Chapter 18 Corporate Taxation: Nonliquidating Distributions True / False Questions The "double taxation" of corporate income refers to the taxation of corporate income at both the entity-level and the shareholder-level True False A distribution from a corporation to a shareholder will always be treated as a dividend for tax purposes True False A corporation's "earnings and profits" account is equal to the company's "retained earnings" account on its balance sheet True False A distribution from a corporation to a shareholder will only be treated as a dividend for tax purposes if the distribution is paid out of current or accumulated earnings and profits True False Green Corporation has current earnings and profits of $100,000 and negative accumulated earnings and profits of ($200,000) A $50,000 distribution from Green to its sole shareholder will not be treated as a dividend because total earnings and profits is a negative $100,000 True False Green Corporation has negative current earnings and profits of ($100,000) and positive accumulated earnings and profits of $200,000 A $50,000 distribution from Green to its sole shareholder will be treated as a dividend because total earnings and profits is a positive $100,000 True False The term "earnings and profits" is well defined in the Internal Revenue Code True False Only income and deductions included on a corporation's income tax return are included in the computation of current earnings and profits True False 18-1 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education Cedar Corporation incurs a net capital loss of $20,000 in 20X3 that cannot be deducted on its income tax return but must be carried forward to 20X4 Cedar will deduct the net capital loss in the computation of current earnings and profits for 20X3 True False 10 Terrapin Corporation incurs federal income taxes of $250,000 in 20X3 Terrapin deducts the federal income taxes in computing its current earnings and profits for 20X3 True False 11 Evergreen Corporation distributes land with a fair market value of $200,000 to its sole shareholder Evergreen's tax basis in the land is $50,000 Assuming sufficient earnings and profits, the amount of dividend reported by the shareholder is $200,000 True False 12 Evergreen Corporation distributes land with a fair market value of $200,000 to its sole shareholder Evergreen's tax basis in the land is $50,000 Evergreen will report a gain of $150,000 on the distribution regardless of whether its earnings and profits are positive or negative True False 13 Evergreen Corporation distributes land with a fair market value of $50,000 to its sole shareholder Evergreen's tax basis in the land is $200,000 Evergreen will report a loss of $150,000 on the distribution regardless of whether its earnings and profits are positive or negative True False 14 Compensation recharacterized by the IRS as a dividend because it was considered "unreasonable" will affect only the income tax liability of the corporation paying the compensation True False 15 Unreasonable compensation issues are more likely to arise in audits of privately held corporations rather than publicly traded corporations True False 16 Stock dividends are always tax-free to the recipient True False 17 The recipient of a tax-free stock dividend will have a zero tax basis in the stock True False 18-2 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 18 The recipient of a taxable stock dividend will have a tax basis in the stock equal to the fair market value of the stock received True False 19 A stock redemption is always treated as a sale or exchange for tax purposes True False 20 Tammy owns 60 percent of the stock of Huron Corporation Unrelated individuals own the remaining 40 percent For a stock redemption to be treated as an exchange under the "substantially disproportionate" rule, Tammy must reduce her stock ownership to below 48 percent True False 21 Brothers and sisters are considered "family" under the stock attribution rules that apply to stock redemptions True False 22 Diego owns 30 percent of Azul Corporation Azul Corporation owns 50 percent of Verde Corporation Under the attribution rules applying to stock redemptions, Diego is treated as owning 15 percent of Verde Corporation True False 23 The "family attribution" rules are automatically waived in a complete redemption of a shareholder's stock True False 24 Battle Corporation redeems 20 percent of its stock for $100,000 in a stock redemption that is treated as an exchange by the shareholders Battle's E&P at the date of the redemption is $200,000 Battle will reduce its earnings and profits by $100,000 because of the redemption True False 25 A distribution in partial liquidation of a corporation is always treated as a sale or exchange by an individual shareholder True False Multiple Choice Questions 18-3 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 26 Which statement best describes the concept of the "double taxation" of corporation income? A B C D Corporate income is subject to two levels of taxation: the regular tax and the alter Corporate income is taxed twice at the corporate level: first when earned and then Corporate income is taxed when earned by a C corporation and then a second tim Corporate income is subject to two levels of taxation: at the federal level and a se 27 Which of the following forms of earnings distributions would not be subject to double taxation at the corporate and shareholder level? A B C D Compensation paid to a shareholder/employee of the corporation 28 Which of the following statements best describes the priority of the tax treatment of a distribution from a corporation to a shareholder? A B C D The distribution is a dividend to the extent of the corporation's earnings and profit The distribution is a return of capital, then a dividend to the extent of the corporat The distribution is a return of capital, then gain from sale of stock, and finally a di The shareholder can elect to treat the distribution as either a dividend to the exte 29 Which of the following statements best describes current earnings and profits? A B C D Current earnings and profits is another name for a corporation's retained earnings Current earnings and profits is a precisely defined tax term in the Internal Revenue Current earnings and profits is an ill-defined tax concept in the Internal Revenue C Current earnings and profits is a conceptual tax concept with no definition in the I 30 Which of the following statements best describes the role of current and accumulated earnings and profits in determining if a distribution is a dividend? A B C D A distribution will only be a dividend if total earnings and profits (current plus accu A distribution can never be a dividend if current earnings and profits are negati A distribution will be a dividend if current earnings and profits for the year are pos A distribution will never be a dividend if current earnings and profits for the year a 18-4 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 31 A calendar-year corporation has positive current E&P of $500 and accumulated negative E&P of $1,200 The corporation makes a $400 distribution to its sole shareholder Which of the following statements is true? A B C D The distribution will not be a dividend because total earnings and profits is a nega The distribution may be a dividend, depending on whether total earnings and profi The distribution will be a dividend because current earnings and profits are positiv A distribution from a corporation to a shareholder is always a dividend, regardless 32 A calendar-year corporation has negative current E&P of $500 and accumulated positive E&P of $1,000 The corporation makes a $600 distribution to its sole shareholder Which of the following statements is true? A B C D $500 of the distribution will be a dividend because total earnings and profits is $ $0 of the distribution will be a dividend because current earnings and profits are $600 of the distribution will be a dividend because accumulated earnings and pro Up to $600 of the distribution could be a dividend depending on the balance in ac 33 Which of these items is not an adjustment to taxable income or net loss to compute current E&P? A B C D Dividends received deduction Tax-exempt income Net capital loss carryforward from the prior year tax return Refund of prior year taxes for an accrual method taxpayer 34 Grand River Corporation reported taxable income of $500,000 in 20X3 and paid federal income taxes of $170,000 Not included in the computation was a disallowed meals and entertainment expense of $2,000, tax-exempt income of $1,000, and deferred gain on an installment sale of $25,000 The corporation's current earnings and profits for 20X3 would be: A B C D 35 Au Sable Corporation reported taxable income of $800,000 in 20X3 and paid federal income taxes of $272,000 Not included in the computation was a disallowed penalty of $25,000, life insurance proceeds of $100,000, and an income tax refund from 20X2 of $50,000 Au Sable is an accrual basis taxpayer The corporation's current earnings and profits for 20X3 would be: A B C D 18-5 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 36 Oakland Corporation reported a net operating loss of $500,000 in 20X3 and elected to carry the loss forward to 20X4 Not included in the computation was a disallowed meals and entertainment expense of $20,000, tax-exempt income of $10,000, and deferred gain on an installment sale of $250,000 The corporation's current earnings and profits for 20X3 would be: A B C D 37 Packard Corporation reported taxable income of $1,000,000 in 20X3 and paid federal income taxes of $340,000 Included in the taxable income computation was a dividends received deduction of $5,000, a net capital loss carryover from 20X2 of $10,000, and gain of $50,000 from an installment sale that took place in 20X1 The corporation's current earnings and profits for 20X3 would be: A B C D 38 Abbot Corporation reported a net operating loss of $400,000 in 20X3, which the corporation elected to carry forward to 20X4 Included in the computation of the loss was regular depreciation of $100,000 (E&P depreciation is $40,000), first year expensing under §179 of $50,000, and a dividends received deduction of $10,000 The corporation's current earnings and profits for 20X3 would be: A B C D 39 Madison Corporation reported taxable income of $400,000 in 20X3 and accrued federal income taxes of $136,000 Included in the computation of taxable income was regular depreciation of $200,000 (E&P depreciation is $60,000) and a net capital loss carryover of $20,000 from 20X2 The corporation's current earnings and profits for 20X3 would be: A B C D 18-6 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 40 Greenwich Corporation reported a net operating loss of $800,000 in 20X3, which the corporation elected to carry forward to 20X4 The computation of the loss did not include a disallowed fine of $50,000, life insurance proceeds of $500,000, and a current year charitable contribution of $10,000 that will be carried forward to 20X4 The corporation's current earnings and profits for 20X3 would be: A B C D 41 Bruin Company reports current E&P of $200,000 in 20X3 and accumulated E&P at the beginning of the year of $100,000 Bruin distributed $400,000 to its sole shareholder on January 1, 20X3 How much of the distribution is treated as a dividend in 20X3? A B C D 42 Aztec Company reports current E&P of $200,000 in 20X3 and accumulated E&P at the beginning of the year of negative $100,000 Aztec distributed $300,000 to its sole shareholder on January 1, 20X3 How much of the distribution is treated as a dividend in 20X3? A B C D 43 Inca Company reports current E&P of negative $100,000 in 20X3 and accumulated E&P at the beginning of the year of $200,000 Inca distributed $300,000 to its sole shareholder on January 1, 20X3 How much of the distribution is treated as a dividend in 20X3? A B C D 18-7 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 44 Wildcat Corporation reports current E&P of negative $200,000 in 20X3 and accumulated E&P at the beginning of the year of $100,000 Wildcat distributed $300,000 to its sole shareholder on December 31, 20X3 How much of the distribution is treated as a dividend in 20X3? A B C D 45 Beaver Company reports current E&P of $100,000 in 20X3 and accumulated E&P at the beginning of the year of $200,000 Beaver distributed $400,000 to its sole shareholder on January 1, 20X3 The shareholder's tax basis in her stock in Beaver is $200,000 How is the distribution treated by the shareholder in 20X3? A B C D $400,000 divide $100,000 dividend, $200,000 tax-free return of basis, and $100,000 capital ga $200,000 dividend and $200,000 tax-free return of basis $300,000 dividend and $100,000 tax-free return of basis 46 Longhorn Company reports current E&P of $100,000 in 20X3 and accumulated E&P at the beginning of the year of negative $200,000 Longhorn distributed $300,000 to its sole shareholder on January 1, 20X3 The shareholder's tax basis in his stock in Longhorn is $100,000 How is the distribution treated by the shareholder in 20X3? A B C D $300,000 divide $100,000 dividend, $100,000 tax-free return of basis, and $100,000 capital ga $100,000 dividend and $200,000 tax-free return of basis $0 dividend, $100,000 tax-free return of basis, and $200,000 capital gain 47 Husker Corporation reports current E&P of negative $200,000 in 20X3 and accumulated E&P at the beginning of the year of $300,000 Husker distributed $200,000 to its sole shareholder on December 31, 20X3 The shareholder's tax basis in her stock in Husker is $50,000 How is the distribution treated by the shareholder in 20X3? A B C D $200,000 divide $100,000 dividend, $50,000 tax-free return of basis, and $50,000 capital gain $100,000 dividend and $100,000 tax-free return of basis $0 dividend, $50,000 tax-free return of basis, and $150,000 capital gain 18-8 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 48 Tar Heel Corporation had current and accumulated E&P of $500,000 at December 31 20X3 On December 31, the company made a distribution of land to its sole shareholder, William Roy The land's fair market value was $100,000 and its tax and E&P basis to Tar Heel was $25,000 William assumed a mortgage attached to the land of $10,000 The tax consequences of the distribution to William in 20X3 would be: A B C D $100,000 dividend and a tax basis in the land of $100,000 $100,000 dividend and a tax basis in the land of $90,000 Dividend of $90,000 and a tax basis in the land of $100,000 Dividend of $90,000 and a tax basis in the land of $90,000 49 Cavalier Corporation had current and accumulated E&P of $500,000 at December 31 20X3 On December 31, the company made a distribution of land to its sole shareholder, Tom Jefferson The land's fair market value was $200,000 and its tax and E&P basis to Cavalier was $50,000 The tax consequences of the distribution to Cavalier in 20X3 would be: A B C D No gain recognized and a reduction in E&P of $200,000 $150,000 gain recognized and a reduction in E&P of $200,000 $150,000 gain recognized and a reduction in E&P of $50,000 No gain recognized and a reduction in E&P of $50,000 50 Montclair Corporation had current and accumulated E&P of $500,000 at December 31, 20X3 On December 31, the company made a distribution of land to its sole shareholder, Molly Pitcher The land's fair market value was $200,000 and its tax and E&P basis to Montclair was $50,000 Molly assumed a liability of $25,000 attached to the land The tax consequences of the distribution to Montclair in 20X3 would be: A B C D No gain recognized and a reduction in E&P of $200,000 $150,000 gain recognized and a reduction in E&P of $200,000 $150,000 gain recognized and a reduction in E&P of $175,000 No gain recognized and a reduction in E&P of $175,000 51 Catamount Company had current and accumulated E&P of $500,000 at December 31, 20X3 On December 31, the company made a distribution of land to its sole shareholder, Caroline West The land's fair market value was $200,000 and its tax and E&P basis to Catamount was $250,000 The tax consequences of the distribution to Catamount in 20X3 would be: A B C D No loss recognized and a reduction in E&P of $250,000 $50,000 loss recognized and a reduction in E&P of $250,000 $50,000 loss recognized and a reduction in E&P of $150,000 No loss recognized and a reduction in E&P of $200,000 18-9 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 52 Paladin Corporation had current and accumulated E&P of $500,000 at December 31, 20X3 On December 31, the company made a distribution of land to its sole shareholder, Maria Mendez The land's fair market value was $200,000 and its tax and E&P basis to Paladin was $250,000 Maria assumed a liability of $25,000 attached to the land The tax consequences of the distribution to Paladin in 20X3 would be: A B C D No loss recognized and a reduction in E&P of $200,000 $50,000 loss recognized and a reduction in E&P of $200,000 $50,000 loss recognized and a reduction in E&P of $225,000 No loss recognized and a reduction in E&P of $225,000 53 Which of the following payments could be treated as a constructive dividend by the IRS? A B C D End-of-year bonus payment to a shareholder/employee Rent paid to a shareholder/lessor Interest paid to a shareholder/creditor All of these payments could be treated as a constructive dividend by the IRS 54 Which of the following factors would not be considered in determining if compensation paid to a shareholder/employee is reasonable? A B C D The individual's duties and responsibilities What individuals performing in comparable capacities at other companies are p Whether the corporation has a formal compensation policy The individual's marginal income tax rate 55 Which of the following statements is not considered a potential answer to the dividend puzzle (why corporations pay dividends)? A B C D Paying dividends avoids the double taxation of corporate income Demanding that managers pay out dividends restricts their investment activities a Paying dividends is a source of investor goodwill Dividends are a signal to the capital markets about the health of a corporation's 56 Which of the following stock dividends would be tax-free to the shareholder? A B C D A 2-for-1 stock split to all holders of common stock A stock dividend where the shareholder could choose between cash and stock A stock dividend to all holders of preferred stock Both a 2-for-1 stock split to all holders of common stock and a stock dividend to a 18-10 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education Topic: Tax framework for property distributions 78 St Clair Company reports positive current E&P of $500,000 in 20X3 and positive accumulated E&P at the beginning of the year of $400,000 St Clair Company distributed $600,000 to its sole shareholder, Danielle Brush on December 31, 20X3 Danielle's tax basis in her St Clair stock is $120,000 How much of the $600,000 distribution is treated as a dividend to Danielle and what is her basis in St Clair stock after the distribution? $600,000 dividend and a tax basis of $120,000 Feedback: All $600,000 is treated as a dividend because the distribution is less than the company's total earnings and profits of $900,000 Danielle's tax basis in her Erie stock remains $120,000 AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Easy Topic: Earnings, profits, and shareholder dividends 79 Austin Company reports positive current E&P of $200,000 and negative accumulated E&P of $300,000 Austin distributed $250,000 to its sole shareholder, Betsy Bevo, on December 31, 20X3 Betsy' tax basis in her stock is $125,000 How much of the $250,000 distribution is treated as a dividend to Betsy and what is her tax basis in Austin stock after the distribution? $200,000 dividend and a tax basis in Austin stock of $75,000 Feedback: Betsy has dividend income of $200,000, an amount equal to the company's current E&P She reduces her tax basis in the Austin stock by $50,000, the excess of the distribution over the dividend amount AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Medium Topic: Earnings, profits, and shareholder dividends 18-214 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 80 Elk Company reports negative current E&P of $200,000 and positive accumulated E&P of $300,000 Elk distributed $200,000 to its sole shareholder, Barney Rubble, on December 31, 20X3 Barney's tax basis in his Elk stock is $75,000 What is the tax treatment of the distribution to Barney and what is his tax basis in Elk stock after the distribution? $100,000 dividend income, $75,000 tax-free return of capital, $25,000 capital gain His tax basis in the Elk stock is $0 Feedback: Barney reports a dividend of $100,000, the accumulated E&P at December 31, 20X3 The excess $100,000 distribution first reduces his basis in Elk stock, and the excess is treated as capital gain from sale of the stock His tax basis in Elk stock is $0 AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Medium Topic: Earnings, profits, and shareholder dividends 81 Houghton Company reports negative current E&P of ($500,000) and negative accumulated E&P of ($800,000) Houghton distributed $100,000 to its sole shareholder, Blossom Applegate, on December 31, 20X3 Blossom's tax basis in her Houghton stock is $50,000 What is the tax treatment of the distribution to Blossom and what is her tax basis in Houghton stock after the distribution? $0 dividend to Blossom, $50,000 tax-free return of capital, and $50,000 capital gain Her tax basis in Houghton stock is $0 Feedback: No part of the distribution is treated as a dividend because both current and accumulated E&P are negative The first $50,000 of the distribution is a taxfree return of capital and the remaining $50,000 is treated as gain from sale of stock Her tax basis in Houghton stock is $0 AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Medium Topic: Earnings, profits, and shareholder dividends 18-215 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 82 Loon, Inc reported taxable income of $600,000 in 20X3 and paid federal income taxes of $202,000 Not included in the company's computation of taxable income is tax-exempt interest of $30,000, disallowed meals and entertainment expenses of $15,000, and disallowed expenses related to the tax-exempt income of $4,000 Loon deducted depreciation of $200,000 on its tax return Under the alternative (E&P) depreciation method, the deduction would have been $80,000 Compute the company's current E&P for 20X3 $529,000 Feedback: AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Medium Topic: Earnings, profits, and shareholder dividends 18-216 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 83 Orchard, Inc reported taxable income of $800,000 in 20X3 and paid federal income taxes of $272,000 Included in the company's computation of taxable income is gain from sale of a depreciable asset of $200,000 The income tax basis of the asset was $50,000 The E&P basis of the asset using the alternative depreciation system was $75,000 Compute the company's current E&P for 20X3 $503,000 Feedback: AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Medium Topic: Earnings, profits, and shareholder dividends 84 Walloon, Inc reported taxable income of $1,000,000 in 20X3 and paid federal income taxes of $340,000 The company reported a capital gain from sale of investments of $150,000, which was partially offset by a $40,000 net capital loss carryover from 20X2, resulting in a net capital gain of $110,000 included in taxable income Compute the company's current E&P for 20X3 $700,000 Feedback: AACSB: Analytic AACSB: Reflective Thinking 18-217 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Easy Topic: Earnings, profits, and shareholder dividends 85 Otter Corporation reported taxable income of $400,000 from operations for 20X3 The company paid federal income taxes of $136,000 on this taxable income During the year, the company made a distribution of land to its sole shareholder, Emmet Jugg The land's fair market value was $50,000 and its tax and E&P basis to Otter was $30,000 Emmet assumed a mortgage attached to the land of $10,000 Any gain from the distribution will be taxed at 34% The company had accumulated E&P of $900,000 at the beginning of the year Compute Otter's total taxable income and federal income tax paid because of the distribution (assume a tax rate of 34%) Using your solution, compute Otter's current E&P for 20X3 $277,200 Feedback: AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Medium Topic: Earnings, profits, and shareholder dividends 18-218 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 86 Ozark Corporation reported taxable income of $500,000 from operations for 20X3 During the year, the company made a distribution of land to its sole shareholder, Marcus Twain The land's fair market value was $100,000 and its tax and E&P basis to Ozark was $125,000 Marcus assumed a mortgage attached to the land of $25,000 Ozark's tax rate is 34% The company had accumulated E&P of $850,000 at the beginning of the year Compute Ozark's total taxable income and federal income tax paid because of the distribution Using your solution, compute Otter's accumulated E&P at January 1, 20X4 $500,000 taxable income, $170,000 federal income tax, $1,080,000 accumulated E&P at the beginning of 20X3 Feedback: AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Hard Topic: Earnings, profits, and shareholder dividends 18-219 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 87 Sherburne Corporation reported current earnings and profits for 20X3 of $500,000 During the year, the company made a distribution of land to its sole shareholder, Ted Bozeman The land's fair market value was $150,000 and its tax and E&P basis to Sherburne was $100,000 Ted assumed a mortgage attached to the land of $25,000 What amount of dividend income does Ted report because of the distribution and what is Ted's income tax basis in the land received from Sherburne? $125,000 dividend and a tax basis of $150,000 in the land Feedback: Ted reports dividend income of $125,000, computed as the fair market value of the land received of $150,000 less the mortgage he assumes of $25,000 Ted's income tax basis in the land equals its fair market value of $150,000 AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Medium Topic: Earnings, profits, and shareholder dividends 18-220 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 88 Sunapee Corporation reported taxable income of $700,000 from operations for 20X3 During the year, the company made a distribution of land to its sole shareholder, Jean McCarthy The land's fair market value was $125,000 and its tax and E&P basis to Sunapee was $75,000 Jean assumed a mortgage attached to the land of $25,000 Sunapee's tax rate is 34% Compute Sunapee's total taxable income and federal income tax paid because of the distribution Using your solution, compute Sunapee's current E&P for 20X3 Taxable income of $750,000, federal income tax of $255,000, and current E&P of $495,000 Feedback: AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-02 Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder Level of Difficulty: Medium Topic: Earnings, profits, and shareholder dividends 18-221 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 89 Tappan Company pays its sole shareholder, Carlita Hill, a salary of $200,000 At the end of each year, the company pays Carlita a "bonus" equal to the difference between the corporation's taxable income for the year (before the bonus) and $75,000 For 20X3, Tappan reported pre-bonus taxable income of $800,000 and paid Carlita a bonus of $725,000 On audit, the IRS determined that individuals working in Carlita's position earned on average $300,000 per year The company had no formal compensation policy and never paid a dividend How much of Carlita's compensation (salary plus bonus) might the IRS recharacterize as a dividend? Assuming the IRS recharacterizes $500,000 of Carlita's bonus as a dividend, what additional income tax liability does Tappan Company face? (Ignore payroll taxes) The IRS could recharacterize $625,000 as a dividend If the IRS recharacterizes $500,000 as a dividend, Tappan's tax liability would increase by $181,750 Feedback: The IRS could treat Carlita as receiving a constructive dividend to the extent the "bonus" is considered unreasonable compensation The IRS could argue that the total "compensation" in excess of what an individual in Carlita's position typically receives as compensation should be recharacterized as a dividend Carlita's compensation would be $300,000 She would report the disallowed compensation of $625,000 ($200,000 + $725,000 - $300,000) as a dividend Tappan would be denied a deduction for the $500,000, increasing the company's taxable income from $75,000 to $575,000 The company's tax on $575,000 is $195,500 The company's tax on $75,000 is $13,750 The company would owe additional taxes of $181,750 AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-03 Identify situations in which a corporation may be deemed to have paid a "constructive dividend" to a shareholder Level of Difficulty: Medium Topic: Constructive dividends 18-222 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 90 Townsend Corporation declared a 1-for-1 stock split to all common stock shareholders of record on December 31, 20X3 Townsend reported current E&P of $400,000 and accumulated E&P of $1,000,000 The total fair market value of the stock distributed was $500,000 Regina Williams owned 1,000 shares of Townsend common stock with a tax basis of $200 per share ($2,000,000 total) The fair market value of the common stock was $300 per share on December 31, 20X3 What is Regina's income tax basis in the new and existing common stock she owns in Townsend, assuming the distribution is tax-free? $100 per share Feedback: The new common stock is allocated part of the tax basis of the old common stock based on relative fair market value In a for stock split, Regina would allocate half of the basis of the old common stock of $200 to the new common stock, making her tax basis in the old and new common stock $100 per share AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-04 Explain the basic tax rules that apply to stock dividends Level of Difficulty: Medium Topic: Stock dividends 91 Sweetwater Corporation declared a stock dividend to all common stock shareholders of record on December 31, 20X3 Shareholders will receive share of Sweetwater common stock for each shares of common stock they already own Pierre Dorgan owns 500 shares of Sweetwater common stock with a tax basis of $150 per share The fair market value of the Sweetwater common stock was $90 per share on December 31 What is Pierre's income tax basis in his new and existing common stock in Sweetwater, assuming the distribution is non-taxable? $125 per share Feedback: The new stock is allocated part of the tax basis of the existing common stock based on relative fair market value After the common stock dividend, Pierre will own 600 shares of Sweetwater common stock (500 + 500/5), each with the same fair market value His basis in each share of common stock will be $125, computed as (500 shares × $150 basis)/600 AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-04 Explain the basic tax rules that apply to stock dividends Level of Difficulty: Medium Topic: Stock dividends 18-223 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 92 Buckeye Company is owned equally by James and his brother Terrelle, each of whom own 500 shares in the company Terrelle wants to reduce his ownership in the company, and it was decided that the company will redeem 200 of his shares for $5,000 per share on December 31, 20X3 Terrelle's income tax basis in each share is $1,000 Buckeye has current E&P of $10,000,000 and accumulated E&P of $20,000,000 What is the amount and character (capital gain or dividend) recognized by Terrelle because of the stock redemption? $800,000 capital gain Feedback: Terrelle reduces his ownership in Buckeye Company from 50% to 37.5% (300/800) Terrelle meets the "substantially disproportionate" test to treat the redemption as an exchange He reduces his ownership below 50%, and his ownership percentage after the redemption is less than 80% of his ownership before the redemption (80% × 50% = 40%) As a result, Terrelle recognizes a capital gain of $800,000 ($1,000,000 - $200,000) AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-05 Comprehend the different tax consequences that can arise from stock redemptions Level of Difficulty: Medium Topic: Stock redemptions 93 Pine Creek Company is owned equally by Bob and his sister Samantha, each of whom own 1,000 shares in the company On December 31, 20X3, Pine Creek redeemed 200 of Samantha's shares for $5,000,000 in a transaction treated as an exchange by Samantha Pine Creek has current E&P of $10,000,000 and accumulated E&P of $30,000,000 (computed without regard to the stock redemption) Assuming Pine Creek did not make any dividend distributions during 20X3, by what amount does the company reduce its E&P because of the redemption? $4,000,000 Feedback: Pine Creek reduces its accumulated E&P by the lesser of the cash distributed ($5,000,000) or the percentage of stock redeemed times accumulated E&P at the date of the redemption, after reduction by any dividends paid during the year (200/2,000 × $40,000,000 = $4,000,000) AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-05 Comprehend the different tax consequences that can arise from stock redemptions Level of Difficulty: Medium Topic: Stock redemptions 18-224 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 94 Goose Company is owned equally by Val and her sister Eugenia, each of whom own 500 shares in the company Val wants to reduce her ownership in the company and have the transaction treated as an exchange for tax purposes Determine the minimum amount of stock that Goose must redeem from Val for her to treat the redemption as being "substantially disproportionate with respect to the shareholder" and receive exchange treatment 167 shares Feedback: Val must reduce her stock ownership in Goose below 40% because of the exchange The algebraic equation to solve for the number of shares to have redeemed is (500 - X)/(1,000 - X) < 40%, where X equals the number of shares redeemed Solving for X, the number of shares to be redeemed equals 167 After a redemption of 167 shares, Val will own 333 out of 833 shares of Goose stock 333/833 = 39.98%, which is below the required 40% threshold to have the redemption treated as an exchange for tax purposes AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Apply Learning Objective: 18-05 Comprehend the different tax consequences that can arise from stock redemptions Level of Difficulty: Hard Topic: Stock redemptions 95 Crystal, Inc is owned equally by John and his wife Arlene, each of whom own 500 shares in the company Arlene wants to reduce her ownership in the company, and it was decided that the company will redeem 200 of her shares for $5,000 per share on December 31, 20X3 Arlene's income tax basis in each share is $1,000 Crystal has current E&P of $1,000,000 and accumulated E&P of $3,000,000 What is the amount and character (capital gain or dividend) recognized by Arlene as a result of the stock redemption, assuming only the "substantially disproportionate with respect to the shareholder" test is applied? $1,000,000 dividend Feedback: Arlene reduces her direct ownership in Crystal, Inc from 50% to 37.5% (300/800) However, under the family attribution rules, she is deemed to own the 500 shares owned by her husband, John Her stock ownership before the exchange is 100%, and her ownership after the exchange is still 100% (800/800) Arlene fails the "substantially disproportionate" test to treat the redemption as an exchange As a result, she recognizes a dividend of $1,000,000 ($5,000 × 200 shares) AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-05 Comprehend the different tax consequences that can arise from stock redemptions Level of Difficulty: Easy Topic: Stock redemptions 18-225 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 96 Crescent Corporation is owned equally by George and his daughter Olympia, each of whom own 100 shares in the company George wants to retire from the company, and it was decided that the company will redeem all 100 of his shares for $10,000 per share on December 31, 20X3 George's income tax basis in each share is $2,000 Crescent has current E&P of $1,000,000 and accumulated E&P of $5,000,000 What must George to ensure that the redemption will be treated as an exchange? George must file a "triple i agreement" with the IRS, in which he agrees he will not acquire a prohibited interest in the next 10 years By filing such an agreement, George can waive the family attribution rules and be treated as having a complete termination of his interest in Crescent Corporation Feedback: A prohibited interest includes being an employee, consultant, or director AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Understand Learning Objective: 18-05 Comprehend the different tax consequences that can arise from stock redemptions Level of Difficulty: Medium Topic: Stock redemptions 97 Tiger Corporation, a privately-held company, has one class of voting common stock, of which 1,000 shares are issued and outstanding The shares are owned as follows: How many shares of stock is Mark deemed to own under the family attribution rules in a stock redemption? 750 Feedback: Mark is deemed to own his shares, his wife's shares, and his daughter's shares AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-05 Comprehend the different tax consequences that can arise from stock redemptions Level of Difficulty: Medium Topic: Stock redemptions 18-226 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 98 Geneva Corporation, a privately-held company, has one class of voting common stock, of which 1,000 shares are issued and outstanding The shares are owned as follows: Madison has a 20 percent interest in the partnership The remaining 80 percent is owned by unrelated individuals Madison owns 40% of Packer Corporation The other 60 percent is owned by her father How many shares of stock is Madison deemed to own under the family attribution rules in a stock redemption? 800 Feedback: Madison is deemed to own her shares, her percentage ownership in the partnership's shares (50), her granddaughter's shares, and 100 percent of the corporation's shares (300) Under the family attribution rules, she is treated as owning 100 percent of the corporation AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Apply Learning Objective: 18-05 Comprehend the different tax consequences that can arise from stock redemptions Level of Difficulty: Hard Topic: Stock redemptions 99 Half Moon Corporation made a distribution of $300,000 to Arnold Swartz in partial liquidation of the company on December 31, 20X3 Arnold owns 100% of Half Moon Corporation (1,200 shares) The distribution was in exchange for 50% of Arnold's stock in the company (600 shares) At the time of the distribution, the shares had a fair market value of $500 per share Arnold's income tax basis in the shares was $250 per share Half Moon had total E&P of $2,000,000 at the time of the distribution What is the amount and character (capital gain or dividend) of any income or gain recognized by Arnold as a result of the partial liquidation? $150,000 capital gain Feedback: An individual receives exchange treatment on distributions in partial liquidation of stock As a result, Arnold reports capital gain of $150,000 on the stock exchanged ($300,000 - $150,000) AACSB: Analytic AACSB: Reflective Thinking 18-227 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-06 Describe a partial liquidation from a stock redemption and the difference in tax consequences to the shareholders Level of Difficulty: Medium Topic: Partial liquidations 100 Yellowstone Corporation made a distribution of $300,000 to Cheney, Inc in partial liquidation of the company on December 31, 20X3 Cheney, Inc owns 50 percent of Yellowstone Corporation (1,000 shares) The other 50 percent is owned by an unrelated corporation The distribution was in exchange for 50% of Cheney's stock in the company (500 shares) At the time of the distribution, the shares had a fair market value of $800 per share Cheney's income tax basis in the shares was $500 per share Yellowstone had total E&P of $5,000,000 at the time of the distribution What is the amount and character (capital gain or dividend) of any income or gain recognized by Cheney as a result of the partial liquidation? $300,000 dividend Feedback: A corporation receives dividend treatment on distributions in partial liquidation of stock As a result, Cheney, Inc reports a dividend of $300,000, which is eligible for an 80% dividends-received deduction AACSB: Analytic AACSB: Reflective Thinking AICPA: BB Critical Thinking Blooms: Analyze Blooms: Apply Learning Objective: 18-06 Describe a partial liquidation from a stock redemption and the difference in tax consequences to the shareholders Level of Difficulty: Medium Topic: Partial liquidations 18-228 Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education ... are the tax consequences to Comet because of the stock redemption? A B C D No reduction in E&P because of the exchange A reduction of $50,000 in E&P because of the exchange A reduction of $62,500... are the tax consequences to Comet because of the stock redemption? A B C D No reduction in E&P because of the exchange A reduction of $50,000 in E&P because of the exchange A reduction of $40,000... because of the stock redemption? A B C D No reduction in E&P because of the exchange A reduction of $150,000 in E&P because of the exchange A reduction of $187,500 in E&P because of the exchange