the discussion in Chapter 15 A distribution by a corporation to its shareholders can be treated as a dividend for Federal income tax purposes even though it is not formally declared or designated as a dividend Also, it need not be issued pro rata to all shareholders Nor must the distribution satisfy the legal requirements of a dividend as set forth by applicable state law The key factor determining dividend status is a measurable economic benefit conveyed to the shareholder This benefit, when described as a constructive dividend, is distinguishable from actual corporate distributions of cash and property in form only p 5-15 16 Because of Mike’s relationship with Judy, the IRS may argue that any excessive compensation paid to Mike or Judy is a constructive dividend Imputed interest on the loan to Judy may also be a dividend The following questions are relevant: • Are the salary payments to Judy and Mike reasonable? • What are Judy’s and Mike’s qualifications? • What are the nature and scope of Judy’s and Mike’s work? • How does the overall salary paid to Judy and Mike compare with the company’s gross and net income? • What is the corporation’s salary policy towards all employees? • Regarding the advance to Judy, was it a bona fide loan? • Was the loan evidenced by a written instrument? • Was collateral or other security provided? • What is Judy’s financial capacity to repay the loan? • What is Parakeet’s dividend-paying history? • What is the amount of imputed interest on the loan to Judy? pp 5-16, 15-17, and Examples 22 and 30 17 a The determination of the reasonableness of compensation paid to an employee who is not a shareholder but is related to the sole owner of the corporate-employer should be made in the same manner as that for a shareholder-employee The same factors used to © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions 5-11 determine the reasonableness of salary paid to the owner should be used to determine the reasonableness of salary paid to the related employees b That the employee-shareholder does not have a college degree should be relevant only with respect to the nature and scope of the employee’s work Is a college education usually required for the type of work performed? c The fact that the employee-shareholder has another full-time job might indicate that salary paid is excessive d If the employee-shareholder was underpaid in the past, a portion of current salary could be for service rendered in prior years e If a corporation has substantial E & P and has never paid a dividend, it is more likely that a constructive dividend may be found f Disproportionately large year-end bonuses, related to profit, paid to shareholderemployees would be vulnerable to constructive dividend treatment p 5-17 and Example 30 18 Danielle would prefer a dividend because she would have $42,500 after tax [$50,000 dividend – ($50,000 × 15% tax rate)] If paid a bonus, only $36,000 after tax [$50,000 bonus – ($50,000 × 28% tax rate)] results However, this ignores the effect of the payments on Orange Corporation If Orange paid Danielle a deductible bonus, it would save $17,000 ($50,000 deduction for bonus payment x 34% tax rate) in taxes (There is no deduction for a dividend payment.) Since Danielle is $6,500 better off with a dividend ($42,500 after tax from a dividend – $36,000 after tax with a bonus) and Orange is $17,000 better off with a bonus, overall the two parties are $10,500 better off with a bonus ($17,000 benefit from bonus for Orange – $6,500 benefit from a dividend for Danielle) As Danielle is the sole shareholder of the corporation, she is in a position to choose the bonus alternative Examples 28 and 29 19 The salaries paid to Chris and Joey are vulnerable to constructive dividend treatment since neither shareholder appears to have earned them There is also a problem regarding the $600,000 salary payment to Samantha Why is she receiving $350,000 more than Jack when it appears they share equally in managing the company’s operations? Although Samantha is not a shareholder, her relationship to Chris and Joey is enough of a tie-in to raise the unreasonable compensation issue Furthermore, Green Corporation has never distributed a dividend although it has substantial E & P Given the dividend history and the salary disparities, the IRS might successfully argue that all of the salary paid to Joey and Chris, as well as the $350,000 paid to Samantha (beyond the amount paid to Jack), is unreasonable Example 30 20 There would be a problem if Katrina makes the pledge because Condor Corporation will have satisfied Katrina’s obligation Condor’s payment to the charity may be treated as indirect compensation to her Thus, Katrina should not have made the pledge Instead have the corporation make the contribution directly In determining whether Condor has paid Katrina “unreasonable” compensation, both the direct compensation of $500,000 and the indirect payment of $150,000 made on her behalf will be considered Examples 31 and 32 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-12 2012 Corporations Volume/Solutions Manual 21 Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 November 10, 2011 Gull Corporation 626 White Hill Marathon, TX 79842 Dear President of Gull Corporation: This letter is in response to your question with respect to the stock dividend distributed to your shareholders Our conclusion is based upon the facts as outlined in your November letter and any change in these facts may cause our conclusion to be inaccurate Your shareholders have taxable income equal to the fair market value of the stock dividend Distributions of preferred stock to some common shareholders and of common stock to other common shareholders is a taxable event Should you need more information or need to clarify our conclusion, not hesitate to contact me Sincerely yours, Jon S Davis, CPA Partner TAX FILE MEMORANDUM November 10, 2011 FROM: Jon S Davis SUBJECT: Gull Corporation Based on the facts summarized in a letter (dated November 3) from the president of Gull Corporation, the following occurred Gull Corporation declared a dividend permitting its shareholders to elect to receive either 12 shares of cumulative preferred stock or additional shares of Gull common stock for every 20 shares of common stock held at the time of the dividend declaration One shareholder elected to receive preferred stock while all other shareholders chose the common stock dividend At issue: Is the distribution of a stock dividend taxable if some of the shareholders elect to receive preferred stock while others elect to receive common stock? Analysis: Section 305 governs the taxability of stock dividends It provides that stock dividends are not taxable if they represent pro rata distributions on common stock However, this general rule has five exceptions, one of which applies in the instant situation A distribution of preferred stock to some common shareholders and of common stock to other common shareholders is a taxable event Conclusion: The shareholders have taxable income equal to the fair market value of the stock dividend pp 5-18 and 5-19 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions 5-13 22 The rules that determine the tax treatment of stock distributions are based on the proportionate interest concept Stock distributions are generally excluded from income because the proportionate ownership interest of the shareholder is not changed by the distribution Thus, § 305, which is based on this doctrine, excludes from gross income pro rata distributions of stock or stock rights paid on common stock Conversely, stock dividends are taxable when shareholders’ proportionate interests in the corporation may change as a result of the stock distribution This is the case for each of the five exceptions listed in § 305(b) pp 5-18 and 5-19 23 If stock rights are nontaxable and the value of the rights is less than 15% of the value of the old stock, the basis of the rights is zero unless the shareholder elects to have some of the basis in the formerly held stock allocated to the rights If the fair market value of the rights is 15% or more of the value of the old stock and the rights are exercised or sold, the shareholder must allocate some of the basis in the formerly held stock to the rights Taxable stock rights produce taxable income to the shareholder to the extent of the fair market value of the rights The fair market value then becomes the shareholder’s basis in the rights If the rights are exercised, the holding period for the new stock begins on the date the rights (whether taxable or nontaxable) are exercised The basis of the new stock is the basis of the rights plus the amount of any other consideration given p 5-20 PROBLEMS 24 Sarah and Mason each have dividend income of $200,000 {[$240,000 (accumulated E & P) + $160,000 (current E & P)] ÷ 2} The dividend income will be subject to the reduced tax rate on dividends available to individuals The remaining $40,000 of the $440,000 distribution reduces the basis ($20,000 each) in the shareholders’ stock with any excess treated as a capital gain Thus, Sarah reduces her $8,000 stock basis to zero and has a capital gain of $12,000, while Mason reduces his stock basis from $32,000 to $12,000 and has no income tax consequences Example 25 a Capon reports the $600,000 dividend as gross income but claims a dividends received deduction under § 243 of $420,000 (70% × $600,000) None of the other items affect taxable income Thus, taxable income is $1,380,000 ($1,200,000 taxable income before dividends + $600,000 dividend – $420,000 dividends received deduction) b Capon Corporation’s E & P as of December 31 is $2,240,000, computed as follows: $400,000 (beginning balance in E & P) + $1,380,000 (taxable income) + $420,000 (dividends received deduction) + $90,000 (tax-exempt interest) – $50,000 (interest on indebtedness to purchase tax-exempt bonds) pp 5-3 and 5-4 26 Robert reports a $500,000 taxable dividend and a $300,000 capital gain The $600,000 gain on the sale of the land increases current E & P Current E & P before the distribution is $500,000 [$600,000 (gain on sale) – $100,000 (current year deficit)] The current E & P balance triggers dividend treatment for $500,000 of the distribution Of the remaining $450,000 distributed, $150,000 is a tax-free recovery of basis and $300,000 is taxed as capital gain After the distribution, Robert’s stock basis is $0 pp 5-4, 5-9, and Examples and © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-14 27 2012 Corporations Volume/Solutions Manual Sparrow Corporation’s current E & P is computed as follows: Taxable income Federal income tax liability Interest income from tax-exempts Disallowed portion of meals and entertainment expenses Life insurance premiums paid, net of increase in cash surrender value ($3,500 – $700) Proceeds from life insurance policy, net of cash surrender value ($130,000 – $20,000) Excess capital losses Excess of MACRS depreciation over E & P depreciation ($26,000 – $16,000) Allowable portion of 2010 § 179 expenses (20% × $100,000) Organizational expense amortization Dividends received deduction (70% × $25,000) LIFO recapture adjustment Installment sale gain Current E & P $330,000 (112,000) 5,000 (1,500) (2,800) 110,000 (13,000) 10,000 (20,000) 933* 17,500 10,000 (3,000)** $331,133 *($14,000 organizational expenses/180 months) × 12 months **[($40,000 sales price – $32,000 adjusted basis)/$40,000 sales price] × $15,000 Concept Summary 5.1 28 a b c d e f g h i Taxable Income Increase (Decrease) $20,000 ($36,000) No effect $9,000 ($60,000) ($60,000) No effect ($90,000) No effect E & P Increase (Decrease) No effect $33,900* $140,000 $21,000** $60,000 $48,000*** ($12,000)† ($10,000)†† ($50,000) *Although mining exploration costs are deductible in full under the income tax, they are amortized over 120 months when computing E & P Since $300 per month is amortizable ($36,000/120 months), $2,100 is currently deductible for E & P purposes ($300 × months) Thus, of the $36,000 income tax deduction, $33,900 is added back to E & P ($36,000 – $2,100 deduction allowed) **The receipt of a $30,000 dividend generates a dividends received deduction of $21,000 with a net effect on taxable income of a $9,000 increase For E & P purposes, the dividends received deduction is added back ***Only 20% of current-year § 179 expense is allowed for E & P purposes Thus, 80% of the amount deducted for income tax purposes is added back †In each of the four succeeding years, 20% of the § 179 expense is allowed as a deduction for E & P purposes © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions †† 5-15 ADS straight-line depreciation is allowed for E & P purposes; thus, E & P is decreased by $10,000 (the excess of ADS depreciation over the amount allowed under MACRS) Concept Summary 5.1 29 To compute Osprey’s E & P for 2011, the $12,000 of Federal income taxes paid is subtracted from taxable income To compute E & P for 2012, Osprey adds $7,000 to taxable income to reflect the Federal income tax refund Concept Summary 5.1 30 Dividend income is $100,000, tax-free recovery of basis is $40,000, and capital gain is $60,000 To determine the amount of dividend income, the balances of both accumulated and current E & P as of June 30 must be netted because of the deficit in current E & P As onehalf of the loss (or $230,000) is deemed to have occurred on June 30, the $330,000 in accumulated E & P is reduced by $230,000 The $100,000 balance in E & P triggers dividend income The remaining $100,000 of the distribution is recovery of capital, reducing basis to zero and then triggering capital gain Example 11 31 The shareholder has a return of capital of $75,000 The $75,000 reduces the basis in Turkey Corporation stock; any excess over basis is capital gain There is no dividend income because of the absence of E & P On the date of the sale, E & P is a negative $72,500 [$405,000 (beginning balance in accumulated E & P) – $405,000 (deficit in current E & P from sale of the asset on June 30) – $72,500 (one-half of the $145,000 negative E & P not related to asset sale)]; thus, the $75,000 distribution constitutes a return of capital Generally, deficits are allocated pro rata throughout the year unless the parties can prove otherwise Here the shareholder can prove otherwise Examples 11 and 26 32 Cardinal Corporation has no accumulated E & P at the time of the distribution The shareholder has a taxable dividend equal to the current E & P determined at year-end, which was $80,000 The balance of the distribution, $40,000, reduces the shareholder’s basis in the stock, and any excess over basis results in capital gain pp 5-8 to 5-10 33 a Bunting Corporation and Jennifer each have a taxable dividend of $30,000 Sparrow Corporation’s current E & P is $65,000; thus, the entire distribution is a taxable dividend even though Sparrow has no accumulated E & P Assuming the taxable income limitation does not apply, Bunting Corporation is entitled to a dividends received deduction of $24,000 (80% × $30,000) Thus, Bunting is only taxed on $6,000 ($30,000 distribution – $24,000 dividends received deduction) Because Jennifer is an individual, she pays tax on the entire dividend, subject to the preferential 15%/0% tax rates if the dividend is qualifying b To determine Sparrow Corporation’s accumulated E & P at the end of the year, its current E & P ($65,000) is reduced by the amount of the distributions ($60,000) The remaining $5,000 is then netted against the deficit in accumulated E & P of $150,000, leaving a net deficit of $145,000 pp 5-8 to 5-11 34 a Dividend Income $ 70,000 Return of Capital $60,000 b $140,000 $70,000 Taxed to the extent of current E & P Accumulated E & P and current E & P netted on the date of distribution © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-16 2012 Corporations Volume/Solutions Manual c $150,000 $ –0– Taxed to the extent of current and accumulated E & P d $ 80,000 $50,000 Accumulated E & P and current E & P are netted on the date of distribution There is a dividend to the extent of any positive balance e $100,000 $30,000 When the result in current E & P is a deficit for the year, the deficit is allocated on a pro rata basis to distributions made during the year On June 30, E & P is $100,000 [current E & P is a deficit of $20,000 (i.e., 1/2 of $40,000) netted with accumulated E & P of $120,000] pp 5-8 to 5-10 35 The $170,000 in current E & P is allocated on a pro rata basis to the two distributions made during the year: thus, $127,500 of current E & P is allocated to Mike [$170,000 current E & P × ($300,000 distribution to Mike/$400,000 total distributions)] and $42,500 is allocated to Steve [$170,000 current E & P × ($100,000 distribution to Steve/$400,000 total distributions)] Accumulated E & P is applied in chronological order beginning with the earliest distribution Thus, the entire accumulated E & P balance of $110,000 is allocated to Mike As a result, $237,500 ($127,500 from current E & P + $110,000 from accumulated E & P) of Mike’s July distribution is taxed as dividend income The remaining $62,500 of the $300,000 distribution reduces Mike’s stock basis to $87,500 ($150,000 basis – $62,500 recovery of capital) Consequently, Mike recognizes a capital gain of $112,500 on the sale of the stock [$200,000 (sales price) – $87,500 (remaining stock basis)] Of the $100,000 distributed to Steve, $42,500 will be treated as a dividend, and the remaining $57,500 reduces stock basis to $142,500 [$200,000 (original cost) – $57,500 (reduction in basis from the distribution)] pp 5-8 to 5-10 36 If Sarah does not include the dividend in net investment income, her tax is $1,500 ($10,000 dividend × 15% tax rate) In addition, $10,000 of investment interest expense is not deductible until she has investment income At that point, the interest expense generates a tax benefit of $3,500 (35% × $10,000) Thus, excluding the dividend from net investment income yields a current-year tax of $1,500 and a tax savings in the future of $3,500 If Sarah elects to treat the dividend as net investment income, ordinary income of $10,000 and an additional deduction of $10,000 result Her tax liability, therefore, is $0 [($10,000 dividend income – $10,000 interest expense) × 35%] Ignoring the time element, Sarah is better off by using qualifying dividend treatment Overall, she saves a total of $2,000 in tax ($3,500 tax saved in the future – $1,500 tax paid this year) However, because the tax savings will not be available for many years, Sarah should perform a present value analysis If the expected present value of the $3,500 tax saved is less than the current tax of $1,500, Sarah is better off electing to include the dividend in investment income p 5-12 37 The $1,000 dividend will be taxed to Judy as ordinary income Because she did not hold the stock for more than 60 days during the 121-day period beginning 60 days before the exdividend date, the dividend does not qualify for the preferential 15%/0% tax rates Example 12 38 a Silver recognizes a gain on the distribution of the land to Heather The amount of the gain is $12,000 ($54,000 fair market value – $42,000 adjusted basis) Since Silver’s gain increases its E & P, it will have $12,000 of current E & P and $76,000 of accumulated E & P available to apply to the distribution The entire value of the land © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions 5-17 ($54,000) is a dividend to Heather, leaving $34,000 of accumulated E & P ($88,000 total E & P at year-end – $54,000 distribution) as the beginning balance for next year Heather’s basis in the land is its fair market value ($54,000) b The distribution triggers $12,000 of gain to Silver and creates $12,000 of current E & P Consequently, the distribution generates a $12,000 dividend to Heather (to the extent of current E & P) The remaining $42,000 of the value of the land decreases Heather’s stock basis from $56,000 to $14,000 and is a tax-free recovery of capital Heather’s basis in the land is $54,000 c Silver recognizes $12,000 of gain and increases current E & P by $12,000, as a result of the distribution of appreciated land The amount deemed distributed is the fair market value of the land, net of the mortgage, or $8,000 ($54,000 fair market value – $46,000 mortgage) Since there is $12,000 of current E & P and $76,000 of accumulated E & P, the entire $8,000 distribution is taxed as a dividend Current E & P is reduced by the $8,000 distribution, leaving accumulated E & P with a beginning balance for the following year of $80,000 ($76,000 accumulated E & P + $12,000 current E & P – $8,000 distribution) Heather’s basis in the land is its fair market value ($54,000) d While Silver realizes an $8,000 loss, none of the loss is recognized on the distribution Heather receives a $54,000 dividend and she takes a basis of $54,000 in the land Silver has accumulated E & P at the beginning of the following year of $14,000 [$76,000 accumulated E & P – $62,000 (greater of $62,000 adjusted basis of the land or $54,000 fair market value)] e Silver recognizes gain on the distribution of $12,800 for income tax purposes ($14,000 fair market value – $1,200 adjusted basis for income tax purposes) Current E & P is increased to $8,800 ($14,000 fair market value – $5,200 adjusted basis for E & P) Heather receives a $14,000 dividend and takes a $14,000 basis in the furniture Silver’s E & P is reduced by $14,000, leaving $70,800 of accumulated E & P at the start of the following year ($76,000 accumulated E & P + $8,800 current E & P – $14,000 distribution) pp 5-13 to 5-15 39 a Peach has a gain of $150,000 on the distribution, computed as follows: $400,000 (liability on the property exceeds fair market value) – $250,000 (basis of the property) Peach’s E & P is increased by the $150,000 gain In addition, E & P is decreased by $400,000 (representing the deemed fair market value of the property), reduced by the $400,000 liability of the property, or zero Thus, E & P is $800,000, computed as follows: $650,000 (beginning E & P balance) + $150,000 (gain on distribution) b Karla has dividend income of zero, computed as follows: $400,000 (value of the property based on liability) – $400,000 (liability on the property) Karla has a basis of $400,000 in the property pp 5-13 to 5-15 40 Michael has a taxable dividend of $170,000 [$300,000 (fair market value of the land) – $130,000 (liability assumed)] Michael’s basis in the land is $300,000 Green Corporation does not recognize a loss on the distribution, but the distribution reduces its E & P account by $210,000 [$340,000 (adjusted basis of the land) – $130,000 (liability assumed by Michael)] pp 5-13 to 5-15 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-18 2012 Corporations Volume/Solutions Manual 41 To determine the taxability of the $43,000 distribution, the balance of both accumulated and current E & P as of October must be determined and netted This is necessary because of the deficit in current E & P Three-fourths of the $28,000 loss, or $21,000, reduces accumulated E & P to $33,000 as of October ($54,000 – $21,000) Thus, of the $43,000 distribution, $33,000 is taxed as a dividend and $10,000 represents a return of capital Example 11 42 Holly has a $65,000 taxable dividend and a $65,000 basis in the land Penguin Corporation does not recognize a loss on the distribution and its E & P is reduced by $80,000 pp 5-13 to 5-15 43 • What basis Eloise and Olivia have in their stock in Cerulean Corporation after their initial transfers for stock? • Does Olivia’s transfer qualify under § 351 of the Code as a nontaxable exchange? • How is Cerulean Corporation taxed on the property distribution to Eloise? • How the distributions to Eloise and to Olivia affect Cerulean’s E & P? • How will Eloise and Olivia be taxed on the distributions? • What is Olivia’s basis in her stock when she sells it to Magnus? • How are Eloise and Magnus taxed on the $90,000 distribution to each? pp 5-2 to 5-15 and Chapter 44 a Peter’s gross income from the distribution is $60,000 [$140,000 (value of the property) – $80,000 (liability)] b Corporate E & P after the distribution is $102,450, computed as follows: Accumulated E & P at start of year Add: Taxable income Proceeds of term life insurance Subtract: Federal income tax Life insurance premiums Property distribution Prior-year installment sale income E & P of Purple after the distribution $ 65,000 $320,000 55,000 (108,050) (3,500) (210,000)* (16,000) 37,450 $102,450 *E & P is reduced by the greater of the fair market value ($140,000) or adjusted basis of the property ($290,000), less the amount of liability on the property ($80,000) c Peter’s tax basis for the property is $140,000 d If Purple had sold the business property at its $140,000 fair market value, it would have recognized a loss of $150,000 This loss would offset $150,000 of taxable income in the current year, creating Federal tax savings of $58,500 ($150,000 × 0.39) After paying off the $80,000 loan, Purple would have a total of $118,500 to distribute to Peter [$58,500 (tax savings) + $140,000 (sales proceeds) – $80,000 (loan balance)] © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions 5-19 Immediately following the property sale and distribution of cash, Purple’s E & P balance would be: Accumulated E & P at start of year Add: Taxable income (reduced by $150,000 loss) Proceeds of term life insurance Subtract: Federal income tax Life insurance premiums Cash distribution Prior-year installment sale income E & P of Purple after the distribution $ 65,000 $170,000 55,000 (49,550) (3,500) (118,500) (16,000) 37,450 $102,450 Thus, Peter recognizes a taxable dividend of $118,500 Purple’s E & P would be reduced to $98,500 after the distribution Note that this result is better than distribution of the property to Peter In particular, the corporation receives a $150,000 deduction, while Peter’s income is only increased by $58,500 Concept Summary 5.1 and Examples 2, 14, and 20 45 a Iris Corporation has dividend income of $20,000 [$100,000 (fair market value of the land) – $80,000 (liability on the land)] The $20,000 dividend creates a $16,000 dividends received deduction under § 243 Consequently, only $4,000 of the dividend is subject to tax Iris Corporation has a basis of $100,000 in the land b Fresia Corporation may not deduct the loss on the land Its E & P is reduced by $80,000 [the $160,000 basis of the land (which is greater than the fair market value) – the $80,000 liability on the land] Examples 14 and 20 46 Advances to shareholders that are not bona fide loans are constructive dividends Whether an advance qualifies as a bona fide loan is a question of fact to be determined in light of the particular circumstances Positive factors: • The advance is evidenced by a written instrument • The shareholder furnished collateral for the advance Negative factors: • Likely forgone interest here, as the loan is interest-free Additional information needed: • How long has the advance been outstanding? • Has James made any payments on the advance? • Can James afford to make payments on the advance? © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-20 2012 Corporations Volume/Solutions Manual • What did James with the funds? • Does James regularly receive such advances? It is difficult to determine with the amount of information provided whether the advance is a bona fide loan The additional information needed and noted above would help determine if a loan or a constructive dividend is involved pp 5-17, 5-18, and Example 22 47 a The result of this transaction is a realized loss of $50,000 (the difference between basis of $350,000 and fair market value of $300,000) and a constructive dividend of $25,000 (the difference between the $300,000 fair market value and the $275,000 paid for the office building) Due to the application of § 267, Parrot cannot recognize the realized loss but it does reduce E & P The constructive dividend also reduces E & P Thus, E & P is reduced by $75,000 (the sum of the $50,000 disallowed loss and the $25,000 constructive dividend) b The loan to Jerry generates imputed interest since no interest was charged The amount of imputed interest is $13,125 ($250,000 × 7% × 3/4 year) and that amount is deemed paid as interest to the corporation The deductibility of the interest by Jerry depends on how the loan proceeds are used Parrot has taxable interest income of $13,125 and is deemed to pay a dividend to Jerry equal to the amount of interest Parrot’s E & P is increased by the amount of interest income and reduced by the amount of deemed dividend payment c Bargain rentals create constructive dividends to shareholders In the present case, the amount of constructive dividends to both Tom and Jerry equals the fair rental value of the airplane Thus, Tom has $42,000 (120 hours × $350 hourly rental rate) of dividend income and Jerry has dividend income of $56,000 (160 hours × $350 hourly rental rate) Parrot’s E & P is reduced by the same amounts d The $11,000 excess amount ($20,000 – $9,000) paid to Tom by Parrot over the fair rental value of the equipment is treated as a constructive dividend taxable to Tom and reduces Parrot’s E & P pp 5-15 to 5-18 48 Because the distribution of preferred stock is taxable to Katie, her basis in the newly acquired shares is equal to its fair market value of $40,000 The holding period of the preferred stock begins on the date of receipt p 5-19 49 Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 February 18, 2011 Julie Swanson 3737 Canyon Drive Minneapolis, MN 55434 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions 5-21 Dear Ms Swanson: This letter is in response to your question with respect to the sale of the Great Egret Corporation stock you received as a nontaxable stock dividend Our conclusion is based upon the facts as outlined in your February 10 letter Any change in facts may cause our conclusion to be inaccurate Originally, you paid $12,000 for 5,000 shares of stock in Great Egret Corporation and last year a nontaxable stock dividend of 1,000 additional shares was received The 1,000 shares were sold in the current year for $9,000 The gain on the sale of the 1,000 shares is determined by subtracting your basis in the shares sold from the sales price The tax basis in the 1,000 shares is determined by dividing the $12,000 cost by 6,000 (5,000 original shares plus 1,000 new shares) This results in a basis of $2 per share ($12,000 ÷ 6,000) Your gain of $7,000 is computed as follows: $9,000 (selling price) – $2,000 (tax basis in the 1,000 new shares) The $7,000 gain on the sale is a long-term capital gain The gain is long term because the original Great Egret stock has been held for more than one year Should you need more information or need to clarify our conclusion, not hesitate to contact me Sincerely yours, Jon S Davis, CPA Partner TAX FILE MEMORANDUM February 16, 2011 FROM: Jon S Davis SUBJECT: Julie Swanson Today I conferred with Julie Swanson regarding her letter of February 10 Two years ago, Ms Swanson purchased 5,000 shares of Great Egret Corporation for $12,000 Last year, she received a nontaxable stock dividend of 1,000 additional shares She sold the 1,000 shares this year for $9,000 and has asked me to determine the tax consequences of the sale At issue: How is the gain on the sale of shares of stock received as nontaxable stock dividends determined, and how is it taxed? Conclusion: The shareholder’s basis in the original 5,000 shares ($12,000) is reallocated to the 6,000 shares held after receiving the stock dividend Her basis after the stock dividend is $2 per share ($12,000 ÷ 6,000 shares) Her gain on the sale of the 1,000 shares is $7,000 [$9,000 (selling price) – $2,000 (basis in 1,000 shares)] The gain is a long-term capital gain because the holding period of the original shares tacks on to the shares received as a nontaxable stock dividend pp 5-18 and 5-19 50 Because the fair market value of the rights is 15% or more of the value of the old stock, Lauren must allocate her basis in the stock between the stock and the stock rights Lauren allocates basis as follows: Fair market value of stock: 300 shares x $110 = Fair market value of rights: 150 rights × $55 = Basis of stock: $9,000 × $33,000/$41,250 = $7,200 Basis of rights: $9,000 × $8,250/$41,250 = $1,800 Basis per right: $1,800 ÷ 150 rights = $12 $33,000 8,250 $41,250 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-22 2012 Corporations Volume/Solutions Manual There is a capital gain on the sale of the rights of $1,935, computed as follows: Sales price of 45 rights Less: Basis of 45 rights (45 × $12) Long-term capital gain $2,475 (540) $1,935 Basis of new stock is $7,560, computed as follows: 105 rights × $12 Additional consideration ($60 × 105 shares) Basis on newly acquired stock $1,260 6,300 $7,560 Holding period of the 105 new shares begins on the date of purchase Example 25 51 a If Ivana were paid a bonus, she would receive $10,800 after tax [$15,000 bonus – ($15,000 × 28% tax rate)] If she received a dividend, she would receive $12,750 after tax [$15,000 dividend – ($15,000 × 15% tax rate)] Thus, she would be $1,950 better off ($12,750 – $10,800) with a dividend b If Robin Corporation paid Ivana a $15,000 bonus, it would receive a deduction for the payment This would reduce Robin’s tax liability The net after-tax cost of the bonus would be $9,900 [$15,000 bonus – $5,100 tax savings (34% tax rate × $15,000)] In contrast, a dividend payment is not deductible, so no taxes would be saved by Robin The cost of the dividend would be $15,000 Therefore, Robin would be $5,100 [$15,000 (cost of a dividend) – $9,900 (cost of a bonus)] better off if it paid a bonus c If Robin paid Ivana a $20,000 bonus, she would receive $14,400 after tax [$20,000 bonus – ($20,000 × 28% tax rate)] This would be better than receiving a $15,000 dividend, which would provide $12,750 after tax A $20,000 bonus would cost Robin Corporation $13,200 after tax [$20,000 bonus – (34% tax rate × $20,000)] This is less expensive than a nondeductible $15,000 dividend d Since both Robin Corporation and Ivana are better off with a $20,000 bonus than they are with a $15,000 dividend, the corporation should pay a bonus Examples 28 and 29 52 November 10, 2011 Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 Heron Corporation 12 Nature Trail Way Daytona Beach, FL 32114 Dear President of Heron Corporation: This letter is in response to your question concerning the tax consequences on the planned distribution of $600,000 to your shareholders over the next four years Our conclusion is based upon the facts as outlined in your April letter and any change in these facts may cause such conclusion to be inaccurate © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporations: Earnings & Profits and Dividend Distributions 5-23 Heron Corporation has a deficit in accumulated E & P of $300,000 as of January 1, 2011 Starting this year, Heron Corporation expects to generate annual E & P of $150,000 for the next four years and would like to distribute this amount to its shareholders The corporation’s objective is to make the distribution in a manner that causes the least amount of dividend income to its shareholders Heron Corporation should not make a distribution in 2011 but distribute $300,000 on December 31, 2012 Again make no distribution in 2013 but distribute the remaining $300,000 on December 31, 2014 By distributing $300,000 every other year, only half of the distribution, or $150,000, is taxed to the shareholders as dividend income Because E & P for 2011 ($150,000) is netted with the deficit in accumulated E & P ($300,000), at the end of 2011 there is a deficit in E & P ($150,000) When a distribution of $300,000 is made in 2012, only $150,000 is taxed, as dividend income is limited to current E & P ($150,000) This is again the case in 2013 and 2014 On the other hand, if $150,000 is distributed each year, the shareholders are taxed on the entire distribution because it is covered by current E & P The deficit in accumulated E & P does not cause part of the distribution to be nontaxable Should you need additional information or need to clarify our conclusion, not hesitate to call on me Sincerely yours, Jon S Davis, CPA Partner TAX FILE MEMORANDUM November 10, 2011 FROM: Jon S Davis SUBJECT: Heron Corporation Today I talked to the president of Heron Corporation with respect to the April 1, 2011 letter Heron Corporation has a deficit in its accumulated E & P of $300,000 as of January 1, 2011 Starting in 2011, Heron Corporation expects to generate annual E & P of $150,000 for the next four years and wishes to distribute this amount to its shareholders Heron Corporation wants to know how it should distribute the $600,000 over a four-year period in order to cause the least amount of dividend income to its shareholders (all individuals) At issue: When a corporation has a deficit in accumulated E & P, is it possible to structure a corporate distribution so that a part of the distribution will not constitute dividend income even though current E& P is available? Conclusion: If Heron Corporation does not make a distribution in 2011 or in 2013, only half of the $600,000 total distribution, or $300,000, constitutes dividend income This is the case because in 2011 the $150,000 current E & P is netted with the $300,000 deficit in E & P to reduce the deficit in accumulated E & P to $150,000 as of December 31, 2011 In 2012, when Heron Corporation distributes $300,000 to its shareholders, only $150,000 of the distribution is dividend income This is so because there is a $150,000 deficit in accumulated E & P, but the distribution is taxed to the extent of current E & P As current E & P is only $150,000, dividend income is limited to this amount The remaining $150,000 is a return of capital to the shareholders After the distribution in 2012, accumulated E & P remains a deficit of $150,000 (distributions cannot increase a deficit) In 2013, Heron Corporation makes no distribution Thus, at the end of 2013, accumulated E & P is zero (the $150,000 deficit is netted with the © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-24 2012 Corporations Volume/Solutions Manual $150,000 current E & P for 2013) In 2014, when Heron Corporation has current E & P of $150,000, it makes a distribution of $300,000—only $150,000 of which represents dividend income The remaining $150,000 is a return of capital Example 27 The answers to the Research Problems are incorporated into the Instructor’s Guide with Lecture Notes to accompany the 2012 Annual Edition of SOUTH-WESTERN FEDERAL TAXATION: CORPORATIONS, PARTNERSHIPS, ESTATES & TRUSTS © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... http://downloadslide.blogspot.com 5-12 2012 Corporations Volume/Solutions Manual 21 Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 November 10, 2011 Gull Corporation 626 White... http://downloadslide.blogspot.com 5-14 27 2012 Corporations Volume/Solutions Manual Sparrow Corporation s current E & P is computed as follows: Taxable income Federal income tax liability Interest...To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 5-2 2012 Corporations Volume/Solutions Manual Question/ Problem Learning Objective