SM-CH04

CHAPTER 4

4-

2002 Annual Edition/Solutions Manual

Corporations: Earnings and Profits and Dividend Distributions4-

CHAPTER 4

CORPORATIONS: EARNINGS AND PROFITS AND

DIVIDEND DISTRIBUTIONS

SOLUTIONS TO PROBLEM MATERIALS

Status:

Q/P

Question/

Present

in Prior

Problem

Topic

Edition

Edition

1

Taxation of corporate distributionsUnchanged1

2

Definition of earnings and profitsUnchanged2

3

Effect of selected transactions in adjusting taxableModified3

income (for determining E & P)

4

Comparison of accounting methods under E & PUnchanged4

and income tax

5

Effect of distribution, taxable dividend or returnUnchanged5

of capital, in selected situations

6

Effect on E & P of gains and losses from propertyUnchanged6

transactions

7

Planning corporate distributionsbeginning or endUnchanged7

of tax year

8

Purpose of property dividend versus cash dividendUnchanged8

9

Property distribution: choice of propertyNew

10

Issue recognitionUnchanged10

11

Effect of selected situations in adding to orUnchanged11

generating a deficit in E & P

12

Impact of liabilities on tax treatment of propertyUnchanged12

distributions

13


14

Necessity of dividend distribution to meet stateUnchanged14

legal requirements in determining tax treatment

15


16

Selected factors in determining reasonableness ofUnchanged16

compensation

17

Importance of double taxation to corporate andUnchanged17

individual shareholders

Status:

Q/P

Question/

Present

in Prior

Problem

Topic

Edition

Edition

18

Unreasonable compensationModified18

19

Unreasonable compensation; ways to draw fundsModified19

from corporation

20

Election to receive common or preferred stock dividendNew

21

Distribution of preferred stock or stock rights toUnchanged21

common and preferred stockholders

22

Explain tax effects of nontaxable stock rights;Unchanged22

taxable stock rights

23

Amount of dividend incomeModified23

24

Amount of taxable income; balance in E & PUnchanged24

25

Deficit in E & P followed by sale on installmentModified25

method; taxation of dividend distribution

26

Amount of dividend income; deficit in current E & PUnchanged26

with positive balance in accumulated E & P

27

Cash distributions; determination of taxable amountUnchanged27

28

Cash distributions; determination of taxable amount;Unchanged28

gain on sale of stock

29

Cash distributions; determination of taxable amountUnchanged29

30

Effect of specified transactions on taxable income;New

on E & P

31

Effect of specified transactions on taxable income;Unchanged31

on E & P

32

Tax treatment to shareholder and to corporationUnchanged32

on distribution of property subject to liability

in excess of basis

33

Tax treatment to corporate shareholder and toUnchanged33

distributing corporation of property subject to a

liability

34

Taxation of dividend when E & P has positiveUnchanged34

balance but corporation has current loss

35

Property distribution; taxation to shareholder andUnchanged35

to corporation

36

Property distribution where FMV is less thanUnchanged36

adjusted basis

37


38

Constructive dividendsModified38

39

Property dividend; liability assumed by shareholder;Modified39

determination of E & P; distribution of loss

property

40

Property distribution to corporate shareholder; basisUnchanged40

in excess of FMV; liability assumed by

shareholder

41

Effect of specified transactions on taxable income;Unchanged41

on E & P

42

Dividend distribution; effect on E & PUnchanged42

Status:

Q/P

Question/

Present

in Prior

Problem

Topic

Edition

Edition

43

Dividend distribution; effect on E & P Unchanged43

44

Dividend distribution; effect on E & PUnchanged44

45

Interest free loan to shareholderUnchanged45

46

Basis of nontaxable preferred stock dividendUnchanged46

47

Stock dividend; basis allocation; gain on saleModified47

48

Stock rights; basis allocation; gain on saleUnchanged48

49

How to structure a dividend paymentUnchanged49

50

Source of dividend distributionUnchanged50

Research

Problem

1

Earnings and profits and tax evasionUnchanged1

2

Reasonable compensationNew

3

Dividend in anticipation of corporate saleUnchanged3

4

Corporate deduction of luxury auto and constructiveUnchanged4

dividend to shareholder

5

Internet activityUnchanged5

6

Internet activity: Trust preferred stockUnchanged6

7

Internet activityUnchanged7

CHECK FIGURES23.

24.a.

24.b.

25.

26.

27.a.

27.b.

27.c.

27.d.

27.e.

28.a.

28.b.

28.c.

28.d.

28.e.

29.

30.a.

30.b.

30.c.

30.d.

30.e.

30.f.

31.a.

31.b.

31.c.

31.d.

31.e.

31.f.

31.g.Ordinary dividend income $130,000 each, George reduces basis in stock to $38,000, Albert reduces stock basis to zero and capital gain $2,000.

$315,000.

$630,000.

$300,000 taxable dividend.

$50,000 taxable dividend, $135,000 capital gain.

$70,000; $80,000.

$40,000; $50,000.

$220,000; $0.

$80,000; $40,000.

$110,000; $10,000.

$120,000; $10,000.

$100,000; $0.

$70,000; $0.

$50,000; $20,000.

$90,000; $0.

Carrie Lynn dividend income $135,000, $15,000 reduced basis in stock and capital gain $165,000 on sale; Rajib dividend $40,000 and $110,000 reduction in basis.

$20,000; ($20,000).

No effect; ($27,000).

No effect; ($7,500).

No effect; ($43,000).

No effect; ($8,500).

$25,000; $0.

No effect; ($40,000).

($30,000); $26,000.

$50,000; $150,000.

$3,000; $7,000.

No effect; no effect.

($12,000); $9,600.

No effect; ($2,400).31.h.

31.i.

32.a.

32.b.

33.a.

33.b.

33.c.

34.

35.

36.

39.a.

39.b.

39.c.

39.d.

40.a.

40.b.

41.

42.

43.

44.

46.

47.

48.($80,000); $30,000.

No effect; $60,000.

$75,000.

$0.

$80,000.

$110,000.

Reduces $120,000.

$25,000 dividend and $10,000 return of capital.

Crossbill recognizes gain $140,000 and E & P reduced $145,000; Janel taxable dividend $145,000 and basis equipment $180,000.

Homer dividend $60,000 and basis in land $60,000; Gold $0 loss recognized and E & P reduced $100,000.

$20,000.

$77,350.

$100,000.

$98,000 taxable dividend; E & P is $77,350.

Dividend income $10,000, dividends received deduction $8,000, basis $60,000 in land.

$40,000.

$129,139; $145,900.

Return of capital $40,000.

Taxable dividend $10,000 and return of capital $20,000.

Taxable dividend $70,000 each; $210,000.

Common stock basis is $22,500; preferred stock is $2,500.

$5,500 long-term capital gain.

Long-term capital gain on sale $510 and basis new stock $3,960.

Discussion Questions

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.

pp. 4-2 and 4-12 2.Earnings and profits is the factor which fixes the upper limit on the amount of dividend income shareholders would have to 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 possesses similarities to the accounting concept of retained earnings. However, E & P and retained earnings often are not the same. For example, a stock dividend which 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. 4-3 and Concept Summary 4-1

3.a.To determine current E & P for 2001, Oriole Corporation's taxable income is increased by the entire amount of the deferred gain on the installment sale.

b.Oriole Corporation's taxable income for 2001 is increased by the amount of the capital loss carryover in determining Oriole Corporation's E & P for 2001. As the excess capital losses would have reduced E&P in 2000, there is no need for further reduction in 2001.

c.Oriole Corporation's taxable income is reduced by the excess charitable contributions in determining its E & P. The excess charitable contributions that cannot be utilized in computing Oriole Corporation's taxable income is nonetheless a reduction in its E&P account for the year.

d.Gains and losses from property transactions affect the determination of E & P only to the extent that they are recognized for tax purposes. Thus, the deferred gain would also be deferred for purposes of E & P and no adjustment to taxable income would be necessary.e.Oriole Corporation's taxable income for 2001 is reduced by the Federal income taxes paid in computing its E & P for 2001.

f.For E & P purposes, 179 expenses are deducted over a five-year period. Consequently, one-fifth of the 179 deduction in 1999 would be subtracted from taxable income in 2001 to determine current E & P.

pp. 4-3 to 4-7 and Concept Summary 4-1

4.The accounting methods employed when computing E & P are considerably more conservative than the methods allowed when computing the income tax. 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 usedin 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. 4-5 to 4-7

5.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 is a return of capital. 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. 4-7 to 4-11 and Concept Summary 4-2

6.Gains and losses from property transactions generally affect the determination of E&P only to the extent they are recognized for tax purposes. Thus, for example, a gain on an involuntary conversion not recognized by the corporation because the insurance proceeds are suitably reinvested does not affect E & P. p. 4-5

7.This is not a valid assumption. Any current E & P for the year is deemed to be available when the distribution occurs. p. 4-10

8.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.4-11

9.As auto A yields the best tax result for Swallow Corporation, it should distribute this car to one of the shareholders. In contrast, distributing B would trigger a taxable gain of $5,000, while distributing C produces a nondeductible loss of $5,000. To preserve the loss on C and avoid recognizing gain on B, Swallow should consider selling C and then distributing cash to the second shareholder. p. 4-12

10.Probably not, unless the corporation has some capital losses it cannot use. In the case of corporations, capital gains are taxed the same as ordinary income. See the discussion in Chapter2.

11.a.A dividend distribution cannot generate or add to a deficit in E & P.

b.An operating loss can both generate and add to a deficit in E & P. Deficits can only arise through corporate losses.

p. 4-13

12.If distributed property is subject to a liability or if a shareholder assumes a liability in a property distribution, the amount of the distribution is reduced by the liability, both for the shareholder and for purposes of determining E & P. For purposes of determining gain at the corporate level on distributions of appreciated property, a special rule applies when a property is subject to liabilities in excess of basis. In particular, the fair market value of distributed property is deemed to be not less than the amount of the liability. pp. 4-11 to 4-13

13.(Is the distribution from corporate earnings?

Is the distribution in partial or complete liquidation of Yellow Corporation?

Does the distribution qualify as a stock redemption for tax purposes?

What is the tax basis of each of the shareholder's stock investment in Yellow Corporation?

What is the E & P of Yellow Corporation?

Has corporate E & P been determined accurately for tax purposes?

How will the distribution affect E & P for Yellow Corporation?

Another factor that is important is the nature of the shareholder. In the case of a corporate shareholder (Maize Corporation in this situation), dividend treatment would be preferable to a capital gain result since the dividends received deduction is available to corporate shareholders.

pp. 4-2 to 4-13 and Chapters 2 and 5

14.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, often described as a constructive dividend, is distinguishable from actual corporate distributions of cash and property in form only. p. 4-13

15.(Is the salary payment reasonable?

What are Tina's qualifications?

How does her salary payment compare with salaries for comparable positions in other comparable businesses?

What is the nature and scope of her work?

How does her salary compare with gross and net income?

What is the corporation's salary policy toward all employees?

Was the advance a bona fide loan?

Was it evidenced by a written instrument?

Did Tina furnish collateral or other security for the advance?

What is her financial capacity to repay the loan?

How did she use the funds?

What is Buff Corporations dividend paying history?

What is the amount of imputed interest on the loans?

pp. 4-14 and 4-15

16.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 salary paid the shareholder-employee. The degree of relationship between the sole owner of the corporation and the employee should be considered initially to determine if, in essence, the salary could be considered as having been paid to the owner. If so, the same factors used to determine the reasonableness of that paid to the owner should be used to determine the reasonableness of that paid to the related employee.

b.That the employee-shareholder never completed high school should be relevant only with respect to the nature and scope of the employee's work. Is education beyond high school required for the type of work performed by the employee-shareholder and the salary received for such work?

c.The fact that the employee-shareholder is a full-time college student might well cause any salary paid to be deemed excessive.

d.If the employee-shareholder was underpaid during the formative period of the corporation, this is evidence of reasonableness of the compensation if a portion thereof is for service rendered in prior years.

e.If a corporation has substantial E & P and pays only a nominal dividend each year, a constructive dividend may be found.

f.Year-end bonuses would be vulnerable to constructive dividend treatment, particularly if they are related to profit for the year, are paid only to shareholder-employees, and are determined at year-end on an arbitrary basis.

pp. 4-14, 4-15, 4-21 to 4-23, and Example 27

17. Blackbirds concerns may be misplaced because corporate shareholders are entitled to a dividends received deduction. In the present case, Blackbird and Junco will each receive an 80% dividends received deduction because they each own 50% of the corporation. Since there may be other benefits conferred by the corporate form that are not available to partnerships (e.g., limited liability, easier access to the capital markets, ease of ownership transfer, etc.), it may be that the small tax on dividends faced by the corporations will be outweighed by non-tax factors.

If Blackbird and Junco were individuals, the dividends received deduction would not be available, so the double tax issue takes on added relevance.

See discussion of the dividends received deduction in Chapter 2.

18.The salaries paid to Sam and Jennifer are vulnerable to constructive dividend treatment since neither shareholder appears to have earned them.

There is also a problem regarding the $400,000 salary payment to Walter. Why is he receiving $350,000 more than Richard when it appears they share equally in the operation of the corporation? Although Walter is not a shareholder, his relationship to Sam and Jennifer is enough of a tie-in to raise the unreasonable compensation issue.

Peregrine Corporation has distributed only one small dividend during the past ten years 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 Sam and Jennifer is unreasonable compensation and that $350,000 of the salary paid to Walter is unreasonable.

Example 27

19.There would be a problem. Amethyst Corporation will have satisfied Fionas obligation. Amethyst Corporation's payment to the charity may be treated as indirect compensation to her.

In determining whether Amethyst Corporation has paid Fiona unreasonable compensation, both the direct payment of $300,000 and the indirect $50,000 will be considered. Fiona should not have made a pledge to the charity. She should have just permitted the corporation to make the contribution directly. Examples 28 and 29

20.

Hoffman, Raabe, Smith, and Maloney, CPAs

5101 Madison Road

Cincinnati, OH 45227

November 1, 2001

Cormorant Corporation

6730 Pima Drive

Madison, WI 53708

Dear President of Cormorant 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 1 letter. Any change in facts may cause our conclusion to be inaccurate.

Your shareholders will have taxable income in the amount of 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, do not hesitate to contact me.

Sincerely yours,

Jon S. Davis, CPA

Partner

TAX FILE MEMORANDUM

November 1, 2001

FROM:Jon S. Davis

SUBJECT:Cormorant Corporation

Today I conferred with the President of Cormorant Corporation with respect to his November 1 letter. The corporation asked whether their shareholders would have any taxable gain on the receipt of a stock dividend. Cormorant Corporation declared a dividend permitting its shareholders to elect to receive either 8 shares of cumulative preferred stock or 2 additional shares of Cormorant common stock for every 10 shares of common stock held at the time of the dividend declaration. Two of the shareholders 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 the exceptions applies in the current situation. In particular, a distribution of preferred stock to some common shareholders and of common stock to other common shareholders is a taxable event.Conclusion: The shareholders will have taxable income equal to the fair market value of the stock dividend.

pp. 4-17 and 4-18

21.A distribution that results in the receipt of preferred stock by all common shareholders on a pro-rata basis is not taxable. However, most distributions of stock to preferred stockholders are taxable (the exception is certain adjustments to conversion ratios of convertible preferred stock). The amount of dividend income recognized by the preferred shareholders is equal to the number of shares of stock received times the fair market value of each share.

If the stock rights were received, the tax effect would have been the same as if preferred stock were received. For common shareholders, the rights would have been exempt from tax. If the rights were less than 15% of the value of the common stock held, the basis of the rights would have been zero. However, the common shareholders could have elected to allocate some of the common stock basis to the rights. If the rights were equal to or greater than 15% of the value of the common stock held, allocation of basis between the common stock and rights would have been required.

For the preferred stockholders, the rights would have been a taxable distribution. The amount of income recognized would have equaled the fair market value of the rights. The fair market value also would have been the basis of the rights in the hands of the preferred shareholders.

pp. 4-17 to 4-19

22.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 is 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.

pp. 4-18 and 4-19

Problems

23.George and Albert have ordinary dividend income of $130,000 each [$200,000 (Swan Corporations accumulated E & P) + $60,000 (Swan Corporations current E & P) 2]. The remaining $20,000 of the $280,000 distribution reduces the basis (up to $10,000 each) in the shareholders stock in Swan Corporation with any excess treated as a capital gain. George reduces his basis from $48,000 to $38,000. Albert has a reduction in stock basis from $8,000 to zero and a capital gain of $2,000. Example 1

24.a.Vireo reports $300,000 dividends as taxable income but has a dividends received deduction under 243 of $210,000 (70% X $300,000). None of the other items affect taxable income. Thus, there is a net increase of $90,000 (as a result of the dividends and associated dividends received deduction), or a taxable income of $315,000.

b.Vireo Corporations E & P as of December 31 is $630,000, computed as follows: $80,000 (beginning balance in E & P) + $315,000 (taxable income) + $210,000 (dividends received deduction) + $50,000 (tax-exempt interest) - $25,000 (interest on indebtedness to purchase tax-exempt bonds).

pp. 4-3 and 4-4

25.Buck reports $300,000 as a taxable dividend. The $550,000 gain on the sale of the land increases E & P by that amount in 2001. The E & P balance prior to the $300,000 distribution is $150,000 [$550,000 (gain on sale) - $280,000 (accumulated deficit) - $120,000 (current year deficit)]. Current E & P before the distribution is $430,000 [$550,000 (gain on sale) - $120,000 (current year deficit)]. Since there is adequate current E & P, the entire distribution is a dividend.

p. 4-5 and Example 6

26. Dividend income is $50,000 and $150,000 is a return of capital, of which $135,000 is taxed as a capital gain. To determine the amount of dividend income, the balances of both accumulated and current E & P as of September 30 must be netted because of the deficit in current E & P. Three-quarters of the loss, or $300,000, is deemed to have occurred by September 30; thus, the $350,000 in accumulated E & P is reduced by $300,000. The $50,000 balance remaining in E & P triggers dividend income. Example11

27.

Amount Return of

Taxable Capital

a.$ 70,000$80,000Accumulated E & P and current E & P are netted

on the date of distribution. There is a dividend

to the extent of any positive balance.

b.$ 40,000$50,000Taxed to the extent of current E & P.

c.$220,000$ -0-Taxed to the extent of current and accumulated

E&P.

d.$ 80,000$40,000Accumulated E & P and current E & P netted on

date of distribution.

e.$110,000$10,000When 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 $110,000 [current E & P is a deficit of

$30,000 (i.e., 1/2 of $60,000) netted with

accumulated E & P of $140,000].

pp. 4-7 to 4-11

28.

Amount Capital

Taxable Gain

a.$120,000$10,000Taxed to the extent of current E & P. Capital gain to extent distribution exceeds E & P plus stock basis.

b.$100,000$ -0-Taxed to the extent of current and accumulated E&P.

c.$ 70,000$ -0-Taxed to the extent of current E & P.

d.$ 50,000$20,000Accumulated 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.$ 90,000$ -0-When the result in current E & P is a deficit for the year, suchdeficit is allocated on a pro rata basis to distributions made duringthe year. Thus, on June 30,current E & P is a deficit of $80,000 (i.e., 1/2 of $160,000). This is netted with accumulated E& P of $210,000 to cause all of the distribution to be taxed.

pp. 4-7 to 4-11

29.The $80,000 in current E & P is allocated on a pro rata basis to the two distributions made during the year; thus, $40,000 of current E & P is allocated to Carrie Lynns distribution and $40,000 is allocated to Rajibs distribution. Accumulated E & P is applied in chronological order beginning with the earliest distribution. Thus, the entire $95,000 is allocated to Carrie Lynns distribution. As a result, the distribution of $150,000 to Carrie Lynn on July 1 is taxed as dividend income to the extent of $135,000 ($95,000 AEP + $40,000 current E & P for of the year). The remaining $15,000 reduces the basis in Carrie Lynns stock to $35,000. Carrie Lynn then recognizes a capital gain of $165,000 on the sale of the stock [$200,000 (selling price) - $35,000 (remaining basis in the stock)]. The distribution to Rajib of $150,000 is a taxable dividend of $40,000 and a $110,000 reduction in his stock basis. Thus, Rajibs basis in the Junco stock is $90,000 [$200,000 (original cost) - $110,000 (reduction in basis from the distribution)].

pp. 4-7 to 4-11

30.

Taxable Income E & P

Increase (Decrease) Increase (Decrease)

a. $20,000

($20,000)

b.No effect

($27,000)

c.No effect

($ 7,500)

d.No effect

($43,000)

e.No effect

($ 8,500)

f.$25,000

$ -0-

Note: E & P is not increased in f. because the $25,000 has already been included in taxable income. The realized gain is not an increase in E&P, only the recognized gain that is included in taxable income.

Concept Summary 4-1

31.Taxable IncomeE & P

Increase (Decrease)Increase (Decrease)

a.No effect($ 40,000)*

b.($30,000)$ 26,000**

c.$50,000$150,000

d.$ 3,000$ 7,000***

e.No effectNo effect

f.($12,000)$ 9,600

g.No effect($ 2,400)

h.($80,000)$ 30,000

i.No effect$ 60,000

*While the related party loss is not deductible under the income tax, it must be subtracted from E & P.

**Although intangible drilling costs are deductible in full under the income tax, they must be amortized over 60 months when computing E & P. Since $500 per month is amortizable ($30,000/60 months), $4,000 is currently deductible for E&P purposes ($500 X 8 months). Thus, of the $30,000 income tax deduction, $26,000 must be added back to E & P ($30,000 - $4,000 deduction allowed).

***The receipt of a $10,000 dividend will generate a dividends received deduction of $7,000. The net effect on taxable income is an increase of $3,000. For E & P purposes, the dividends received deduction must be added back.

Only 20% of current-year 179 expense is allowed for purposes of E & P. 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.

Only ADS straight-line depreciation reduces E & P; thus, E & P is increased by $30,000, which is the excess of MACRS depreciation taken over the amount allowed under ADS.

Concept Summary 4-1

32.a.Vireo has a gain of $75,000 on the distribution, computed as follows: $195,000 (liability on the property exceeds fair market value) - $120,000 (basis of the property). Vireos E & P is increased by the $75,000 gain. In addition, E & P is decreased by $195,000 (representing the deemed fair market value of the property), less the $195,000 liability on the property, or zero. Thus, E & P is $285,000, computed as follows: $210,000 (beginning E & P balance) + $75,000 (gain on distribution).

b.Pete has dividend income of zero, computed as follows: $195,000 (value of the property based on liability) - $195,000 (liability on the property). Pete has a basis of $195,000 in the property.

pp. 4-11 to 4-13

33.a.Dividend income to Orca is $80,000 [$110,000 (fair market value of the property)- $30,000 (liability assumed)]. The amount taxed to Orca is reduced by the dividends received deduction.

b.Orcas basis in the property is $110,000.

c.The distribution reduces Penguins E & P account by $120,000 [$150,000 (adjusted basis of the property) - $30,000 (liability assumed by Orca)].

pp. 4-11 to 4-13

34.To determine the taxability of the $35,000 distribution, the balance of both accumulated and current E & P as of July 1 must be determined and netted. This is necessary because of the deficit in current E & P. One-half of the $30,000 loss, or $15,000, reduces E&P to $25,000 as of July 1 ($40,000 - $15,000). Thus, of the $35,000 distribution, $25,000 is taxed as a dividend and $10,000 represents a return of capital. Example 11

35.Crossbill Corporation recognizes a gain of $140,000 on the distribution. Crossbills E & P is reduced by $145,000 [$180,000 (fair market value) - $35,000 (liability)]. Janel has a taxable dividend of $145,000 [$180,000 (fair market value) - $35,000 (liability)]. The basis of the equipment to Janel is $180,000. pp. 4-11 to 4-13

36.Homer has a taxable dividend of $60,000 and a basis in the land of $60,000. Gold Corporation does not recognize a loss on the distribution. Golds E & P is reduced by $100,000. pp. 4-11 to 4-13

37.(What basis do Cybil and Sally have in their stock in Copper Corporation after their

initial transfers for stock?

Does Sallys transfer qualify under 351 of the Code as a nontaxable exchange?

How is Copper Corporation taxed on the property distribution to Cybil?

How do the distributions to Cybil and to Sally affect Coppers E & P?

How will Cybil and Sally be taxed on the distributions?

What is Cybils basis in her stock when she sells it to Dana?

How are Cybil and Dana taxed on the $80,000 distribution to each?

pp. 4-2 to 4-13 and Chapter 3

38.a.The result of this transaction is, in effect, a realized loss of $15,000 (the difference between basis of $33,000 and fair market value of $18,000) and a constructive dividend of $13,000 (the difference between the $18,000 fair market value and the $5,000 paid for the parking lot). Due to the application of 267, Redwing cannot recognize the realized loss. However, the loss does reduce Redwings E&P. The constructive dividend also reduces E&P. Thus, E&P is reduced by $28,000 (the sum of the $15,000 disallowed loss and the $13,000 constructive dividend).

b.The loan to Royce will generate imputed interest since no interest was charged. The amount of imputed interest will be $9,000 ($200,000 X 9% X year). This amount will be deemed paid as interest from Royce to the corporation. The deductibility of the interest by Royce will depend upon how the loan proceeds are used. Redwing will have taxable interest income of $9,000. Finally, Redwing will be deemed to pay a dividend to Royce equal to the amount of interest. Redwings E & P will be 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 dividend to both Mike and Royce equals the fair rental value of the yacht. Thus, both shareholders will receive dividend income of $30,000 ($7,500X 4 weeks) and Redwings E&P will be reduced by the same amount.

d.The $7,000 excess amount ($20,000 - $13,000) paid to Mike by Redwing over the fair rental value of the equipment will be treated as a constructive dividend taxable to Mike. The dividend will also reduce Redwings E & P.

pp.4-13 to 4-15

39.a.Taxable income to Lea is $20,000 [$100,000 (value of the property) - $80,000 (liability)].

b.Corporate E & P after the distribution is $77,350, computed as follows:

Beginning E & P$51,000

Add:

Taxable income$320,000

Proceeds of term life insurance46,400

Subtract:

Federal income tax(108,050)

Life insurance premiums(2,000)

Property distribution(220,000)*

Prior year installment sale income(10,000)26,350

E & P of Plover after the distribution$77,350*E & P is reduced by the greater of the fair market value ($100,000) or adjusted basis of the property ($300,000), less the amount of liability on the property ($80,000).

c.The tax basis of the property to Lea is $100,000.

d.If Plover had sold the business property at its $100,000 fair market value, it would have recognized a loss of $200,000. This loss would offset $200,000 of taxable income in the current year, creating Federal tax savings of $78,000 ($200,000 X 0.39). After paying off the $80,000 loan, Plover would have a total of $98,000 to distribute to Lea [$78,000 (tax savings) + $100,000 (sales proceeds) - $80,000 (loan balance)]. Immediately following the property sale, Plovers E & P balance would be:

Beginning E & P

$51,000

Add:

Taxable income$120,000

Proceeds of term life insurance46,400

Subtract:

Life insurance premiums(2,000)

Federal income tax(30,050)

Income from prior year installment sale(10,000)124,350E & P of Plover after the distribution$175,350Thus, Lea recognizes a taxable dividend of $98,000. Plovers E & P would be reduced to $77,350 after the distribution. Note that this result is superior to a distribution of the property to Lea. In particular, the corporation receives a $200,000 deduction, while Leas income is only increased by $78,000.

Concept Summary 4-1 and Examples 2, 13, and 19

40.a.Verdigris Corporation has dividend income of $10,000 [$60,000 (fair market value of the land) less $50,000 (liability on the land)]. The $10,000 is subject to the dividends received deduction under 243 of $8,000, so that only $2,000 is taxed to Verdigris Corporation. Verdigris Corporation has a basis of $60,000 in the land.

b.Rust Corporation may not deduct the loss on the land. Its E & P is reduced by $40,000, the $90,000 basis of the land (which is greater than the fair market value) less the $50,000 liability on the land.

Examples 13 and 19

41.Taxable income:

Income from services rendered

$200,000

Dividend income

40,000

$240,000

Less:Salaries$70,000

Depreciation ($90,000 cost X 14.29%)12,861 82,861

Taxable Income before dividends received deduction

$157,139

Less: Dividends received deduction (70% of $40,000)

28,000

Taxable income

$129,139

E & P:

Taxable income

$129,139

Add:

Tax-exempt income$20,000

Excess of MACRS depreciation over straight-line:

Straight-line is $4,500 [($90,000 cost ( 10) ( 2].

Depreciation under MACRS of $12,861 less

$4,500 straight-line 8,361

Dividends received deduction28,000 56,361

$185,500

Deduct:

STCL on sale of stock$25,000

Estimated Federal income tax14,600 39,600

E & P

$145,900pp. 4-3 to 4-13

42.The shareholder has a return of capital of $40,000. The $40,000 reduces the basis in the Bunting Corporation stock; any excess over basis is capital gain. There is no taxable dividend because the accumulated E & P account is brought up to date on the date of the sale. On the date of the sale, E & P is a negative $10,000 [$175,000 (beginning balance in accumulated E & P) - $175,000 (existing deficit in current E& P from sale of the asset) - $10,000 (one-half of $20,000 negative E&P not related to asset sale)]; thus, the $40,000 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. (If the $195,000 deficit in E & P were prorated throughout the year, there would have been a taxable dividend of $40,000 because E&P would have a positive balance of $77,500 [$175,000 (beginning balance in accumulated E&P) - $97,500 (one-half the $195,000 deficit for the year)]. Examples 11 and 25

43.The shareholder has a taxable dividend of $10,000 and a return of capital of $20,000. Becard Corporation has no accumulated E & P at the time of the distribution. The shareholder is taxed on the current E & P of Becard, which was only $10,000. The balance of the distribution, $20,000, first reduces the adjusted basis of the stock in Becard Corporation. To the extent that the $20,000 exceeds the basis in the stock, a capital gain results. pp. 4-7 to 4-11

44.Indigo Corporation and Lucy each have a taxable dividend of $70,000. Tanager Corporations current E & P is $180,000; thus, the entire distribution is a taxable dividend even though Tanager has no accumulated E & P. Indigo Corporation is entitled to a dividends received deduction of $56,000 (80% X $70,000) because it owns more than 20% of the stock in Tanager Corporation. Thus, Indigo is only taxed on $14,000. Because Lucy is an individual, she pays tax on the entire dividend.

To determine Tanager Corporations accumulated E & P at the end of the year, its current E & P ($180,000) is first reduced by the amount of the distributions ($140,000). The remaining $40,000 is then netted against the accumulated E & P deficit of $250,000, leaving a deficit of $210,000 as of January 1 of the following year.

pp. 4-7 to 4-11

45.Wren Corporation is deemed to have made a dividend to James in the amount of the imputed interest on the loan, determined by using the Federal rate and compounded semiannually. Thus, Wren Corporation is deemed to have made a dividend to James in the amount of $20,500. Although James has dividend income of $20,500, he may be permitted to offset the income with a $20,500 deemed interest payment to Wren. Wren has deemed interest income of $20,500, but has no corresponding deduction. The deemed payment from Wren to James is a nondeductible dividend. Example 21

46.Immediately after the distribution, Hiro has $50,000 worth of Canary stock ($45,000 in common stock and $5,000 in preferred stock). Consequently, the basis of the common stock will equal the ratio of the common stocks fair market value to the total fair market value times the stocks basis, or ($45,000/$50,000) X $25,000, or $22,500. Similarly, the basis of the preferred stock will equal $2,500 [($5,000/$50,000) X $25,000].

Example 23

47.

Hoffman, Raabe, Smith, and Maloney, CPAs

5101 Madison Road


February 20, 2001

Sarah Beckert

1822 N. Sarnoff Rd.

Tucson, AZ 85710

Dear Ms. Beckert:

This letter is in response to your question with respect to your sale of the Grebe 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.

You paid $10,000 for 3,000 shares of stock in Grebe Corporation two years ago. Last year, a nontaxable stock dividend of 1,000 additional shares in Grebe Corporation was received. The 1,000 shares were sold in the current year for $8,000. Your 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 $10,000 cost of the original 3,000 shares by 4,000 (to include the 1,000 new shares). Your basis then would be $2.50 per share ($10,000 ( 4,000). Your gain of $5,500 would then be computed as follows: [$8,000 (selling price) - $2,500 (tax basis in the 1,000 new shares)]. The $5,500 gain on the sale is a long-term capital gain. The gain is long term because you have held your original Grebe stock for more than one year.

Should you need more information or need to clarify our conclusion, do not hesitate to contact me.

Sincerely yours,

Jon S. Davis, CPA

Partner

TAX FILE MEMORANDUM

February 15, 2001

FROM:Jon S. Davis

SUBJECT:Sarah Beckert

Today I conferred with Sarah Beckert regarding her letter to me dated February 10. Two years ago, Ms.Beckert purchased 3,000 shares of Grebe Corporation for $10,000. Last year, she received a nontaxable stock dividend of 1,000 additional shares in Grebe. She sold the 1,000 shares this year for $8,000. She asked me to determine the tax consequences of the stock 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 3,000 shares, $10,000, is reallocated to the 4,000 shares she held after receiving the nontaxable stock dividend. Her basis per share after the stock dividend is $2.50 per share ($10,000 ( 4,000 shares). Her gain on the sale of the 1,000 shares is therefore $5,500 [$8,000 (selling price) - $2,500 (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.4-17 and 4-18

48.Because the fair market value of the rights is 15% or more of the value of the old stock, Karen must allocate her basis in the stock between the stock and the stock rights. Karen allocates basis as follows:

Fair market value of stock: 100 shares X 80 =$ 8,000

Fair market value of rights: 100 rights X 20 =2,000

$10,000

Basis of stock: $3,000 X 8/10 = $2,400

Basis of rights: $3,000 X 2/10 = $ 600 = $6 per right

There is a capital gain on the sale of the rights of $510, computed as follows:

Selling price of 40 rights$750

Less: Basis of 40 rights (40 X $6)240

Long-term capital gain$510Basis of the new stock is $3,960, computed as follows:

60 rights X $6$ 360

Additional consideration ($60 X 60)3,600

$3,960Holding period of the 60 new shares begins on the date of purchase.

Example 24

49.Partridge should recognize the loss as soon as possible and immediately thereafter make the cash distribution. For example, assume these two steps took place on January 2. Because current E & P would be a deficit, accumulated E & P would be brought up to date. At the time of the distribution, the combined E & P balance would be zero [$300,000 (beginning balance in E & P) - $300,000 (existing deficit in current E & P)], and the entire $180,000 would be a return of capital. Current deficits are allocated pro rata throughout the year unless the parties can prove otherwise. Here they can. Example25

50.Hoffman, Raabe, Smith, and Maloney, CPAs

5101 Madison Road


April 15, 2001

Diver Corporation

1010 Oak Street

Oldtown, MD 20742

Dear President of Diver Corporation:

This letter is in response to your question concerning the tax consequences on the planned distribution of $400,000 to your shareholders over the next four yours. Our conclusion is based upon the facts as outlined in your April 1 letter. Any change in facts may cause our conclusion to be inaccurate.

Diver Corporation has a deficit in accumulated E & P of $200,000 as of January 1, 2001. Starting this year, Diver Corporation expects to generate annual E&P of $100,000 for the next four years and would like to distribute this amount to its shareholders. The corporations objective is to distribute the $400,000 over the next four years in a manner that would provide the least amount of dividend income to its shareholders.

Diver Corporation should not make a distribution in 2001. It should then distribute $200,000 on December 31, 2002. It should again make no distribution in 2003. Then it should distribute the remaining $200,000 on December 31, 2004. By distributing $200,000 every other year, only half of the distribution, or $200,000, is taxed to your shareholders as dividend income. This is because E&P for 2001 of $100,000 is netted with the deficit in E&P of $200,000. At the end of 2001, there will be a deficit in E&P of $100,000. When a distribution of $200,000 is made in 2002, only $100,000 of that amount is taxed as the amount of dividend income is limited to the current E&P of $100,000. This is again the case in 2003 and 2004. On the other hand, if $100,000 is distributed each year, your shareholders are taxed on the entire distribution because the corporation will generate that amount of current E & P. The deficit in E&P does not cause part of the distribution to be nontaxable.

Should you need additional information or need to clarify our conclusion, do not hesitate to call on me.

Sincerely yours,

Jon S. Davis, CPA

Partner

TAX FILE MEMORANDUM

April 13, 2001

FROM:Jon S. Davis

SUBJECT:Diver Corporation

Today I talked to the president of Diver Corporation with respect to the April 1, 2001, letter. Diver Corporation has a deficit in its accumulated E & P of $200,000 as of January1, 2001. Starting in 2001, Diver Corporation expects to generate annual E & P of $100,000 for the next four years and would like to distribute this amount to its shareholders. Diver Corporation wants to know how it should distribute the $100,000 over a four year period (for a total distribution of $400,000) to provide 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 sufficient to cover the distribution?

Conclusion: Yes. If Diver Corporation distributes $100,000 annually to its shareholders, the entire distribution constitutes dividend income because current E & P is sufficient to cover the entire distribution. Thus, Divers shareholders have total dividend income of $400,000 over the four year period. However, if Diver Corporation does not make a distribution in 2001 or in 2003, only half of the $400,000 total distribution, or $200,000, constitutes dividend income. This is the case because in 2001 the $100,000 current E&P is netted with the $200,000 deficit in E&P to reduce the deficit in accumulated E&P to $100,000 as of December 31, 2001. In 2002, when Diver Corporation distributes $200,000 to its shareholders, only $100,000 of the distribution is dividend income. This is so because there is a $100,000 deficit in accumulated E&P, but the distribution is taxed to the extent of current E&P. As current E&P is only $100,000, only this amount is dividend income. The remaining $100,000 is a return of capital to the shareholders. After the distribution in 2002, accumulated E&P will remain a deficit of $100,000 since the distribution cannot increase a deficit in E&P. In 2003, Diver Corporation would not make a distribution. Thus, at the end of 2003, accumulated E&P is zero (the $100,000 deficit would be netted with the $100,000 current E&P for 2003). In 2004, Diver Corporation would have current E&P of $100,000. It would then make a distribution of $200,000 to its shareholders, but only $100,000 of the distribution will represent dividend income. The remaining $100,000 will again be a return of capital.

Example 26

The answers to the Research Problems are incorporated into the 2002 Annual Edition of the Instructor's Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: CORPORATIONS, PARTNERSHIPS, ESTATES, AND TRUSTS.

4-1

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SM-CH04