Module 14 Transactions Between a Corporation and Its Shareholders

Module 14Transactions Between a

Corporation and Its Shareholders

Module Topics

1. Capital distributions

2. Earnings and profits

3. Distributions to shareholders

4. Taxation of stock redemptions

5. Taxation of liquidating distributions

Capital Distributions

Key Learning Objectives Why corporations pay dividendsWhy corporations pay dividends Double taxationDouble taxation How corporations avoid double taxationHow corporations avoid double taxation Constructive or disguised dividendsConstructive or disguised dividends

In Class Exercise: Taking Money Out of a Corporation

Mary (the sole shareholder of a corporation) Mary (the sole shareholder of a corporation) needs $10,000needs $10,000 Mary’s MTR = 28%Mary’s MTR = 28%

The corporation taxable income = $40,000The corporation taxable income = $40,000 Corp’s MTR = 15%Corp’s MTR = 15%

What are the tax consequences of taking the What are the tax consequences of taking the money as salary, dividend, or loan?money as salary, dividend, or loan?

Any other legal ways to get the money out?Any other legal ways to get the money out?

Solution: In Class Exercise: Taking Money Out of a Corporation

Increase (decrease) in income tax liability Increase (decrease) in income tax liability

CorpCorp MaryMary Dividend N/A 2,800Dividend N/A 2,800 Salary (1,500) Salary (1,500) 2,800 2,800 Loan N/ALoan N/A N/A N/A

In Class Exercise: Taking Money Out of a Corporation

Did you consider Payroll taxes?Payroll taxes? Unreasonable compensation?Unreasonable compensation? §7872--gift loan?§7872--gift loan? If the corporation could pay the $10,000 If the corporation could pay the $10,000

directly and deduct it?directly and deduct it? If there could there be a disguised dividend If there could there be a disguised dividend

under any of the alternatives?under any of the alternatives?

Earnings and ProfitsE&P

Key Learning Objectives Computing earnings and profits Record keeping and reporting

requirements

Two Types of E&P

Current E&P

Current tax year before any distributions or redemptions

are subtracted Accumulated E&P

Sum of all previous years current E&P (less distributions)

Common Items Increasing E&P

Tax-exempt interest income Full gain on installment sale in year of sale Dividends received deduction Current annual LIFO layer Excess depreciation Federal income tax refund All carryovers utilized during year

Common Items Decreasing E&P

Federal income taxes paid or accrued Excess charitable contribution Capital losses Current year ordinary losses Nondeductible expenses Fines and penalties

Common Items Decreasing E&P

Disallowed portion of R&DDisallowed portion of R&D Foreign tax creditsForeign tax credits §280C--certain expenses for which §280C--certain expenses for which

credits are allowablecredits are allowable Installment sale gain recognizedInstallment sale gain recognized Gains due to different adjusted basesGains due to different adjusted bases

Record Keeping and Reporting Requirements

Key Learning Objectives § 6042(d) requires corporations to furnish

information needed to determine E&P Names of stockholders Year-by-year basis File Form 5452 if distribution not from

E&P

Distributions to Shareholders

Key Learning Objectives Historical note: General Utilities DoctrineHistorical note: General Utilities Doctrine Dividend distributionsDividend distributions Distributions taxability relative to earnings Distributions taxability relative to earnings

and profitsand profits Other transactions between a corporation Other transactions between a corporation

and its shareholdersand its shareholders

Historical Note: General Utilities Doctrine

In a complete liquidation In a complete liquidation There was a distribution of property to There was a distribution of property to

shareholdershareholder Distributing corporation had no gain or Distributing corporation had no gain or

loss recognitionloss recognition Repealed in 1986Repealed in 1986

Distribution is Taxable Dividend to the Extent that

Distribution Distribution << current E&P current E&P Distribution > current E&P BUTDistribution > current E&P BUT

<< current and accumulated E&P current and accumulated E&P If current E&P If current E&P << 0, AND distribution 0, AND distribution

< accumulated E&P< accumulated E&P

Distribution is Non-Taxable Return of Capital

If distribution > current and If distribution > current and accumulated E&P accumulated E&P

Then distribution is return of capital to Then distribution is return of capital to extent of shareholder’s basis in stockextent of shareholder’s basis in stock

Distribution is Taxable asCapital Gain

If distribution > current and accumulated If distribution > current and accumulated E&P AND shareholder’s basis in stockE&P AND shareholder’s basis in stock

Then excess distribution is treated as a Then excess distribution is treated as a capital gaincapital gain

In Class Exercise: How Much is a Taxable Dividend?

Current Accumulated CashCurrent Accumulated CashCase Case E & P E & P DistributedE & P E & P Distributed

A (4,000) 5,000 3,000 A (4,000) 5,000 3,000 B 5,000 (3,000) 4,000 B 5,000 (3,000) 4,000 C 7,000 15,000 12,000 C 7,000 15,000 12,000 D (8,000) (6,000) 1,000 D (8,000) (6,000) 1,000 E 2,000 7,000 15,000E 2,000 7,000 15,000

Solution: In Class Exercise: How Much is a Taxable Dividend?

Case A: $3,000 taxable as dividendCase A: $3,000 taxable as dividend Case B: $4,000 taxable as dividendCase B: $4,000 taxable as dividend Note that in both A and B you do not Note that in both A and B you do not

net current and accumulated E&P to net current and accumulated E&P to determine the dividenddetermine the dividend

Case C: $12,000 taxable as dividendCase C: $12,000 taxable as dividend

Solution: In Class Exercise How Much is Taxable Dividend?

Case DCase D No current or accumulated No current or accumulated E & PE & P

No taxable dividendNo taxable dividend If shareholder’s basis in stock = $3,000If shareholder’s basis in stock = $3,000

$1,000 is non-taxable return of capital$1,000 is non-taxable return of capital

Solution: In Class Exercise How Much is Taxable Dividend?

Case ECase E 9,000 is taxable as dividend9,000 is taxable as dividend If shareholder’s basis in stock = $2,000If shareholder’s basis in stock = $2,000

$4,000 is taxed as a capital gain$4,000 is taxed as a capital gain $2,000 is non-taxable return of capital$2,000 is non-taxable return of capital

Property Distributions

Key Learning Objectives Property distribution is valued at FMV Property distribution is valued at FMV

minus liabilities assumed by shareholderminus liabilities assumed by shareholder The shareholder’s basis of property The shareholder’s basis of property

received is its FMVreceived is its FMV Property will have a new holding periodProperty will have a new holding period

Compliance Query: Distribution of Property Issues To Consider

For corporationFor corporation If complete liquidation,If complete liquidation,

§336--applies to gains and losses§336--applies to gains and losses Some exceptions to loss recognitionSome exceptions to loss recognition

If non-liquidation distribution,If non-liquidation distribution,

§311(b)--applies to gains only§311(b)--applies to gains only

Compliance Query: Distribution of Property Issues to Consider

For shareholderFor shareholder Any dividend? Any return of capital? Any capital gain? Basis in the new property? Holding period of new property?

Compliance Query: Distribution of Property When FMV >Basis

Current E&P = $10,000Current E&P = $10,000 FMV land FMV land = $30,000 = $30,000 Adjusted basis of landAdjusted basis of land = $12,000= $12,000 Shareholder basis in stock = $5,000Shareholder basis in stock = $5,000 What are the tax consequences toWhat are the tax consequences to

Corporation?Corporation? Shareholder?Shareholder?

Solution: Compliance Query Distribution of Property

FMV > Basis

Both §336 and 311(b) apply to gainsBoth §336 and 311(b) apply to gains Gain of $18,000 is recognized by Corp soGain of $18,000 is recognized by Corp so

E&P is increased by $18,000E&P is increased by $18,000 Reduced by taxes paid on the gainReduced by taxes paid on the gain

E&P is then reduced by $30,000E&P is then reduced by $30,000 FMV of distribution FMV of distribution


FMV >Basis

Total distribution to S/H is $30,000Total distribution to S/H is $30,000 If nonliquidating distributionIf nonliquidating distribution

S/H has dividend of $28,000S/H has dividend of $28,000 Remaining $2,000 is return of capitalRemaining $2,000 is return of capital

If liquidating distributionIf liquidating distribution S/H has a $25,000 capital gainS/H has a $25,000 capital gain

$30,000 - $5,000$30,000 - $5,000


FMV > Basis

§336§336

E&PE&P 10,000 10,000

GainGain 18,00018,000

E&P at Dist 28,000E&P at Dist 28,000

DistributionDistribution 30,000 30,000

DividendDividend N/A N/A

Return of capitalReturn of capital 5,000 5,000

Capital gainCapital gain 25,000 25,000

§311 (b)§311 (b)

E&PE&P 10,000 10,000

GainGain 18,00018,000



DividendDividend 28,000 28,000


Capital gain/loss N/ACapital gain/loss N/A

Compliance Query: Distribution of Property When FMV < Basis

E&P = $10,000 E&P = $10,000 FMV land = $30,000FMV land = $30,000 Adjusted basis of land = $40,000 Adjusted basis of land = $40,000 Shareholder basis in stock = $5,000Shareholder basis in stock = $5,000 What are the tax consequences toWhat are the tax consequences to

Corporation?Corporation? Shareholder?Shareholder?


FMV < Basis Only §336 applies to lossesOnly §336 applies to losses Loss of $10,000 is recognized by Corp if Loss of $10,000 is recognized by Corp if

complete liquidationcomplete liquidation E&P is decreased by $10,000E&P is decreased by $10,000

In both cases, E&P is reduced by $30,000In both cases, E&P is reduced by $30,000 FMV of distributionFMV of distribution


FMV < Basis Total distribution to S/H is $30,000Total distribution to S/H is $30,000 If nonliquidating distribution If nonliquidating distribution

S/H has dividend of $10,000S/H has dividend of $10,000

Return of capital of $5,000Return of capital of $5,000

Capital gain ofCapital gain of $15,000$15,000 If liquidating distributionIf liquidating distribution S/H has a $25,000 capital gainS/H has a $25,000 capital gain

$30,000 - $5,000$30,000 - $5,000


FMV > Basis

§336§336

E&PE&P 10,000 10,000

Loss Loss - -10,00010,000

E&P at Dist -0-E&P at Dist -0-


DividendDividend N/A N/A


Capital gainCapital gain 25,000 25,000

§311 (b)§311 (b)

E&PE&P 10,000 10,000

Loss Loss N/A N/A



DividendDividend 10,000 10,000


Capital gain 15,000Capital gain 15,000

Other Transactions between a Corporation and its Shareholders

Key Learning ObjectivesKey Learning Objectives

§1239--gain from sale of depreciable §1239--gain from sale of depreciable propertyproperty

§267--losses, expenses, and interest§267--losses, expenses, and interest §482--allocations of income and §482--allocations of income and

deductionsdeductions

§1239--Gain from Sale of Gain from Sale of Depreciable PropertyDepreciable Property

Sale or exchange occurs between a Sale or exchange occurs between a taxpayer and a related partytaxpayer and a related party

Property is subject to the allowance for Property is subject to the allowance for depreciation or amortizationdepreciation or amortization

Gain recognized is automatically Gain recognized is automatically classified as ordinary incomeclassified as ordinary income

§267 Losses, Expenses, and InterestLosses, Expenses, and Interest

Prevent the artificial creation of losses and Prevent the artificial creation of losses and deductions between related partiesdeductions between related parties

Disallowing the loss to the sellerDisallowing the loss to the seller Requires the matching of income and Requires the matching of income and

expenses for transactions between related expenses for transactions between related partiesparties

§482--Allocations of Income and Deductions Among Taxpayers

Allows the IRS to reallocate income, Allows the IRS to reallocate income, expenses, and credits among two or more expenses, and credits among two or more taxpayerstaxpayers

Requires taxpayers to conduct transactions Requires taxpayers to conduct transactions at arm’s lengthat arm’s length

Taxation of Stock Redemptions

Redemption vs. dividend income treatment Impact of redemption on corporate E&P Constructive stock ownership §306 stock

Stock Redemption

Key Learning Objectives

If certain requirements are metIf certain requirements are met Stockholder is entitled to capital gainsStockholder is entitled to capital gains When a corporation redeems all or part of stockWhen a corporation redeems all or part of stock No gain or loss is recognized by the corporationNo gain or loss is recognized by the corporation Shareholder treats a redemption as a sale to the Shareholder treats a redemption as a sale to the

corporationcorporation

Taxation of Liquidating Distributions

Key Learning Objectives PerspectivesPerspectives Parent subsidiary liquidationsParent subsidiary liquidations §338 election§338 election

Redemption vs. Dividend Income Treatment

Key Learning Objectives Redemption treated as a distribution in part or full Redemption treated as a distribution in part or full

payment in exchange for the stockpayment in exchange for the stock §302(b)(1) Not essentially equivalent to a dividend§302(b)(1) Not essentially equivalent to a dividend §302(b)(2) Major change in ownership quantitative test§302(b)(2) Major change in ownership quantitative test §302(b)(3) Complete liquidation of shareholder’s interest§302(b)(3) Complete liquidation of shareholder’s interest §302(b)(4) Partial liquidation provisions§302(b)(4) Partial liquidation provisions §303 Redemption upon death§303 Redemption upon death

Impact of Redemption on Corporate E&P

Key Learning Objectives Corporate E&P is reducedCorporate E&P is reduced By the lesser of the fair market value of the By the lesser of the fair market value of the

assets distributed or the percentage of stock assets distributed or the percentage of stock redeemed multiplied by E&Predeemed multiplied by E&P

Distributions reduce E&P first, followed by Distributions reduce E&P first, followed by redemptionsredemptions

Constructive Ownership--Family AttributionKey Learning Objectives

When computing the percentage ownership, When computing the percentage ownership, the stock held by related parties must be the stock held by related parties must be consideredconsidered

Related family members Related family members Parents, spouse, children, and grandchildrenParents, spouse, children, and grandchildren Brothers, sisters, and in-laws are not Brothers, sisters, and in-laws are not

considered family membersconsidered family members

Constructive Stock Ownership-- Entity Attribution

Key Learning Objectives If a corporation, partnership, estate, or trust If a corporation, partnership, estate, or trust

owns stockowns stock Partners or beneficiaries no minimum Partners or beneficiaries no minimum

ownership thresholdownership threshold Corporation, a 50% or greater (by value)Corporation, a 50% or greater (by value)

§306--Sale of Preferred Stock

Key Learning Objectives Treats the sale of preferred stock by the shareholder Treats the sale of preferred stock by the shareholder

as ordinary income (not dividend income)as ordinary income (not dividend income) To the extent that the receipt of the original To the extent that the receipt of the original

preferred stock would have been taxable as a preferred stock would have been taxable as a dividenddividend

Any excess is a return of capital and then a capital Any excess is a return of capital and then a capital gain. No loss is allowed on the transaction.gain. No loss is allowed on the transaction.

Perspectives--Liquidating Corporation

Key Learning Objectives All the gains and losses are recognized as if the corporation All the gains and losses are recognized as if the corporation

sold its assetssold its assets Unamortized balance in organizations costs is deductible in the Unamortized balance in organizations costs is deductible in the

year of liquidationyear of liquidation If an item was previously expensed, such as supplies, and was If an item was previously expensed, such as supplies, and was

still on hand when the corporation is liquidated,still on hand when the corporation is liquidated,

income must be recognized. income must be recognized. All of the tax attributes of the liquidating corporation will be All of the tax attributes of the liquidating corporation will be

lost if they cannot be used before the corporation is dissolvedlost if they cannot be used before the corporation is dissolved

Perspectives--Shareholder

Key Learning Objectives Recognizes capital gain or loss on the Recognizes capital gain or loss on the

difference between difference between Net FMV of the property and cash received andNet FMV of the property and cash received and The adjusted basis of the corporate stockThe adjusted basis of the corporate stock

Basis in the new property is equal to its fair Basis in the new property is equal to its fair market valuemarket value

Holding period starts anewHolding period starts anew

Parent-Subsidiary Liquidations

Key Learning Objectives Subsidiary acquires at least 80% of the stock of another Subsidiary acquires at least 80% of the stock of another

corporationcorporation Assets are now indirectly owned by the acquiring corporationAssets are now indirectly owned by the acquiring corporation §332 Parent corporation has no gain or loss recognized on the §332 Parent corporation has no gain or loss recognized on the

receipt of property in return for its ownership interestreceipt of property in return for its ownership interest Tax attributes will be inherited by the parent companyTax attributes will be inherited by the parent company Parent’s basis in the stock (called outside basis) of the target Parent’s basis in the stock (called outside basis) of the target

disappearsdisappears §332 is mandatory§332 is mandatory

§338 Election

Key Learning Objectives

Permits an acquiring corporation to take a basis in the assets Permits an acquiring corporation to take a basis in the assets upon the liquidation of a subsidiary equal to the purchase price upon the liquidation of a subsidiary equal to the purchase price of the stock in the subsidiaryof the stock in the subsidiary

Beneficial when the adjusted basis of the subsidiary’s assets is Beneficial when the adjusted basis of the subsidiary’s assets is less than the purchase price of the stockless than the purchase price of the stock

Subsidiary is deemed to have sold all its assetsSubsidiary is deemed to have sold all its assets Could be a significant tax liabilityCould be a significant tax liability Tax attributes of the subsidiary disappearTax attributes of the subsidiary disappear

Documents

Module 14 Transactions Between a Corporation and Its Shareholders