Corporations: Distributions not in complete liquidation  

CLASS LECTURES:

Corporation—Distributions

After you set up a firm, you need to explore the various tax regulations that govern its distributions. All funds provided to shareholders are considered dividends. This distinction is important because of the specific tax application. Any distribution that is more than the shareholders’ initial investment is considered a gain when stock is sold.

If you have taken an accounting course before, you have probably heard the terms “net income” and “earnings and profit.” Earnings and profit, although being derived from net income, are, indeed, different from net income. Although earnings and profit do relate to a firm’s capital, they differ in how they are computed. A firm’s earnings and profit are determined by tax laws, not Generally Accepted Accounting Principles (GAAP). Section 312 details the guidelines for computing earnings and profit.

There are three types of corporation distributions:

  • Earnings and Profit
  • Dividends
  • Stock Redemption

 

Role of Earnings and Profits

To increase your firm’s taxable income, you can add back any accounting tax-exempt items such as any municipal bonds interest or excluded life insurance proceeds.

It is necessary to also subtract any nondeductible expenses and losses such as related party losses or excess of capital losses.

In addition, a timing adjustment must be made. Timing adjustments refer to specific transactions that affect the year the adjustments are recorded. An example of such a transaction is excess net operating losses.

Furthermore, adjustments resulting from various accounting methods need to be made.

Tax laws require that the firm use the alternative depreciation system when calculating earnings and profit. Let’s understand this with the help of examples.

Example 1

A corporation sells property with a basis of $10,000 to its sole shareholder for $8,000. Because of Section 267 (disallowance of losses on sales between related parties), the $2,000 loss cannot be deducted when calculating the corporation’s taxable income. However, because the overall economic effect of the transaction is a decrease in the corporation’s assets by $2,000, the loss reduces the current earnings and profits for the year of the sale.

Example 2

At the beginning of the year, Gemini Corporation has earnings and profits of $15,000. The corporation generates no additional earnings and profits during the year. On July 1, the corporation distributes $20,000 to its sole shareholder, Brenda, whose stock basis is $4,000. In this situation, Brenda recognizes dividend income of $15,000 (the amount of earnings and profits distributed). In addition, she reduces her stock basis from $4,000 to zero, and she recognizes a taxable gain of $1,000 (the excess of the distribution over the stock basis).

Treatment of Dividends

There are various types of dividends, and as a result, various tax treatments based on whether the shareholders who obtain the dividends are corporations or individuals. Dividends received by a corporation are treated as ordinary income, and tax regulations allow a deduction. If an individual receives dividends, the individual must pay taxes based on a specific rate schedule. Nonqualified dividends received by an individual are taxed as ordinary income.

Let’s understand this with the help of an example. In January, Widget Corporation declared a dividend of $1.00 per share to be paid in February. Mary Black and James Brown are common stockholders of Widget. Each of them owns 2,000 shares. Although both will receive a $2,000 dividend, the number of days they hold the stock will determine their dividend rate.

Property Dividends

A firm can issue cash dividends as well as property dividends. Provided a corporation distributes property instead of cash as a dividend, the value is determined based on the fair market value of the property on the date of distribution. Note: The value of the dividend property is reduced by any associated liability.

Taylor Corporation distributes property (basis of $10,000 and fair market value of $20,000) to Maria, its shareholder. Taylor recognizes a $10,000 gain. Taylor’s earnings and profits is increased by the $10,000 gain and decreased by the $20,000 fair market value of the distribution. Brenda has dividend income of $20,000 (presuming sufficient earnings and profit).

Stock Redemptions

Stock redemptions are discussed in code section 317(b) of the internal revenue service (IRS). This section defines corporate distributions of cash or other property in exchange for a shareholder’s stock as stock redemption.

Section 302(b) stipulates that stock redemption, which qualifies, is treated as a sale or exchange. The IRS has implemented these regulations, provided such distribution is either substantially disproportionate, complete termination, or not essentially equivalent to a dividend. To determine whether a transaction is not essentially equivalent or disproportionate, you have to apply attribution rules. When qualifying for a stock redemption, the earnings and profit account of the distributing corporation is reduced by an amount not in excess of the ratable share of its earnings and profit attributable to the stock redeemed.

 

COURSE TEXTBOOK:

 

 

Title: South-Western Federal Taxation 2018: Comprehensive
Author: William H. Hoffman; James C. Young; William A. Raabe; David M. Maloney; Annette Nellen
Edition: 41
Copyright Date: 2018
Publisher: Cengage South-Western
ISBN: 9781337386005

 

From your course textbook, South-Western Federal Taxation, read the following…

Chapter 19: Corporations: Distributions not in complete liquidation

 

 

ASSIGNMENT:

Please answer BOTH Questions 1 and 2 in a 2-page MS doc .To support your work, use your course lectures and text readings and also use outside sources. As in all assignments, cite your sources in your work and provide references for the citations in APA format.

Question 1

Peach Corporation would like to transfer excess cash to its sole shareholder, Danny, who is also an employee. Danny is in the 28% tax bracket, and Peach is in the 34% bracket. Because Danny’s contribution to the business is substantial, Peach believes that a $50,000 bonus in the current year is reasonable compensation and should be deductible by the corporation. However, Peach is considering paying Danny a $50,000 dividend because the tax rate on dividends is lower than the tax rate on compensation. Is Peach correct in believing that a dividend is the better choice? Why or why not? If you would have been given the responsibility, how would you have handled this situation? Discuss.

Question 2

George Corporation redeems 100 shares of its stock from Jerry for $10,000. Jerry’s basis in those shares is $8,000. Explain possible alternative tax treatments of Jerry’s receiving the $10,000.

 

 

 

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