Ch. 18 Discussion Questions

What are the three potential tax treatments of a cash distribution to a shareholder? Are these potential tax treatments elective by the shareholder?

A cash distribution to a shareholder can be characterized as 1) dividend to the extent of earnings and profits, 2) tax-free return of capital to the extent of the shareholder's tax basis in the stock, or 3) gain from sale of the stock (capital gain). The tax law (section 301(c)) prescribes the tax treatment of the distribution; it is not elective by the shareholder.

List the four basic adjustments that a corporation makes to taxable income or net loss to compute current E&P. What is the rationale for making these adjustments?

A corporation adjusts its taxable income or loss by the following general items to compute current E&P: Inclusion of income that is excluded from taxable income Disallowance of certain expenses that are deducted in computing taxable income but do not require an economic outflow Deduction of certain expenses that are excluded from the computation of taxable income but do require an economic outflow Deferral of deductions or acceleration of income due to separate accounting methods required for E&P purposes

What income tax issues must a corporation consider before it makes a noncash distribution to a shareholder?

A corporation must determine if the property's fair market value exceeds or is less than the property's tax basis. To the extent the fair market value exceeds the tax basis, the corporation recognizes gain on the distribution. Corporations cannot recognize loss if the property's fair market value is less than the tax basis.

How does the double taxation of corporate distributions affect whether an individual business chooses to operate a business as a C corporation or a flow-through entity?

A distribution of corporate income characterized as a dividend is subject to double taxation, first at the corporate level (21 percent) and then a second time at the shareholder level as a dividend. However, the double tax may be preferable because the tax rate at both levels can substantially below the regular individual tax rate. A distribution from a flow-through entity is only taxed once but at the regular tax rate (potentially, 37 percent).

Why might a shareholder who is also an employee prefer receiving a dividend instead of compensation from a corporation?

An individual shareholder might prefer a dividend to compensation because, although the dividend is subject to double taxation, both corporate tax rate and the dividend rate can be substantially below the single tax on compensation. For example, the corporate tax rate is 21 percent and the dividend is taxed at 20 percent (ignoring net investment income tax). Whereas,compensation can be taxed at the relatively high ordinary tax rates (37 percent) plus the federal social security (FICA) taxes.

How does the current earnings and profits account differ from the accumulated earnings and profits account? Is there any congressional logic for keeping the two accounts separate?

Current earnings and profits represents the corporation's earnings and profits of the current year before reduction ("diminution") by any distributions made during the year. Accumulated earnings and profits represents undistributed earnings and profits from all years prior to the current year. Congress created this distinction in 1936 when distributed current year earnings were taxed at the corporate level at a lower rate than undistributed earnings. This dual level of taxation was repealed in 1939, but the congressional distinction between current and accumulated earnings and profits remained in the law.

In general, what is the concept of earnings and profits (E&P) designed to represent?

Earnings and profits is intended to represent the corporation's ability to pay distributions to its shareholders without eroding its invested capital. Earnings and profits is designed to reflect the corporation's economic income, a broader concept than its taxable income.

Assume a calendar-year corporation has a deficit (negative) current E&P of $100 and accumulated E&P of $100. Under this circumstance, a cash distribution of $100 to the corporation's sole shareholder on June 30 will not be treated as a dividend because total E&P at December 31 is $0. True or false? Explain.

False. A portion of the distribution could be treated as a dividend based on accumulated earnings and profits on June 30. If the current year deficit is earned ratably over the year, accumulated earnings and profits on June 30 would be $50 [$100 - 181/365 x ($100)]. A deficit in current earnings and profits is allocated on a per day basis unless determined by tracing specific items that caused the deficit.

Assume a calendar-year corporation has positive current E&P of $100 and an accumulated deficit (negative) E&P of $200. Under this circumstance, a cash distribution of $100 to the corporation's sole shareholder at year-end will not be treated as a dividend because total E&P is negative $100. True or false? Explain.

False. The $100 distribution will be treated as a dividend because it does not exceed current earnings and profits.

A shareholder receives appreciated noncash property in a corporate distribution and assumes a liability attached to the property. How does this assumption affect the amount of gain the corporation recognizes? From the corporation's perspective, does it matter if the liability assumed by the shareholder exceeds the property's gross fair market value?

In general, the shareholder's assumption of a liability attached to appreciated noncash property distributed as a dividend does not affect the gain recognized by the corporation. Gain recognized is the property's fair market value less the property's tax basis. If the liability assumed by the shareholder exceeds the property's fair market value, the property is deemed to have a fair market value equal to the liability assumed for purposes of determining the gain recognized by the corporation.

Will the shareholder's tax basis in noncash property received equal the amount included in gross income as a dividend? Under what circumstances will the amounts be different, if any?

Not always. Where the shareholder assumes a liability attached to the property, the amount of the dividend income is computed as the property's fair market value less the liability assumed (section 301(b)). The shareholder takes a tax basis in the property equal to its fair market value, not reduced by the liability assumed (section 301(d)).

A corporation distributes depreciated noncash property to a shareholder. What impact does the distribution have on the corporation's earnings and profits?

The corporation reduces E&P by the lesser of the property's E&P adjusted basis, reduced by any liability assumed by the shareholder on the distribution.

Assuming adequate amounts of corporate E&P, what is the formula for determining the amount of a noncash distribution a shareholder must include in gross income?

The dividend amount is the fair market value of the property received less any liability assumed on the property.

A shareholder receives appreciated noncash property in a corporate distribution and assumes a liability attached to the property. How does the assumption of a liability affect the amount of dividend reported in gross income?

The shareholder's assumption of a liability attached to noncash property reduces the amount of the dividend income reported.

What is meant by the term double taxation of corporate income?

The term double taxation refers to the fact that under the U.S. system of taxation, corporate earnings are first taxed when earned by a C corporation and then are taxed a second time when the earnings are distributed to the shareholders as a dividend.