Chapter 18
[LO4] Why might a corporation issue a stock dividend to its shareholders?
Corporations often issue stock dividends as a goodwill gesture to their shareholders when they do not have sufficient cash to make a distribution. Many times, corporations will engage in a stock split to increase the number of shares outstanding and lower the trading price of the stock to make it more accessible to a broader class of investors.
[LO2] 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.
[LO2] 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: 1. Inclusion of income that is excluded from taxable income 2. Disallowance of certain expenses that are deducted in computing taxable income but do not require an economic outflow 3. Deduction of certain expenses that are excluded from the computation of taxable income but do require an economic outflow 4. Deferral of deductions or acceleration of income due to separate accounting methods required for E&P purposes
[LO2] 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.
[LO1] How does the issue of double taxation arise when a corporation decides between making a distribution to a shareholder employee as a dividend or compensation?
A distribution characterized as a dividend is subject to double taxation, first at the corporate level and then a second time at the shareholder level, because a corporation cannot deduct it from taxable income. A distribution characterized as compensation is taxed only once, at the recipient level, because it is deducted by the corporation.
[LO5] What stock ownership tests must be met before a shareholder receives exchange treatment under the substantially disproportionate change-in-stock-ownership test in a stock redemption? Why is a change-in-stock-ownership test used to determine the tax status of a stock redemption?
A shareholder meets the substantially disproportionate change-in-stock-ownership test by satisfying three mechanical stock ownership tests: 1. Immediately after the exchange the shareholder owns less than 50% of the total combined voting power of all classes of stock entitled to vote; 2. The shareholder's percentage ownership of voting stock after the redemption is less than 80% of his or her percentage ownership before the redemption; and 3. The shareholder's percentage ownership of the aggregate fair market value of the corporation's common stock (voting and nonvoting) after the redemption is less than 80% of his or her percentage ownership before the redemption. The Code uses a change in stock ownership test to determine the tax status of a stock redemption to distinguish between transactions that resemble sales from transactions that are in substance a dividend distribution (that is, a transaction in which the shareholder does not meaningfully change her stock ownership in the company).
[LO2] What must a shareholder consider in computing the amount of a noncash distribution to include in gross income?
A shareholder must determine the fair market value of the distribution and any liability she will assume on receipt of the property. The shareholder's dividend amount is the fair market value of the property received less any liability assumed on the property.
[LO5] What must a shareholder do to waive the family attribution rules in a complete redemption of stock?
A shareholder must file a "triple i agreement" with the IRS and refrain from having a prohibited interest (shareholder, employee, director, officer, or consultant) for 10 years. The shareholder must agree to notify the IRS district director within 30 days if he or she acquires a prohibited interest within 10 years after the redemption.
[LO5] What are the potential tax consequences to a shareholder who participates in a stock redemption?
A shareholder who participates in a stock redemption potentially could treat the distribution as an exchange (section 302) or as a property distribution (potentially a dividend under section 301).
[LO5] When might a shareholder have to rely on the "not essentially equivalent to a dividend" test in arguing a stock redemption should be treated as an exchange for tax purposes?
A shareholder will have to rely on this test if the distribution cannot meet either the "substantially disproportionate test" or the "complete termination of interest" test, which rely on a mechanical set of criteria.
[LO1] Why might a shareholder who is also an employee prefer receiving a dividend instead of compensation from a corporation?
An individual might prefer a dividend to compensation because the dividend is eligible for a preferential tax rate if the individual employee/shareholder is below a certain income level, whereas compensation is always taxed at the ordinary tax rates, which could be as high as 39.6 percent.
[LO2] How does current earnings and profits account differ from 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.
[LO2] Assume a calendar-year corporation has positive current E&P of $100 and an accumulated deficit (negative) E&P of $200. In 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.
[LO5] Which members of a family are included in the family attribution rules? Is there any rationale for the family members included in the test?
Family members include spouse, children, parents, and grandchildren. These are the family members that are the most closely related to the shareholder by blood. Family members excluded are grandparents, brothers and sisters, aunts and uncles, and nieces, nephews, and cousins.
[LO1] 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.
[LO6] Reveille Corporation experienced a complete loss of its mill as the result of a fire. The company received $2 million from the insurance company. Rather than rebuild, Reveille decided to distribute the $2 million to its two shareholders. No stock was exchanged in return. Under what conditions will the distribution meet the requirements to be a partial liquidation and not a dividend? Why does it matter to the shareholders?
For a distribution to be in partial liquidation of the corporation, it must either be "not essentially equivalent to a dividend" (as determined at the corporate level) or be the result of the termination of a "qualified trade or business." In this case, the test likely will be whether the use of the mill constituted a qualified trade or business. The determination matters most to individuals, who will receive exchange treatment if the transaction is a partial liquidation and a potential dividend if the transaction is viewed not to be a partial liquidation.
[LO5] How does a corporation's computation of earnings and profits differ based on the tax treatment of a stock redemption to the shareholder (that is, as either a dividend or exchange)?
If the redemption is treated as a dividend, the corporation reduces E&P using the dividend reduction rules by generally reducing E&P dollar for dollar by the amount of the dividend. If the redemption is treated as an exchange, the corporation reduces E&P at the date of distribution by the percentage of stock redeemed, not to exceed the fair market value of the property distributed. The distributing corporation reduces its E&P by any dividend distributions made during the year before reducing its E&P for redemptions treated as exchanges.
[LO6] How does the tax treatment of a partial liquidation differ from a stock redemption?
In a partial liquidation, the shareholders have prescribed tax treatments: individuals receive exchange treatment and corporations treat the distribution as a dividend to the extent of earnings and profits. In a stock redemption, each shareholder's tax treatment depends on whether a change in stock ownership requirement is met.
[LO2] 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.
[LO5] Maria has all of her stock in Mayan Corporation redeemed. Under what conditions will Maria treat the redemption as an exchange and recognize capital gain or loss?
Maria will treat the stock redemption as an exchange if she does not own any additional stock through attribution that causes her to fail either of the other two stock ownership tests. If she only owns stock constructively through the family attribution rules, she can waive the family attribution rules by filing a "triple i agreement" with the IRS and avoid acquiring a prohibited interest in the corporation for 10 years (for example, providing services to the corporation as an employee or independent contractor).
[LO5] Ilya and Olga are brother and sister. Ilya owns 200 shares of stock in Parker Corporation. Is Olga deemed to own Ilya's 200 shares under the family attribution rules that apply to stock redemptions?
No. A brother and sister are not included under the family attribution rules.
[LO2] 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)).
[LO4] In general, what causes a stock dividend to be taxable to the recipient?
Stock dividends generally are taxable when they result in, or have the potential to result in, a change in the proportionate stock ownership of the existing shareholders. For example, where a shareholder can choose between cash or stock, there exists the possibility that some shareholders will choose cash and some will choose stock. Those who choose stock will increase their ownership percentage relative to those who choose cash. Where stockholders have the ability to choose between cash and stock, the stock dividend will be taxable to those who choose to receive stock.
[LO3] Amy is the sole shareholder of a corporation. Rather than have the corporation pay her a dividend, Amy decides to have the corporation declare a "bonus" at year-end and pay her tax-deductible compensation. What potential tax issue may arise in this situation? Which parties, Amy or the corporation or both, are affected by the classification of the payment?
The IRS might argue that a portion of the distribution is really a disguised dividend if the compensation is "unreasonable." If the IRS prevails, the corporation will be denied a deduction for the portion of the "bonus" determined to be a disguised dividend. Amy would now be eligible for a reduced rate of tax on the dividend portion of her "bonus" and would not be subject to payroll taxes on the recharacterized amount.
[LO2] A corporation distributes appreciated noncash property to a shareholder as a dividend. 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 fair market value or E&P adjusted basis, reduced by any liability assumed by the shareholder on the distribution.
[LO4] What tax issue arises when a shareholder receives a nontaxable stock dividend?
The shareholder must allocate some of the tax basis of the existing stock to the new stock received based on the relative fair market values of the existing and newly issued stock.
[LO2] A shareholder receives appreciated noncash property in a corporate distribution and assumes a liability attached to the property. How does the liability assumption 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.
[LO5] Why do you think the tax law imposes constructive stock ownership rules on stock redemptions?
The tax law imposes constructive ownership tests to prevent a shareholder from technically disposing of his stock interest while effectively continuing to own stock through family members or through ownership in an entity that nominally owns the stock.
[LO5] What are the criteria to meet the "not essentially equivalent to a dividend" change- in-stock-ownership test in a stock redemption?
To satisfy the "not essentially equivalent to a dividend" requirement, the IRS or a court must conclude that there has been a "meaningful" reduction in the shareholder's ownership interest in the corporation as a result of the redemption. The Code does not provide any mechanical tests to make this determination. At a minimum, the IRS and courts generally require the shareholder to reduce his stock ownership as a result of the transaction and own 50 percent or less of the stock after the transaction.