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
Issue recognitionUnchanged13
14
Necessity of dividend distribution to meet stateUnchanged14
legal requirements in determining tax treatment
15
Issue recognitionUnchanged15
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
Issue recognitionUnchanged37
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
Cincinnati, OH 45227
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
Cincinnati, OH 45227
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