Chapter C:4 Corporate Nonliquidating Distributions Discussion Questions C:4-1 A corporation computes current E&P on an annual basis by making adjustments to taxable income so that the resulting amount represents the corporation's economic ability to pay dividends out of the current year's earnings. The specific adjustments required are outlined in Table C:4-1. Accumulated E&P is the sum of the current E&P (less distributions made out of current E&P) balances for all previous years reduced by the sum of (1) all previous current E&P deficits and (2) any distributions that have been made out of accumulated E&P. pp. C:4-3 and C:4-4. C:4-2 Distinguishing between current and accumulated E&P is necessary because distributions are deemed to come first out of current E&P and then out of accumulated E&P. Thus, if current E&P is positive, any distributions will be dividends to the extent of the current E&P even if accumulated E&P is negative. Also, if E&P is insufficient to cover all distributions, distributions are deemed to come pro rata out of current E&P and then in chronological order out of accumulated E&P. pp. C:4-6 through C:4-8. C:4-3 a. The distribution is a $100,000 dividend payable out of current E&P. b. First, $60,000 of the distribution is a dividend from current E&P. Second, $25,000 is a return of capital that reduces the shareholder's stock basis to zero. Third, the remaining $15,000 is a capital gain. The $50,000 accumulated E&P deficit remains. c. First, $25,000 of the distribution is a return of capital that reduces the shareholder's stock basis to zero. Second, the remaining $75,000 is a capital gain. A $120,000 ($60,000 + $60,000) accumulated E&P deficit remains. d. The distribution is a $100,000 dividend payable out of accumulated E&P. None of the current E&P deficit reduces accumulated E&P since the distribution is made on January 1. If the corporation makes the distribution on October 1, the answers to Parts a through c are the same. However, in Part d, accumulated E&P as of October 1 is $40,000 ($100,000 beginning balance - $60,000 current deficit as of October 1) so that $40,000 of the distribution is a dividend. Allocation of the current E&P deficit to the pre-October 1 period is accomplished by multiplying $80,000 times 9/12ths. (Alternatively, the actual number of days could be used, in which case the accumulated E&P deficit would be $59,836 ($80,000 x 273/365) in a non leapyear tax year.) Of the remaining $60,000, $25,000 is a return of capital that reduces the shareholder's stock basis to zero, and the remaining $35,000 is a capital gain. pp. C:4-6 through C:4-8. C:4-4 a. The distribution amount is the FMV of all property received. If the shareholder assumes or acquires a liability in connection with the distribution, it reduces the amount of the distribution (but not below zero). b. The distribution amount is a dividend to the extent it is paid out of the current and accumulated E&P of the corporation. © 2012 Pearson Education, Inc. publishing as Prentice Hall
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c. The basis of any property received is its FMV. Any liability assumed or acquired by the shareholder in connection with the distribution does not reduce the property's basis. d. The holding period for the property begins on the day after the distribution date. pp. C:4-8 and C:4-9. The answers would not change if they were made to a corporate shareholder because Sec. 301(c) applies the same dividend rules to each type of shareholder. However, a corporation shareholder may be eligible for the dividends-received deduction. C:4-5 a. b. c. d. e.
The tax-exempt interest is added to taxable income to compute current E&P. The dividends-received deduction is added to taxable income. The capital loss carryover is added to taxable income. The federal income taxes are deducted from taxable income. The U.S. production activities deduction is added to taxable income. p. C:4-4.
C:4-6 Yes. It is possible. Taxable income or loss must be adjusted to compute current E&P. If, for example, Badger had $12,000 of tax-exempt income, or if it had a $12,000 positive adjustment for depreciation, its current E&P could be $4,000 or more. If it were $4,000, the $2,500 distribution would be taxed to shareholders as a dividend, and a $1,500 accumulated E&P balance would remain. pp. C:4-6 through C:4-8. C:4-7 Yes. It matters if the corporation has a current E&P deficit and positive accumulated E&P. In such case, the amount of the current E&P deficit accrued on the distribution date reduces the accumulated E&P, and only the remainder is available for paying out dividends. It also matters if the corporation makes more than one distribution made during the year, and there is insufficient E&P for all distributions to be treated as dividends. In such case, current E&P is allocated ratable to all distributions, but accumulated E&P is allocated on a FIFO basis to each distribution. These allocations are particularly important if the corporation’s stock changes hands during the year. pp. C:4-6 through C:4-8. C:4-8 Yes. The corporation should sell the property to a third party and report a $40,000 loss ($120,000 FMV - $160,000 basis) and then distribute the proceeds to its shareholders. If the corporation distributes the property to the shareholders first, the loss cannot be recognized when determining taxable income by either the corporation or its shareholders. If the property is distributed, the $160,000 adjusted basis for the property reduces the distributing corporation's E&P and therefore the taxability of future distributions. pp. C:4-9 through C:4-11. C:4-9 From a tax perspective, it makes no difference whether the property is distributed first and then sold or sold first and the proceeds distributed to the shareholder. Either way, the corporation must recognize a $40,000 gain ($160,000 FMV - $120,000 basis) on the disposition/distribution of the building, and the shareholders have a $160,000 dividend. The shareholder's basis in the building is $160,000. pp. C:4-9 through C:4-11.
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C:4- 10 A constructive dividend is the manner in which the IRS or the courts might characterize an excessive corporate payment to a shareholder to reflect the true economic benefit conferred upon the shareholder. Such dividends are most likely to arise in the context of a closely held corporation. Examples of constructive dividends include excessive compensation paid to a shareholder-employee or excessive lease payments made to a shareholder-lessor. pp. C:4-11 through C:4-13. C:4-11 Stock dividends generally are nontaxable because they do not add to the property the shareholder already owns, nor do they reduce the property of the corporation. As a general rule, the distribution is taxable whenever a stock dividend changes or has the potential to change the shareholder's proportionate interest in the distributing corporation. pp. C:4-13 and C:4-14. C:4-12 A distribution of stock rights is nontaxable unless it changes, or has the potential to change, the shareholder's proportionate interest in the distributing corporation. The same exceptions to tax-free treatment apply to distributions of stock rights as apply to stock dividends. A distribution of stock rights that is nontaxable to shareholders has no effect on the distributing corporation. The shareholders must allocate the basis of the underlying stock between the stock and the rights if the FMV of the rights is at least 15% of the value of the underlying stock. If the FMV is less than 15% of the value of the underlying stock, the basis allocation is elective. pp. C14-14 and C:4-15. C:4-13 A stock redemption is the acquisition by a corporation of its own stock for consideration. Some reasons for a redemption are listed on pages C:4-16. Some redemptions that substantially change the shareholder's proportionate interest closely resemble a sale of stock to a third party and are treated as a sale or exchange, while others that do not produce such a change are essentially equivalent to a dividend and are taxed as a dividend. p. C:4-16. C:4-14 If the redemption is treated as a sale, Andrew recognizes a $2,000 capital gain ($10,000 $8,000). Alternatively, if the redemption is not treated as a sale, Andrew recognizes a $10,000 dividend to the extent of Field Corporation's current and accumulated E&P. In the dividend case, Andrew's $8,000 basis in the redeemed stock is added to his basis in his remaining stock. The 15% maximum tax rate would apply to either the $2,000 capital gain or the $10,000 dividend. p. C:4-17. C:4-15 A redemption is treated as a sale if the redemption satisfies any of the following conditions: • It is substantially disproportionate. • It is a complete termination of the shareholder's interest. • It is not essentially equivalent to a dividend. • It is a partial liquidation of the distributing corporation in redemption of part or all of a noncorporate shareholder's stock. • It is made to pay death taxes. p. C:4-17. C:4-16 The purpose of the attribution rules is to prevent shareholders from either taking advantage of these favorable tax rules or avoiding unfavorable tax rules by deeming family members or related entities to own stock that the shareholder may not own. Attribution rules fall into four categories: family attribution, attribution from entities, attribution to entities, and option attribution. pp. C:4-18 through C:4-20. © 2012 Pearson Education, Inc. publishing as Prentice Hall
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C:4-17 No. The transaction would not be a partial liquidation because the assets will have been acquired by Ace Corporation in a taxable transaction within the past five years (unless Ace is willing to retain the assets and operate the business for at least five years prior to the partial liquidation). pp. C:4-23 through C:4-25. C:4-18 Such a Sec. 303 redemption usually results in the shareholder’s recognizing little or no gain or loss because the estate or beneficiary's basis in the stock redeemed is the stock's FMV on the date of death (or alternate valuation date). Because the stock is redeemed soon after the date of death, the stock's value at the time of redemption is likely to approximate the stock's basis. pp. C:4-25 and C:4-26. C:4-19 A corporation must recognize gain when it distributes appreciated property in redemption of its stock. It does not recognize any loss when it distributes property that has declined in value. Also, the excess of FMV over the property’s E&P basis increases the distributing corporation's E&P (and taxes on the corporation’s gain decrease E&P). As with an ordinary dividend, the amount that increases the E&P balance may be different from the gain that increases taxable income. The E&P account also is reduced. The amount of the reduction depends on whether the redemption is treated as a sale or exchange or as a dividend. If the redemption is treated as a sale or exchange, the corporation must reduce its E&P by the portion of the current and accumulated E&P balances attributable to the redeemed stock. That is, E&P is reduced by a percentage that equals the fraction of the outstanding stock redeemed. The remainder of the distribution reduces the capital account. If the redemption does not qualify for sale or exchange treatment, the corporation must reduce its E&P as it does for any other nonliquidating distribution not involving a stock redemption. p. C:4-27. C:4-20 A preferred stock bailout is to a plan devised by shareholders to use preferred stock to withdraw earnings from a corporation as a capital gain rather than as a dividend. The specific steps of the plan are described on page C:4-28. Section 306 prevents a shareholder from realizing tax benefits by denying capital gain treatment in certain sales or exchanges and redemptions. It operates by causing certain preferred stock held by a distributee to be tainted. When the tainted (or Sec. 306) stock is sold or redeemed, part or all of the gain or income recognized is treated as a dividend or a “deemed” dividend rather than capital gain. Prior to the 2003 Act, dividends and ordinary income were taxed at higher rates than were capital gains. Therefore, Sec. 306 was extremely disadvantageous. In 2011, dividends and capital gains are both taxed at a maximum rate of 15%. Therefore, Sec. 306 has lost much of its sting until “deemed” dividends again are taxed at ordinary rates (currently slated to occur after 2012). pp. C:4-27 through C:4-30. C:4-21 The transaction is treated as a stock redemption because Sec. 304 requires that a sale of stock of one controlled corporation (Plum Corporation) to a second controlled corporation (Cherry Corporation) be treated as a contribution to the capital of the purchasing corporation and a stock redemption of part of the purchasing corporation's stock. If the redemption is substantially disproportionate or meets any of the other exceptions of Secs. 302(b) or 303 that permit exchange treatment, it is treated as a sale by Bill. Otherwise it is treated as a dividend distribution to Bill. In this case, Bill owns 100% of the Plum stock before the redemption and 96% after the redemption (80 shares directly + [80% x 20 shares] indirectly through Cherry). Therefore, the sale fails to © 2012 Pearson Education, Inc. publishing as Prentice Hall
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qualify under any of the sale or exchange exceptions and is treated as a dividend. pp. C:4-30 through C:4- 33. C:4-10 An IRS determination that part of the compensation paid an owner-employee is unreasonable in amount means that the corporation loses its tax deduction for that portion of the payment. Generally, the unreasonable compensation is taxed as a dividend to the owneremployee. The dividend is subject to a 15% maximum tax rate. The corporation still loses the deduction for the reclassified amount, however. The double taxation associated with dividend treatment can be avoided by having the owner-employee enter into a hedge agreement to repay any salary amounts determined to be unreasonable in amount. The shareholder is taxed on the salary payment in the year in which he or she receives the compensation, and the shareholder claims a deduction in the year he or she repays the excess amount to the corporation. pp. C:4-11 through C:4-13, C:4-33, and C:4-34. C:4-23 A bootstrap acquisition is an arrangement whereby a seller sells part of his stock to a purchaser and has the corporation redeem the remainder of his stock. The advantage of this arrangement is that the purchaser needs less cash to make the purchase. The consequence to the seller is the same as though he had sold all his stock to the purchaser because the redemption qualifies for sale treatment as long as the sale and redemption are all part of an integrated plan to terminate the seller's entire interest. pp. C:4-34 and C:4-35.
Issue Identification Questions C:4-24 • • • •
The following tax issues should be considered: • Because the two cash distributions exceed E&P, what portion of each distribution comes out E&P? What portion of each shareholder's distribution is a return of capital? What portion of the return of capital distribution(s) reduces the basis of the shareholder's stock? What portion of each shareholder's return of capital distribution is a capital gain? Is the capital gain recognized long-term or short-term?
A key issue is to what extent Marsha's distribution is a dividend. Dye Corporation has $12,000 of current and accumulated E&P, so only $12,000 can be a dividend to either Barbara or Marsha. Current E&P is allocated ratably to Barbara and Marsha ($4,000 each), and accumulated E&P is allocated on a first-in, first-out basis so the remaining $4,000 of E&P is allocated to Marsha. Therefore, Marsha has an $8,000 dividend and a $2,000 return of capital. Barbara has a $4,000 dividend and a $6,000 return of capital. Any amount received by Marsha or Barbara after recovering their stock basis is a capital gain. The return of capital distribution reduces the basis of Marsha's stock investment and will cause a corresponding increase (decrease) in the capital gain (capital loss) reported on her sale of the Dye stock to Barbara. pp. C:4-3 through C:4-8.
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C:4-25 • • • •
The following issues should be considered: • What reasons might cause the sale price to be $125,000 below the apparent prevailing market price? What gain or loss does Spring Harbor recognize on the sale? What is Spring Harbor’s E&P balance? Do the related party sale rules apply to the sale? If the $125,000 shortfall is treated as a dividend, • At what rate is the dividend taxed? • What gain or loss does Spring Harbor recognize on the distribution? • What is the shareholder's gross income? • What is the shareholder's basis in the land? • What is the shareholder's holding period for the land? • What is the distributing corporation's gain or loss on the distribution? • What effect does the distribution have on the distributing corporation's E&P?
A key issue is whether Spring Harbor can recognize a $25,000 loss on the sale of the land to Neil for $275,000 ($275,000 sale price - $300,000 adjusted basis). It appears that Sec. 267 will prevent the recognition of the loss since, under Sec. 267(b), Neil and Spring Harbor are related parties. An additional issue is whether Neil has a constructive dividend. If similar land has sold recently for $400,000, it appears that the sale price should have been $400,000 instead of $275,000. The $125,000 difference between the actual sales price and the price paid for similar land therefore should be considered a constructive dividend taxed at 15% (in 2011). Classifying the difference as a constructive dividend causes Spring Harbor to recognize a $100,000 ($400,000 - $300,000) capital gain on the deemed land sale under Sec. 311(b) when appreciated property is distributed. It also will trigger a $34,000 ($100,000 x 0.34) income tax liability that will reduce E&P. Neil will take a $400,000 basis in the land. The distribution will reduce E&P by $125,000. pp. C:4-8 through C:4- 13. C:4-26 • • • • • • • • •
The following issues should be considered: • What is Penny's stock ownership before and after the redemption? Are any shares attributed to Penny from her mother? Can Penny elect to waive the family stock ownership attribution rules? What is the amount and character of Penny's gain or income on the stock redemption? What is Penny's basis in the 30 shares of stock she received as a gift from her mother? If the distribution is treated as a dividend, what happens to Penny's basis in her stock? What is Penny's mother's basis in her stock after the redemption (i.e., is any of Penny's remaining basis transferred to her mother)? Does the corporation recognize any gain on the repurchase of the shares? What is its basis for the shares repurchased? What effect does the redemption have on Price Corporation's E&P?
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A key issue is whether the redemption should be treated as a sale or a dividend. Penny is deemed to own the shares owned by her mother. Therefore, she is deemed to have owned 70 shares before the redemption (70/100 = 70% of the Price stock) and 40 shares after the redemption (40/70 = 57% of the Price stock) after the redemption. Thus, the redemption is not substantially disproportionate under Sec. 302(b)(2). Another issue is whether Penny can have the family attribution rules waived under Sec. 302(b)(3). A problem is that she received her shares as a gift from her mother. If Penny can show that tax avoidance was not the principal purpose for the gift of the Price stock, she can sign a waiver, and the redemption will be treated as a sale. In such case, she has a $19,000 ($35,000 $16,000) LTCG taxed at a maximum 15% rate (in 2011). E&P will be reduced by 30% of the current and accumulated E&P, or $30,000 (0.30 x $100,000). If a waiver of the family attribution rules is not possible, Penny will most likely have a $35,000 dividend, also taxed at a maximum 15% rate (in 2011). It is not likely that the Sec. 302(b)(1) "not essentially equivalent to a dividend" rules will apply since Penny still maintains a majority stock ownership position in Price following the redemption. If the distribution is treated as a dividend, her basis for all 30 shares will be reallocated to her mother since she is the individual whose stock ownership prevented the redemption from receiving capital gain treatment. E&P will be reduced by the $35,000 distributed to Penny. The corporation's basis in the redeemed shares is not important since it recognizes no gain or loss when it issues new or treasury stock (Sec. 1032). pp. C:4-16 through C:4-23. C:4-27 • • • • • •
The following issues should be considered: • What is Gumby's Pizza's E&P balance immediately preceding the distribution? If $50,000 in cash is withdrawn from the business, will it be treated as a dividend to George? Will the $50,000 withdrawn from the business be considered to have been received as part of George's stock sale? Can the tax results for the transaction be improved if George has some of his stock redeemed for the $50,000 cash? Would the tax consequences of the transaction be different if the $50,000 is withdrawn from the business either before or as part of the stock sale? Can the $50,000 payment be classified as payment of back wages to George? Would such an amount be deductible by the corporation? What is the amount and character of the gain recognized on George's sale of the stock?
A key issue is whether the $50,000 George receives from Gumby's Pizza is a dividend or is part of the amount he receives for his stock. If Gumby redeems 25% of his stock for $50,000 in cash as part of the same transaction in which his remaining stock is sold to Mary for $150,000, quite likely he can treat the entire $200,000 as received in exchange for his stock under the bootstrap redemption rules. In such case, he has a $130,000 ($200,000 - $70,000) capital gain. However, if he receives $50,000 from Gumby's before entering into the sale agreement with Mary, he will have a $50,000 dividend and then an $80,000 ($150,000 - $70,000) capital gain on a later sale of his stock to Mary. In either case, the total $130,000 is taxed at a 15% rate (in 2011). It is not likely that Gumby can treat the $50,000 payment as additional compensation © 2012 Pearson Education, Inc. publishing as Prentice Hall
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(e.g., a bonus or payment made because of lower-than-normal salary payments made in prior years) and then deduct the payment in computing its corporate tax liability. A possibility might be to treat the $50,000 as paid to George in exchange for a covenant not to compete for a certain period of time. Such payment generally is ordinary income to the recipient but is deductible by the payer over a 15- year period in accordance with Sec. 197. pp. C:4-3 through C:4-8, C:4-33, and C:4-34.
Problems C:4-28 a.
Gross profit from operations Dividends Interest Net capital gain ($8,000 - $1,200) Gross income Minus: Administrative expenses Bad debts Depreciation
$250,000 20,000 10,000 6,800 $286,800 $110,000 5,000 86,000
Charitable contribution [lesser of $8,000 or ($85,800 - $40,000) x 0.10] Dividends-received deduction ($20,000 x 0.80) NOL deduction (carryover) U.S. production activities deduction Taxable income b.
(201,000) $ 85,800 ( 4,580) $ 81,220 ( 16,000) ( 40,000) ( 1,500) $ 23,720
Earnings and profits: Taxable income $ 23,720 Plus: Municipal bond interest $ 12,000 Life insurance proceeds 100,000 Excess depreciation ($86,000 - $42,000) 44,000 NOL deduction (carryover) 40,000 Dividends-received deduction 16,000 U.S. production activities deduction 1,500 213,500 Minus: Excess charitable contribution ($8,000 - $4,580) $ 3,420 Penalties 450 Taxes ($23,720 x 0.15) 3,558 ( 7,428) Current earnings and profits $229,792
pp. C:4-3 through C:4-6.
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C:4-8
C:4-29 Taxable income Plus: Dividends-received deduction ($80,000 x 0.70) NOL deduction (carryover) U.S. production activities deduction Excess depreciation Minus: Long-term capital loss Fines and penalties Federal income taxes ($500,000 x 0.34) Current earnings and profits pp. C:4-3 through C:4-6.
$500,000 $ 56,000 20,000 10,000 40,000
126,000
$ 80,000 6,000 170,000
(256,000) $370,000
C4-30 Beginning of Year 1: ($8,000) (The $2,000 distribution is a return of capital and does not affect the E&P deficit.) Beginning of Year 2: ($20,000) [($8,000) - $12,000] Beginning of Year 3: ($15,000) [($20,000) + ($10,000 - $5,000)] Beginning of Year 4: ($15,000) [($15,000) + ($14,000 - $14,000)] (The $3,000 distribution exceeding current E&P is a return of capital and does not reduce the accumulated E&P deficit.) p. C:4-3. C:4-31 a. $40,000 dividend to Connie; $15,000 out of current E&P and $25,000 out of accumulated E&P; $10,000 is a return of capital that reduces Connie’s basis to zero; the excess $2,000 is taxable as a capital gain. Accumulated E&P at the beginning of next year is zero. b. $30,000 is a dividend to Connie; $10,000 is a return of capital that reduces Connie's basis to zero; the excess $12,000 is taxable as a capital gain. Accumulated E&P deficit at the beginning of next year remains at ($20,000). c. Clover's accumulated E&P as of April 1 (of a non-leap year) is $50,000 [($73,000 ÷ 365) x 90] = $32,000. Therefore, $32,000 is taxable as a dividend; $10,000 is a return of capital that reduces Connie's stock basis to zero; and the remaining $10,000 distribution is taxable as a capital gain. Accumulated E&P deficit at the beginning of next year is ($55,000) [$50,000 - $18,000 pro rata deficit - $32,000 dividend - $55,000 remaining deficit]. d. $10,000 is a return of capital that reduces Connie's basis to zero; the excess $42,000 is taxable as a capital gain. Accumulated E&P deficit at the beginning of next year is ($35,000). pp. C:4-6 through C:4-8.
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C:4-9
C:4-32 a. Pete recognizes a dividend of $40,000, and Cheryl recognizes a dividend of $80,000. Total E&P is $160,000, so E&P is sufficient for all distributions to Pete and Cheryl to be dividends. b. Pete recognizes a dividend of $22,000 [($40,000/$120,000) x $66,000], and Cheryl recognizes a dividend of $44,000 [($80,000/$120,000) x $66,000]. Because both distributions occurred on the same date, current and accumulated E&P of $66,000 are allocated pro rata to each shareholder. The remaining $18,000 to Pete is treated as a return of capital that reduces his stock basis to $7,000. The remaining $36,000 to Cheryl reduces her stock basis to $4,000. pp. C:4-3 through C:4-8. C:4-33 a. Individual Charles Donald Total
Date
Amount
Current E&P
3/1 9/1
$ 60,000 90,000 $150,000
$16,000 24,000 $40,000
Accumulated E&P $30,000 -0$30,000
Dividend $46,000 24,000 $70,000
Return of Capital $14,000 66,000 $80,000
Thus, Charles has $46,000 of dividend income and a $14,000 return of capital, which reduces his basis in the Pearl stock from $80,000 to $66,000. The basis reduction increases Charles's capital gain on the sale to $59,000 [$125,000 - ($80,000 - $14,000)]. Donald has a $24,000 dividend and a $66,000 return of capital, which reduces his stock basis at year-end from $125,000 to $59,000. b. Individual Charles Donald Total
Date
Amount
Current E&P
3/1 9/1
$ 60,000 90,000 $150,000
$ 40,000 60,000 $100,000
Accumulated E&P $ -0-0$ -0-
Dividend
Return of Capital
$ 40,000 60,000 $100,000
$20,000 30,000 $50,000
The return of capital distributions reduce Charles' basis in his Pearl stock from $80,000 to $60,000 and Donald's basis from $125,000 to $95,000. This basis reduction increases Charles's capital gain on the sale to $65,000 [$125,000 - ($80,000 - $20,000)].
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C:4-10
c. Individual Charles Donald Total
Date
Amount
Current E&P
3/1 9/1
$ 60,000 90,000 $150,000
$ -0-0$ -0-
Accumulated E&P $60,000a 35,700b $95,700
Dividend
Return of Capital
$60,000 35,700 $95,700
$ -054,300 $ 54,300
a
59 x ($36,500) = ($5,900) E&P deficit for 1/1-2/28. 365 Note: Had this been a leap year, the denominator in the fraction would have been 366. Acc. E&P on 3/1 = $120,000 - $5,900 = $114,100 available. b
243 x ($36,500) = ($24,300) E&P deficit for 1/1-8/31. 365 Note: Had this been a leap year, the denominator in the fraction would have been 366. Acc. E&P on 9/1 = $120,000 - $24,300 - $60,000 = $35,700 Charles reports a $45,000 capital gain ($125,000 - $80,000) on the stock sale because the distribution does not affect the basis in his stock. The return of capital distribution reduces Donald's stock basis from $125,000 to $70,700 ($125,000 - $54,300). pp. C:4-6 through C:4-8. C:4-34 a. Dina recognizes a taxable dividend of $48,000 ($56,000 - $8,000). b. Dina's basis in the land is $56,000, its FMV. c. Sedgwick Corporation recognizes a $16,000 [($48,000 net FMV + $8,000 release from liability) - $40,000] capital gain on the distribution. d. Sedgwick's E&P is increased by the $16,000 E&P gain, which is the excess of the land’s FMV over its E&P adjusted basis. (Note that the E&P gain and the tax gain are the same in this problem.) E&P is decreased by the $48,000 ($56,000 FMV - $8,000 mortgage) net amount of the distribution and by the $5,440 (0.34 x $16,000) of federal income taxes imposed on the gain, or a net reduction of $37,440. pp. C:4-8 through C:4-11. C:4-35 a. Arlene recognizes a taxable dividend of $20,000. The amount of the property (land) distribution is zero because the liability reduces the FMV, but not below zero. This result occurs under either interpretation of FMV, i.e., whether actual FMV or the greater liability is used (see Part b). b. Two alternatives for the basis exist. One alternative is that the basis of the land is $50,000, or the property's actual FMV. Proponents of this approach argue that Sec. 311(b)(1) applies only for gain recognition purposes. The other alternative is that the land's basis is $60,000 or the FMV determined under Sec. 311(b)(1). See Footnote 9 in text. c. Stowe Corporation must recognize a $45,000 ($60,000 deemed FMV - $15,000 tax basis) capital gain on the distribution. pp. C:4-8 through C:4-11.
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C:4-11
C:4-36 a. Calvin recognizes a dividend of $170,000 ($250,000 FMV - $80,000 mortgage assumed), since Quick Corporation has E&P exceeding the amount distributed. b. Calvin's basis in the building is $250,000. c. Quick recognizes a gain of $100,000 ($250,000 FMV - $150,000 adjusted basis) for taxable income purposes. Because the building was used in Quick's business, $6,000 ($30,000 x 0.20) of the gain is ordinary income recaptured under Sec. 291. The remaining $94,000 ($100,000 - $6,000) is Sec. 1231 gain. d. A $114,000 net decrease is determined as follows: Quick's E&P is increased by the E&P gain of $90,000 ($250,000 FMV-$160,000 E&P adjusted basis) and reduced by the $170,000 net amount of the distribution and by $34,000 ($100,000 x 0.34) in federal income taxes on the $100,000 gain recognized for taxable income purposes, thereby resulting in a net decrease of $114,000. pp. C:4-8 through C:4-11. C:4-37 a. Susan recognizes $200,000 of dividend income and takes a $200,000 basis in the land. Zeta Corporation recognizes a $75,000 Sec. 1231 gain. Zeta's E&P is increased by $75,000 and reduced by the land's $200,000 FMV and by the $25,500 ($75,000 x 0.34) of federal income taxes on the gain. b. Susan recognizes $60,000 ($200,000 - $140,000) of dividend income and takes a $200,000 basis in the land. Zeta recognizes a $75,000 Sec. 1231 gain. Zeta’s E&P is increased by $75,000 and reduced by the land's $60,000 ($200,000 - $140,000) net FMV and by the $25,500 ($75,000 x 0.34) of federal income taxes on the gain. c. Susan recognizes $25,000 of dividend income and takes a basis of $25,000 in the inventory. Zeta recognizes $7,000 of ordinary income. Zeta's E&P is increased by $7,000 and reduced by the inventory's $25,000 FMV and by the $2,380 ($7,000 x 0.34) of federal income taxes on the gain. d. Susan recognizes $450,000 of dividend income and takes a $450,000 basis in the building. Zeta recognizes a $300,000 ($450,000 - $150,000) gain for taxable income purposes of which $15,000 ($75,000 x 0.20) is ordinary income under Sec. 291 and $285,000 ($300,000 $15,000) is Sec. 1231 gain. For E&P purposes, the basis of the building is $165,000 ($225,000 $60,000). The E&P gain (excess of FMV over E&P adjusted basis) is $285,000 ($450,000 $165,000). Zeta’s E&P is increased by $285,000 and reduced by the building's $450,000 FMV and by the $102,000 ($300,000 x 0.34) of federal income taxes on the gain. e. Susan recognizes $8,000 of dividend income and takes an $8,000 basis in the automobile. Zeta recognizes $2,240 of ordinary gain ($8,000 - $5,760) for taxable income purposes. For E&P purposes, the basis of the automobile is $6,800 ($12,000 - $5,200). The E&P gain (excess of FMV over E&P adjusted basis) is $1,200 ($8,000 - $6,800). Zeta’s E&P is increased by $1,200 and reduced by the automobile's $8,000 FMV and by the $762 ($2,240 x 0.34) of federal income taxes on the gain. f. Susan recognizes $35,000 of dividend income and takes a $35,000 basis in the obligation. Zeta recognizes a $10,500 Sec. 1231 gain on the distribution from sale of property in a prior year (the character of the gain depends on the character of the property sold when the obligation was received). Zeta's E&P is reduced by the obligation's $35,000 FMV and by the $3,570 ($10,500 x 0.34) of federal income taxes on the gain. E&P is not increased by the E&P gain on the installment obligation because E&P was increased by the entire gain in the year of sale. pp. C:4-8 through C:4-11. C:4-38 a.
$220,000 ($500,000 paid - $280,000 reasonable compensation) would be © 2012 Pearson Education, Inc. publishing as Prentice Hall
C:4-12
nondeductible by the corporation and a constructive dividend to Wilma. b. $400,000 would likely be a constructive dividend to Harry. c. The net FMV of the property sold is $290,000 ($350,000 - $60,000). Because Wilma paid only $150,000, she has a constructive dividend of $140,000 ($290,000 - $150,000). King Corporation recognizes a total gain of $260,000 ($350,000 FMV - $90,000 basis) on the sale of a portion of the building and the distribution of the remainder of the building. d. Harry recognizes a constructive dividend of $15,000 per year. King's rent expense is reduced by $15,000. e. Wilma has a constructive dividend of $65,000 ($250,000 - $185,000). King's basis in the land is reduced from $250,000 to $185,000. f. Harry and Wilma have a constructive dividend of $8,000. King's deductions for its airplane use are reduced by $8,000. pp. C:4-11 through C:4-13. C:4-39 The $200,000 in disallowed salary and bonuses will be nondeductible by Forward Corporation and taxable as a dividend to Alvin. Forward will lose its salary deduction for a tax cost of $68,000 ($200,000 x 0.34). Alvin will save $40,000 [$200,000 x (0.35 - 0.15)] because of the difference between his ordinary tax rate and the 15% tax rate on the dividend income (in 2011). Thus, the net tax cost is $28,000 ($68,000 - $40,000). pp. C:4-12 and C:4-13. C:4-40 a. None. The stock dividend is nontaxable under Sec. 305(a). b. Robert's basis in each share is $909.09 ($100,000 ÷ 110 shares). His gain on the sale is computed as follows: Amount received on sale $7,000.00 Minus: Basis of five shares (5 x $909.09) (4,545.45) Recognized gain $2,454.55 c. Total basis in the 105 remaining shares is $95,454.55 ($100,000 - $4,545.45), or $909.09 per share. Robert's holding period for all shares begins in 2005 when he acquired the original 100 shares. pp. C:4-13 through C:4-15. C:4-41 a. Tillie recognizes no income when she receives the preferred stock. Tillie's basis in her common and preferred stock is: Basis for 100 preferred shares: $100,000 x $ 10,000 = $ 5,263.16 $190,000 Basis for 1,000 common shares: $100,000 x $180,000 = $94,736.84 $190,000 b. Tillie recognizes a long-term capital gain of $2,368.42 ($5,000 - $2,631.58) on the sale of one-half of the preferred stock.
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c. Tillie's basis in her common stock is $94,736.84. Tillie's basis in her remaining preferred stock is $2,631.58. Her holding period begins in 2007 when she purchased the common stock. pp. C:4-13 through C:4-15. C:4-42 a. Jim recognizes no income when he receives the rights. b. Because the value of the rights ($15) is more than 15% of the value of the underlying stock ($75), the basis of the stock must be allocated to the stock and the right. Jim's basis in his stock is: $10,000 x ($75/$90) = $8,333.33 ($41.67 per share). Jim's basis in his rights is $10,000 x ($15/$90) = $1,666.67 ($8.33 per right). Jim recognizes a long-term capital gain of $1,166.67 ($2,000 - $833.33) when he sells the 100 rights. c. Jim recognizes no gain when he exercises the rights. Their basis is added to the basis of the stock purchased with the rights ($6,000 + $833.33 = $6,833.33). d. Jim recognizes a gain of $700 [(60 x $80) - (60 x $68.33)] on the stock sale. The gain is a short-term capital gain since the holding period begins on the September 10 exercise date. e. Jim's basis in his remaining shares is as follows: Jim's original 200 shares: $8,333.33 ($10,000 - $1,666.67). Jim's 40 remaining shares purchased with the rights: $2,733.33 (40 shares x $68.33). pp. C:4-14 and C:4-15. C:4-43 George's stock will be attributed to: a, his wife; b, his father; e, his daughter; and g, his grandfather. pp. C:4-18 through C:4-20. C:4-44 Lara owns: 60 shares directly 10 shares through LMN Partnership (0.20 x 50 shares) 70 shares through LST Partnership (0.70 x 100 shares) 0 shares through Lemon Corporation 54 shares through Lime Corporation (0.60 x 90 shares) Thus, total deemed constructive ownership is 194 shares. pp. C:4-18 through C:4-20. C:4-45 Because Paul still owns 100% of Presto Corporation's stock, the redemption is treated as a dividend under Sec. 301. Paul recognizes a $30,000 dividend to be taxed at a maximum 15% rate (in 2011). His $2,500 ($10,000 x 25/100) basis in the redeemed shares is added to his $7,500 ($10,000 - $2,500) basis in his remaining 75 shares, so his basis in the remaining 75 shares is $10,000. Presto’s E&P is reduced by the amount distributed, or $30,000. pp. C:4-18 through C:4-20, and C:4-27. C:4-46 a. Ethel owns 50% of the Benton stock before the redemption and 53.33% (160/300) after the redemption. Therefore, Ethel treats the redemption as a dividend and must recognize $20,000 (40 shares x $500) of dividend income. Ethel's remaining 160 shares have a total basis of $46,000 (200 shares x $230 each) or $287.50 per share.
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Fran owns 25% of the Benton stock before the redemption and 23.33% (70/300) after the redemption. The 23.33% is not less than 80% of Fran’s prior percentage ownership. Therefore, the redemption is not substantially disproportionate. Thus, unless Fran can establish that the redemption is not essentially equivalent to a dividend under Sec. 302(b)(1), she treats the redemption as a dividend distribution and must recognize $15,000 (30 shares x $500) of dividend income. Fran's remaining 70 shares have a total basis of $23,000 (100 shares x $230 each), or $500 per share. Georgia owns 12.5% of the Benton stock before the redemption and 6.67% (20/300) after the redemption. Therefore, the redemption is substantially disproportionate and Georgia treats the redemption as a sale of stock under Sec. 302(b)(2) and recognizes a long-term capital gain of $8,100 [30 x ($500 - $230)]. Georgia's remaining 70 shares have a basis of $230 each. b. If Ethel is Georgia’s mother, Ethel is considered to own 62.5% of the Benton stock (250/400) before the redemption and 60% (180/300) after the redemption. Therefore, Ethel still would have to treat the redemption distribution as a dividend. Georgia also is considered to own 62.5% before the redemption and 60% after the redemption and will be considered to have received a dividend. Thus, the tax consequences to Ethel and Fran do not change from Part a. However, Georgia must report a dividend of $15,000 (30 shares x $500) instead of a capital gain of $8,100 as in Part a. pp. C:4-16 through C:4-23. C:4-47 The redemption is treated as a sale of stock by Amy, Beth, and Carla. Each recognizes a $15,000 ($20,000 - $5,000) capital gain on their redeemed shares. All these shareholders have a $1,000 per share basis for their remaining shares. Delta Corporation recognizes a $20,000 dividend because its stock ownership percentage does not change and because the redemption does not qualify for exchange treatment under Sec. 302(b)(4). Delta's basis in its remaining 20 shares is $25,000, or $1,250 per share. Delta is entitled to an 80% dividends-received deduction for the distribution. pp. C:4-23 through C:4-25. C:4-48 a. A redemption of stock held by either John's estate or John, Jr. will qualify as a sale under Sec. 303. The value of the stock in the gross estate ($1,500,000) is more than 35% of the adjusted gross estate [$787,500 = 0.35 x ($2,500,000 - $250,000)]. John, Jr. is eligible for Sec. 303 treatment because he is responsible for all the taxes and expenses of the estate. The maximum qualified redemption under Sec. 303 is $600,000 ($250,000 + $350,000). A redemption of stock held by John's wife will not qualify under Sec. 303 because it is not included in the gross estate. b. The redemption qualifies under Sec. 303. However, only $600,000 (150 shares x $4,000 per share) qualifies for sale treatment under Sec. 303. The estate will report a $37,500 capital gain [$600,000 - ($1,500,000 x 150/400)] on this part of the redemption. The remaining $200,000 of the redemption proceeds is taxed as a dividend to the estate at the maximum 15% rate (in 2011). pp. C:4-25 through C:4-27. C:4-49 a. If the redemption qualifies for sale treatment, White's E&P is reduced by 30%, the percentage of stock that was redeemed. Thus, it is reduced by $24,000 (0.30 x $80,000). The remaining $6,000 of the distribution reduces the balance in the capital account. b. If the redemption does not qualify for sale treatment, White's E&P is reduced by $30,000. p. C:4-27. © 2012 Pearson Education, Inc. publishing as Prentice Hall
C:4-15
C:4-50 a. Because this redemption is a complete termination of interest, Alan recognizes a gain of $40,000 ($100,000 - $60,000 basis). Barbara and Dave each retain a basis of $60,000 in their remaining shares. Time's E&P is reduced by $80,000 (100/300 shares x $240,000). Time’s tax basis paid-in capital is reduced by $20,000 ($100,000 redemption amount - $80,000). b. If Barbara is Alan's mother, Alan is considered to own 200/300 =66 2/3% before the redemption and 100/200 = 50% after the redemption. This redemption is not substantially disproportionate. Therefore, the redemption could be treated as a $100,000 dividend to Alan. If so, Barbara's basis in her shares is increased by Alan's basis in the 100 shares surrendered, so her basis is $120,000 ($60,000 + $60,000); Dave's basis remains at $60,000; and Time's E&P is reduced by $100,000, the amount of the dividend to Alan. However, the IRS in Rev. Rul 75-502, 1975-2 C.B. 111, held that a redemption was not essentially equivalent to a dividend where a shareholder’s interest dropped from 57% before the redemption to 50% after the redemption. Hence, the shareholder received sale treatment on the redemption. Because the facts in Alan’s situation are similar to those in Rev. Rul. 75-502, he probably can assert that the redemption of his stock is not essentially equivalent to a dividend and claim sale treatment similar to Part a. See Part c, for yet another option. c. If Alan agrees not to obtain any interest in Time for ten years, the family attribution rules can be waived. Therefore, the redemption could be treated as a sale, and Alan could recognize a $40,000 gain. Barbara and Dave each retain a $60,000 basis in their remaining shares. Time's E&P is reduced by $80,000 [(100/300) x $240,000]. Time’s tax basis paid-in capital is reduced by $20,000 ($100,000 redemption amount - $80,000). pp. C:4-16 through C:423. C:4-51 a.
Before the redemption: 30 + 7.5 = 37.5 shares (37.5%) After the redemption: 5 + 7.5 = 12.5 shares (16.67%) The redemption is treated as a sale since it is substantially disproportionate. Bea has a capital gain of $25,000 ($30,000 - $5,000). Excel Corporation's E&P is reduced by $25,000 (0.25 x $100,000). Excel’s tax basis paid-in capital is reduced by $5,000 ($30,000 redemption amount $25,000). b. Before the redemption: 30 + 7.5 = 37.5 shares (37.5%) After the redemption: 20 + 7.5 = 27.5 shares (30.55%) Generally, this redemption is treated as a $12,000 dividend to Bea because the 80% test is not met (0.80 x 37.5% = 30.00%). Alternatively, sale or exchange treatment may be available under Sec. 302(b)(1) since Bea goes from one minority position to another. If so, she recognizes a $10,000 ($12,000 - $2,000) long-term capital gain. If the transaction is a dividend, Excel’s E&P is reduced by $12,000 (amount distributed). If it is a sale, E&P is reduced by $10,000 (0.10 x $100,000), and tax basis paid-in capital is reduced by $2,000 ($12,000 redemption amount $10,000). c. Before the redemption: 25 + 15 = 40 shares (40%) After the redemption: 15 shares (20%) The redemption is treated as a sale because it is substantially disproportionate. Carl must recognize a $26,000 ($30,000 - $4,000) capital gain. Excel has a $25,000 (0.25 x $100,000) reduction in its E&P, and a $5,000 reduction in its tax basis paid-in capital. This redemption also qualifies as a complete termination if the family attribution rules are waived.
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d. The redemption qualifies as a sale. Carl's estate must recognize a $2,000 gain ($30,000 - $28,000 FMV of the Excel stock on Carl's date of death). Excel again has a $25,000 reduction in its E&P, and a $5,000 reduction in its tax basis paid-in capital. e. Before the redemption: 20 shares (out of 100) (20%) After the redemption: 0 shares (out of 80) (0%) The redemption is either a complete termination or substantially disproportionate. (No stock is attributed from Tetra Corporation to Andrew because Andrew owns less than 50% of the Tetra stock.) Andrew must recognize a $21,000 ($24,000 - $3,000) capital gain. Excel must recognize an $18,000 ($24,000 - $6,000) gain on the distribution of the land. Its E&P is increased by $18,000 minus the $6,120 ($18,000 x 0.34) of federal income taxes attributable to the gain and minus $22,376 [0.20 x ($100,000 + $18,000 - $6,120)], which is less than the $24,000 distribution. Tax basis paid-in capital is reduced by $1,624 ($24,000 - $22,376). f. Before the redemption: 25 + 75 = 100 shares (100%). After the redemption: 25 shares (out of 25) (100%). As a result of the attribution rules, Carl owns 100% of Excel stock before and after the redemption. Thus, the substantially disproportionate requirements are not met as they were in Part c. To qualify for sale treatment, Carl must waive the family attribution rules. If Carl does so, he will recognize a $26,000 ($30,000 - $4,000) capital gain. Excel has a $25,000 (0.25 x $100,000) reduction in E&P. pp. C:4-16 through C:4-27. C:4-52 a. Bailey recognizes a dividend of $100,000 subject to the 15% tax rate (in 2011). Checker Corporation reduces its E&P by $100,000, the amount of the dividend. b. Bailey has a dividend of $100,000, which is ordinary income. However, Bailey is entitled to an 80% dividends-received deduction. Checker reduces its E&P by $100,000, the amount of the dividend. c. Bailey recognizes a long-term capital gain of $60,000 ($100,000 - $40,000 basis). Checker reduces its E&P by $70,000 (25% of the $280,000 balance) because she surrendered 25% of the outstanding stock in a redemption qualifying as a sale. d. The results are the same as Part c. Bailey recognizes a $60,000 long-term capital gain, and Checker reduces its E&P by $70,000. e. If Bailey is an individual, she would prefer long-term capital gain treatment. Although capital gains and dividends are both taxed at a maximum rate of 15% (in 2011), she deducts her basis in her stock in calculating her $60,000 of capital gain, whereas dividend treatment does not allow the deduction of basis so she would have to report $100,000 of dividends. Furthermore, she may be able to offset some or all of her capital gains with capital losses. If Bailey is a corporation, it normally would prefer dividend treatment. A dividend would increase Bailey’s taxable income by $20,000 ($100,000 - $80,000 DRD). A capital gain would increase taxable income by $60,000, with no special rate on capital gains for corporations. However, if the corporation realized a $60,000 capital loss, it could offset the loss against the $60,000 capital gain. In such case, Bailey Corporation might prefer the capital gain. pp. C:4-16 through C:4-27.
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C:4-53 a. Yes. Beth has a deemed dividend to the extent of the issuing corporation's E&P at the time the Sec. 306 stock was issued. The remainder is treated as a return of capital or capital gain. b. Yes. All amounts received are treated as a return of capital or capital gain under the general rules of Sec. 301. c. Yes. Under the Sec. 301 dividend rules, Ruth recognizes dividend income to the extent of Zero's E&P at the end of the year in which the redemption occurs. The remainder, if any, is treated as a return of capital or capital gain. d. Maybe. No tax is due at the time of the gift, but the stock retains its Sec. 306 taint in the hands of the donee, Barry. e. No. Because Ed completely terminates his interest in Zero, the redemption is treated as a sale, and Sec. 306 does not apply. f. No. Section 306 does not apply to inherited stock. pp. C:4-28 through C:4-30. C:4-54 a. stock is follows:
The preferred stock is Sec. 306 stock. Fran's basis in the preferred and common allocated as $150,000 x $60,000 = $20,000 Preferred: $450,000
Common:
$300,000 x $60,000 = $40,000 $450,000
When Fran sells the preferred stock, $100,000 (the E&P at the time the stock was distributed) is a deemed dividend to Fran, $20,000 is a return of capital, and $80,000 is a capital gain. Star Corporation makes no adjustment to its E&P. b. $100,000 is a deemed dividend and $10,000 is a return of capital. Fran's remaining $10,000 basis is added to her basis in the common stock, so the common stock basis is $50,000 ($40,000 + $10,000). Star makes no adjustment to its E&P. c. Under the Sec. 301 rules, $175,000 is a dividend [up to the amount of E&P in the year of the redemption ($100,000 + $75,000)]; Fran's $20,000 basis in the preferred shares is recovered tax-free; and the remaining $5,000 of the distribution is a capital gain. Star’s E&P is reduced by $75,000. pp. C:4-28 through C:4-30. C:4-55 a. The sale is recast as a redemption of Razzle stock issued as a result of Bob's capital contribution of the Dazzle stock to Razzle. The Sec. 302 stock ownership is tested by looking at Bob's ownership of the Dazzle stock. • Bob's ownership of Dazzle stock before the redemption: 60% of Dazzle stock. • Bob's ownership after the redemption: 30 shares directly and 80% x 30 shares indirectly = 54 shares = 54% of Dazzle stock. The redemption is treated as a $50,000 dividend to Bob because the combined E&P of Dazzle and Razzle is $65,000 ($25,000 + $40,000). b. Bob's basis in his remaining Dazzle stock is $6,000 (30/60 x $12,000). Bob's basis in his Razzle stock is increased to $14,000 by his $6,000 basis in the redeemed Razzle stock. c. Razzle's E&P is reduced by the first $40,000 of the distribution, and Dazzle's E&P is reduced by the remaining $10,000 ($50,000 - $40,000) of the distribution. © 2012 Pearson Education, Inc. publishing as Prentice Hall
C:4-18
d. Razzle's basis in its Dazzle shares is $6,000, the same as Bob's pre-sale basis. e. If Bob owned only 50% of the Razzle stock before the sale, Bob owns 60% of the Dazzle stock before and 45% after the sale [30 shares + (50% x 30 shares)], so the redemption is treated as a sale under Sec. 302(b)(2). Bob recognizes a capital gain of $44,000 ($50,000 $6,000 basis). pp. C:4-30 through C:4-32. C:4-56 a. The sale is recast as a redemption. Because Jane still owns more than 50% of Parent after the redemption, [100 shares directly and 20 (50% x 80% x 50) shares indirectly out of 200 outstanding shares], or 60% of Parent's stock, the $40,000 is taxed as a dividend to Jane. b. Jane's basis in her remaining 100 shares of Parent stock is $15,000. c. Subsidiary’s E&P is reduced to $20,000 ($60,000 - $40,000). d. Subsidiary’s basis in the Parent shares is $40,000. e. The recast redemption is substantially disproportionate {75% before the redemption and 70 [50 + 20 (25% x 80% x 100)] shares, or 35%, after the redemption}. Therefore, Jane recognizes a capital gain of $70,000 [$80,000 - (100/150 x $15,000)]. pp. C:4-32 and C:4-33. C:4-57 a. Jana will recognize $450,000 ($750,000 - $300,000) of capital gain on her sale of 75 shares of Stone Corporation stock to Michael. She will recognize an additional $150,000 ($250,000 - $100,000) of capital gain on the redemption of her remaining shares by Stone. Michael will take a basis in his stock of $750,000, the amount paid for the 75 shares purchased. Stone will recognize no gain or loss on the redemption if the redemption is for cash. If Stone uses property to redeem Jana's stock, it will recognize gain (but not loss) on the property used as though the property was sold. Because the redemption of one-fourth of the Stone stock is treated as a sale, the corporation's E&P will be reduced by $150,000, which is one-fourth of the available E&P. b. The results are the same even though the redemption takes place before the sale. As long as the redemption and sale are part of one transaction, the redemption will qualify as a sale. pp. C:4-34 and C:4-35.
Comprehensive Problem C:4-58 a.
Sigma Corporation’s taxable income and tax liability: Income: Operating gross profit Long-term capital gain Total income Deductions: Salary to Brian Payroll tax on Brian’s salary Depreciation Other operating expenses Total deductions
$290,000 20,000 $310,000 $ 80,000 6,000 25,000 89,000 $200,000 Taxable income
Income tax [$22,250 + 0.39 ($110,000 - $100,000)] Sigma’s portion of payroll tax © 2012 Pearson Education, Inc. publishing as Prentice Hall
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$110,000 $26,150 6,000
Total corporate tax liability Brian’s taxable income and tax liability: Salary income Dividend income AGI Minus: Standard deduction Personal exemption Total deductions Taxable income
$32,150 $ 80,000 60,000 $140,000 $ 5,800 3,700 ( 9,500) $130,500
Ordinary taxable income ($130,500 - $60,000 dividend income)
$70,500
Tax on ordinary taxable income [$4,750 + 0.25 ($70,500 - $34,500)] Tax on dividend income (0.15 x $60,000) Brian’s portion of payroll tax Total tax on Brian
$13,750 9,000 6,000 $28,750
Total corporate and individual tax ($32,150 + $28,750)
$60,900
Sigma Corporation’s E&P: Taxable income
$110,000
Plus:
Tax-exempt income Excess of tax depreciation over E&P depreciation ($25,000 - $21,000) Total additions Minus: Federal income taxes Dividend distribution Total reductions Current E&P after dividend distribution
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$ 7,000 4,000 11,000 $26,150 60,000 ( 86,150) $ 34,850
b.Brian’s taxable income and tax liability: Operating gross profit Minus: Business deductions: Depreciation Other operating expenses Total deductions Net income from business Plus: Long-term capital gain Minus: One-half self-employment tax AGI Minus: Standard deduction Personal exemption Total deductions
$290,000 $ 25,000 _89,000 (114,000) $176,000 20,000 ( 8,500) $187,500 $ 5,800 3,700 (
9,500)
Taxable income
$178,000
Ordinary taxable income ($178,000 - $20,000 LTCG)
$158,000
Tax on ordinary income [$17,025 + 0.28 ($158,000 - $83,600)] Tax on long-term capital gain ($20,000 x 0.15) Total income tax Self-employment tax Total tax
$ 37,857 3,000 $ 40,857 17,000 $ 57,857
c.
In the sole proprietorship case, long-term capital gains are taxed once at the individual’s preferential capital gains tax rate (e.g., 15% in 2011), taxexempt income is excluded from gross income, and operating profits are taxed once at the individual’s ordinary tax rate. In the C corporation case, long-term capital gain is taxed once at the corporation’s ordinary tax rate and again at the shareholder’s 15% tax rate (in 2011) when distributed as a dividend. Tax-exempt income is excluded from the corporation’s gross income but is taxed at the shareholder’s ordinary tax rate when distributed as a dividend. Operating profits are taxed once at the corporation’s ordinary tax rate and again at the shareholder’s capital gain tax rate when distributed as a dividend.
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Tax Strategy Problem C:4-59 a. John would have a $50,000 dividend. Jamaica Corporation would reduce its E&P by $50,000. b. John would have a $50,000 dividend and a $50,000 basis in the XYZ stock. Jamaica would recognize a $40,000 gain on the XYZ stock. Jamaica’s E&P would be increased by $40,000 assuming taxable income basis and E&P basis are equal and reduced by the $13,600 ($40,000 x 0.34) of federal taxes on the gain and by the XYZ stock’s $50,000 FMV, for a net reduction of $23,600 ($40,000 - $13,600 - $50,000). The disadvantage of this choice is that the corporation must recognize $40,000 and pay tax of $13,600 even though it has not sold the stock and has not received any cash. c. John would have a dividend of $50,000 and a $50,000 basis in the ABC stock. Jamaica’s E&P would be reduced by the $72,000 E&P adjusted basis of the stock to Jamaica. The disadvantage of this choice is that, if the stock is distributed to John, neither John nor Jamaica can ever take the $22,000 loss that Jamaica sustained on this stock before the distribution. d. John would recognize a $50,000 dividend ($81,000 FMV - $31,000 liability assumed). Jamaica would recognize $59,000 of ordinary income under Sec. 1245, the amount by which the $81,000 FMV exceeds Jamaica’s tax basis in the equipment distributed. Jamaica’s E&P would be increased by the $41,000 ($81,000 FMV - $40,000 E&P adjusted basis) E&P gain and reduced by the equipment’s net FMV of $50,000 ($81,000 FMV - $31,000 liability) and by the $20,060 ($59,000 x 0.34) tax on the gain, for a net reduction of $29,060 ($41,000 - $50,000 $20,060). The disadvantage of this choice is similar to that in Part b. Jamaica must recognize a $59,000 gain even though it has not sold the equipment and has not received any cash. e. John would recognize a $50,000 dividend and take a $50,000 basis in the installment obligation. Jamaica would recognize an $18,000 capital gain in the year it distributes the obligation. Its E&P would be increased by the $18,000 gain (assuming taxable income basis and E&P basis are equal) and decreased by the obligation’s $50,000 FMV and by the $6,120 ($18,000 x 0.34) of federal tax on the gain, for a net reduction of $38,120 ($18,000 - $50,000 $6,120). The disadvantage of this choice is that Jamaica’s gain on the installment obligation is accelerated to the year of distribution instead of spread over the term of the note. f. It would not make any difference if John’s stock were redeemed for the property listed. Because John owns all the Jamaica stock, any redemption will be treated as a dividend to the extent of Jamaica’s E&P. g. The best option probably would be cash so that Jamaica would not have to recognize any gain. The worst option probably would be the ABC stock because the loss of $22,000 on the stock could never be recognized by John or Jamaica. This option should be avoided. Of the property distributions resulting in gains, the installment obligation seems least objectionable because it triggers the least gain recognition to the corporation. h. Yes. If John’s 100 shares represented one third of Jamaica’s outstanding shares, unrelated parties owned the remaining 200 shares, and Jamaica exchanged all of John’s shares for each of the properties listed, the distribution would be treated as a redemption in complete termination of John’s interest. Consequently, the following tax consequences would ensue. From the corporation’s perspective, Jamaica would increase its E&P by the excess of the FMV of any appreciated property distributed over that property’s E&P adjusted basis. It then would reduce its E&P by one third (i.e., 100 shares/300 shares), not to exceed the actual distribution © 2012 Pearson Education, Inc. publishing as Prentice Hall
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amount. Any distribution exceeding the one-third amount would reduce Jamaica’s tax basis paidin capital. From the shareholder’s perspective, John would recognize gain or loss equal to difference between the distribution amount and the aggregate adjusted bases of the stock surrendered. The character of the gain or loss would depend on the nature of the distributed property in John’s hands (i.e., how he used such property). John’s basis in any noncash property received would be the property’s FMV. The holding period for that property would be the day after the exchange date. i. Yes. If John were an investor, treating the distribution as a sale would be preferable to treating the distribution as a dividend because John could offset his other capital gains with any losses recognized in the sale, and his other capital losses with any gains recognized in the sale. On the other hand, from a tax rate perspective, treating the distribution as a sale or a dividend probably would make no difference to John because for most taxpayers both gains and dividends are taxed at a flat 15% (through 2011).
Case Study Problems C:4-60 The points listed below should be mentioned in the memorandum to the three sisters. The student should prepare a properly formatted memorandum with good grammar and punctuation. Purchase Transaction 1.
Amy will report a $60,000 ($100,000 - $40,000) long-term capital gain on the sale of the Theta stock to Beth and/or Meg. She might consider an installment sale, which will defer the recognition of the gain over the payment period and provide some interest income for Amy.
2.
The purchasing shareholder(s) will take a $100,000 cost basis in the new block of stock and may control up to two-thirds of the Theta stock. Beth and Meg instead may purchase one-half of Amy's stock so that they are equal shareholders immediately following the sale.
3.
The sale transaction does not result in any reduction of the Theta’s earnings and profits.
4.
A sale transaction might be preferred since it does not require an outlay of any of Theta’s assets. If Beth and/or Meg encounter difficulties in raising the required $100,000, a properly structured bootstrap acquisition could be used where Theta redeems some of the shares and Beth and/or Meg purchase the remaining shares.
Redemption Transaction 1.
Amy will report a $60,000 long-term capital gain on the redemption. No attribution of stock occurs from either Beth or Meg to Amy because the family attribution rules do not apply to siblings. Therefore, the redemption of Amy's stock is considered a complete termination of Amy's interest under Sec. 302(b)(3). © 2012 Pearson Education, Inc. publishing as Prentice Hall
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2.
The two sisters may prefer to have the corporation redeem the shares because each sister will control one-half of the outstanding stock after the redemption. The redemption also does not require any economic outlay by any of the three shareholders.
3.
The stock redemption will result in a $50,000 ($150,000 x 0.333) reduction in Theta's earnings and profits, and a $50,000 reduction in paid-in capital.
C:4-61 The client letter should address the following issues: If Maria has a good faith belief that her position relating to the compensation amounts has a realistic possibility of being sustained administratively or judicially on its merits, if challenged, then according to Statements on Standards for Tax Services (SSTS) No. 1, Tax Return Positions (see Appendix E in the text), she may recommend that such a position be taken on the tax return. If she does not have such a good faith belief, she nevertheless may recommend the position if there is a reasonable basis for the position and she advises the taxpayer to disclose that position on the return. If she does not have such a good faith belief, and the position is not disclosed on the return, she should not recommend the position be taken, and she should not prepare or sign the return. The advice Maria gives regarding the deductibility of the compensation should be written and supported by adequate work papers. Although oral advice may serve a client's needs appropriately in routine matters, SSTS No. 7, Form and Content of Advice to Taxpayers, Para. 6, recommends written communications in important, unusual, or complicated transactions (see Appendix E in the text). The client letter should indicate what kind of support exists for the current and prior years' compensation amounts, what kinds of audit risk exists, and the possible consequences of a subsequent audit.
Tax Research Problems C:4-62 In drafting the letter, the student should follow the basic steps in the tax research process. The letter should set forth the facts, identify key issues, discuss Sec. 302 and other applicable law, analyze the facts in terms of the law, derive logical conclusions, and present sound recommendations. A key issue that the student should address is whether the management of WEA facilities by a company wholly owned by Weymouth, in consideration for 20% of WEA’s revenues, violates Sec. 302(c)(2)(A)(ii) and Weymouth’s agreement with the IRS. Contractually, under the Widells’ proposal, Fortunelle will provide management services for WEA in return for arms length compensation. However, through his 100% ownership of Fortunelle, Weymouth may be deemed to have reacquired an interest in WEA. Facts that may be significant in determining the outcome include • Weymouth’s family relationship with WEA’s shareholders • His past equity interest in WEA • His past WEA management role • His 100% ownership interest in Fortunelle • Fortunelle’s proposed management role • Fortunelle’s proposed revenue-sharing arrangement Section 302(b)(3) provides that, if a redemption is in complete redemption of all the stock of the corporation owned by the shareholder, the redemption will be treated as a sale. Therefore, © 2012 Pearson Education, Inc. publishing as Prentice Hall
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any gain or loss realized by the shareholder will be capital in character. Under Sec. 318(a)(1)(A), for purposes of Sec. 302, corporate stock owned by parents is attributed to their children. Under Sec. 302(c)(2)(A), the Sec. 318(a)(1)(A) attribution rules may be waived if the shareholder meets all the following conditions: i. Immediately after the distribution, the shareholder retains no interest in the corporation (including an interest as officer, director, or employee) other than an interest as a creditor, ii. The shareholder does not acquire any such interest within ten years from the date of the distribution, and iii. The shareholder files an agreement to notify the IRS if he or she acquired such interest. Under the terms of the Widells’ proposal, it appears that Weymouth will have met all three conditions. First, immediately after the corporate distribution of the WEA property, Weymouth retained no interest in WEA. Second, Weymouth will not have acquired an interest within ten years from the date of the distribution. (Fortunelle as a legal entity, not Weymouth as an individual, will have provided management services in an independent contractor capacity.) Third, Weymouth filed an agreement to notify the IRS if he acquires any interest. Weymouth, however, might not have satisfied condition (ii). Because of (1) his 100% ownership of Fortunelle, (2) the nature of the services that Fortunelle would provide for WEA, and (3) the proposed revenue-sharing arrangement, Weymouth might be deemed to have reacquired an interest in WEA, both as an owner and as an officer, within the ten-year period. Therefore, the Sec. 318(a)(1)(A) family attribution rules might not be waived, the redemption will not have been in complete redemption of all WEA stock owned by Weymouth, and the distribution would not have qualified for sale treatment. In Rev. Rul. 70-104, 1971 C.B. 66, the IRS ruled that a father’s performance of services for a corporation pursuant to a consulting agreement gives rise to an interest in the corporation for Sec. 302 waiver purposes. On the other hand, in Estate of Milton S. Lennard, 61 T.C. 554 (1974), the Tax Court ruled that a corporation’s employing a former shareholder did not give rise to an interest for Sec. 302 waiver purposes where (1) the former shareholder was employed as an independent contractor, (2) the corporation determined operating policy, (3) the corporation could terminate the employment at will, and (4) the compensation was reasonable in amount relative to the services performed. The facts of the present case are analogous to those of Chertkof v. Commissioner, 48 AFTR 2d 81-5194, 81-1 USTC ¶9462 (4th Cir, 1981). In Chertkof, a closely held family corporation distributed real estate to the principal owner’s son in complete redemption of the son’s equity interest. At the time of the distribution, the son had the Sec. 318 family attribution rules waived by executing with the IRS an agreement not to reacquire an equity interest within ten years and to notify the IRS if he did so. As a result of the waiver, the distribution was treated as a sale, and the son recognized capital gain. Following the distribution, the son organized his own real estate company and capitalized it with the distributed real estate. Years later, the son’s wholly owned company entered into an agreement to manage the real estate of the family corporation in consideration for a percentage of its annual revenues. Contending that the real parties to the agreement were the son and the closely held family corporation, the Fourth Circuit Court of Appeals held that the son effectively had reacquired an © 2012 Pearson Education, Inc. publishing as Prentice Hall
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interest in the family corporation and that this reacquisition violated Sec. 302(c)(2)(A)(ii). Consequently, the Sec. 318(a)(1)(A) family attribution rules effectively were not waived, the redemption was not in complete redemption of the son’s equity interest, and the son should have recognized a dividend, not capital gain C:4-63 The memorandum should point out that Sec. 274 requires a corporation to meet strict substantiation requirements to deduct travel and entertainment expenses. These substantiation requirements can be found in Reg. Secs. 1.274-1 and -2. If the corporation does not meet these requirements, the outlays are nondeductible under Sec. 162. The question here is whether these disallowed expenses are considered a dividend to Charles who incurred the expenses. In Henry Schwartz Corp., 60 T.C. 728 (1973), a corporation was denied travel and entertainment expense deductions because it failed to adequately substantiate the costs as required by Sec. 274(d). It was obvious in this case that some of these expenses were for the corporate business and thus were ordinary and necessary expenses. To the extent the outlay was ordinary and necessary to the corporation's business; the expenses were not considered a dividend to the shareholder even though they were disallowed to the corporation. The IRS originally acquiesced in the Henry Schwartz Corp. decision (1974-2 C.B. 4) concerning the portion of the disallowed expenses that were a constructive dividend. It subsequently has nonacquiesced (1981-2 C.B. 3). Thus, the IRS likely will consider the $10,000 expense to be a dividend to Charles. Charles might prevail in omitting the $10,000 from gross income if he litigated the matter in the Tax Court based on the Henry Schwartz Corp. decision. Additional support for the taxpayer's position may come from Palo Alto Town & Country Village, Inc. v. CIR, 41 AFTR 2d 78-517, 78-1 USTC ¶9200 (9th Cir., 1977), where the appeals court held that the test for a constructive dividend was twofold; "not only must the expenses be non-deductible to the corporation, but also they must represent some economic gain or benefit to the owner-taxpayer." C:4-64 Listed below are the major points that should be covered in the memorandum to the tax manager. The student should prepare the memorandum using proper form with good grammar and punctuation. 1. Under Sec. 311(b)(1), Benson Corporation must recognize gain on the distribution of Parcel A to Scott Brown. The amount of the gain is $35,000 ($75,000 - $40,000) and its character is capital. However, under Sec. 311(a), the corporation recognizes no loss on the distribution of Parcel B to Lynn Brown. 2. Under Sec. 312, Benson must reduce its E&P by the FMV ($75,000) of Parcel A and by the E&P adjusted basis ($120,000) of Parcel B. Note that the recognized gain of $35,000 on Parcel A was included in Benson’s taxable income and therefore increased Benson’s E&P net of applicable tax [i.e., $35,000 - (0.34 x $35,000) = $23,100]. If Benson’s E&P basis did not equal its taxable income basis, Benson would further adjust E&P to reflect the difference between the taxable income gain and the E&P gain. © 2012 Pearson Education, Inc. publishing as Prentice Hall
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3.
Under ASC 845-10-30-1, Benson must record both the gain on Parcel A ($35,000), and the loss on Parcel B ($45,000). The dividend is then recorded as a debit to retained earnings and a credit to property dividends at an amount equal to the property’s FMV. The entries then would be:
At date of declaration: Investment in Land Gain on Appreciation of Land Loss on Depreciation of Land Investment in Land Retained Earnings (Property Dividends Declared) Property Dividends Payable
35,000 35,000 45,000 45,000 150,000 150,000
At date of distribution: Property Dividends Payable Investment in Land 4.
150,000 150,000
Schedule M-1 would report the difference between the $10,000 loss reported for book purposes and the $35,000 gain reported for tax purposes, which is the $45,000 loss disallowed for tax purposes.
C:4-65 There does not appear to be any compensatory intent for the bonus payments to John and Jean. Rather, the bonus payments appear to be “disguised dividends.” Therefore, these payments are likely to be treated as dividends to John and Jean and no deduction will be allowed to Plum Corporation. See O.S.C. & Associates, Inc. v. Comm., 84 AFTR 2d 99-5735, 99-2 USTC ¶50,765 (9th Cir., 1999). In this case with similar facts, the Ninth Circuit affirmed the Tax Court in declaring that compensation based on gross profits and proportional to stock holdings were disguised dividends. The Court held that it was irrelevant whether the compensation or any part of it might have represented reasonable compensation. The method of calculation of the bonuses was not based on the value of services performed but was structured to distribute profits in proportion to stock holdings. C:4-66 The memorandum should explain that Sec. 162(a)(1) permits a taxpayer to deduct a reasonable allowance for salaries or other compensation for personal services actually rendered that is paid or incurred during the tax year. Regulation Sec. 1.162-8 holds that, “The income tax liability of the recipient in respect of an amount ostensibly paid to him as compensation, but now allowed to be deducted as such by the payor, will depend upon the circumstances of each case.” Such amounts may be taxed to the recipient as a dividend. But, “in the absence of evidence to justify other treatment, excessive payments for salaries or other compensation for personal services will be included in gross income of the recipient.” In the case at hand, it seems likely that Sara will be required to include all the amounts © 2012 Pearson Education, Inc. publishing as Prentice Hall
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paid to her as compensation, despite the disallowance of a deduction for the “unreasonable” part of the payments by the corporation. The IRS is unlikely to reclassify the excess compensation as a dividend because, under current law, dividends for years 2003-2010 would be taxed at a maximum rate of 15%. The IRS is likely to follow the Sterno case (Sterno Sales Corp. v. U.S., 15 AFTR 2d 979, 65-1 USTC ¶9419 (Ct. Cl. 1965)) where the Court ruled that the taxpayer could not treat excess compensation as a dividend just because it was more advantageous than compensation. The Court required the taxpayer to treat the excess amounts as compensation because that was how they were classified when paid to the taxpayer. Revenue Ruling 69-115, 1969-1 C.B. 50, holds that shareholder-employees of a closely held corporation are entitled to deduct as a business expense in the year of repayment the portion of the salaries they received that were declared unreasonable compensation. Only the amounts they were legally obligated to repay under an agreement with the corporation can be deducted. The obligation to repay the salaries must be enforceable under state law. No deduction is available for any amounts that are voluntarily repaid. Also see Vincent E. Oswald, 49 T.C. 645 (1968), acq. 1968-2 C.B. 2, where the Tax Court held that a repayment was denied a deduction for amounts the shareholder voluntarily repaid prior to the adoption of a by-laws amendment requiring such repayments. Amounts were deductible, however, when paid after the corporation adopted a by-laws agreement requiring repayment of nondeductible compensation payments. In the case at hand, the unreasonable compensation equals: 2008, $50,000; 2009, $75,000; and 2010, $115,000. All the compensation is taxed in the tax year in which it is received. Only the portion of the compensation repaid after the adoption of the by-laws amendment on December 15, 2009 can be deducted. This amount should be: 2008, $0; 2009, $3,125 (1/24 x $75,000); and 2010, $115,000. One could treat a ratable share of the repayment as being deductible in each of the five years in which a payment is made so that one-fifth of the 2009 and 2010 amounts [$23,625 = 0.20 x ($3,125 + $115,000)] is deductible in years 2012 through 2016.
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“What Would You Do In This Situation?” Solution Ch. C:4, p. C:4-35. The IRS Wants a Bonus Too. You should first alert your clients that this issue is subject to scrutiny. You also should advise your clients of the parameters used by the IRS on this issue. These would include, but not be limited to, the contractual arrangements entered into by members of the firm, the existence of other payments characterized as dividends (if any), and the revenue paid out during the year in proportion to the estimated fair market value of the services rendered by the individual members of the firm. You should examine the formula used to derive the bonus payment. Was it based on the percentage of revenue earned by each shareholder, or was it based on his or her percentage of ownership in the professional corporation? You also should determine the tax consequences to the corporation and the shareholders. Paying some dividends instead of all salary may not be costly because dividends currently are taxed at a maximum rate of 15% (in 2011). Also, dividends are not subject to payroll taxes. Therefore, even though the corporation cannot deduct dividend payments, the difference in overall tax between salary payments and dividend payments may not be great. In any event, the final position you take should be in accordance with Paragraph 5a of the AICPA's Statement on Standards for Tax Services No. 1, Tax Return Positions (reproduced in Appendix E of the text). Your position should be based on a good faith belief that it has a realistic possibility of being sustained administratively or judicially on its merits. If your views on this issue are at variance with your client's views, you should consult your own counsel before deciding on further recommendations and/or on whether to continue a professional relationship with that client. As a practical matter, if your clients insist on taking a position that is at variance with that of the IRS, you can file protective claims for the clients while these cases are litigated in court.
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