Essentials of taxation 2016 cengage chapter 13

The Big Picture slide 1 of 3• Lime Corporation, an ice cream manufacturer, has had a very profitable year... The Big Picture slide 2 of 3• Lime Corporation has had both good and bad ye

© 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

The Big Picture (slide 1 of 3)

• Lime Corporation, an ice cream manufacturer,

has had a very profitable year

distributes the following:

• Cash of $200,000 to Orange Corporation, and

• Real estate worth $300,000 (adjusted basis of $20,000)

The Big Picture (slide 2 of 3)

• Lime Corporation has had both good and bad

years in the past.

balance sheet for Lime indicates a year-end deficit

in retained earnings

• Consequently, the distribution of cash and land

is treated as a liquidating distribution for

financial reporting purposes, resulting in a

reduction of Lime’s paid-in capital account.

The Big Picture (slide 3 of 3)

• The tax consequences of the distributions to

the corporation and its shareholders depend on

a variety of factors

• Explain the tax effects of the distributions to

both Lime Corporation and its 2 shareholders

• Read the chapter and formulate your response.

Taxable Dividends

• Distributions from corporate earnings and

profits (E & P)

• Taxed as ordinary income or as preferentially taxed

dividend income

• Distributions in excess of E & P

return of capital)

• Excess distribution over basis is capital gain

Earnings & Profits

(slide 1 of 2)

• No definition of E & P in Code

• Similar to Retained Earnings (financial

reporting), but often not the same

Earnings & Profits

(slide 2 of 2)

• E & P represents:

recognized on corporate distributions

without impairing capital

Calculating Earnings & Profits

(slide 1 of 4)

• Calculation generally begins with taxable

income, plus or minus certain adjustments

deductions to taxable income including:

• Muni bond interest

• Excluded life insurance proceeds

• Federal income tax refunds

• Dividends received deduction

• Domestic production activities deduction

Calculating Earnings & Profits

(slide 2 of 4)

plus or minus certain adjustments (cont’d)

– Subtract certain nondeductible items:

• Nondeductible portion of meal and entertainment expenses

• Related-party losses

• Expenses incurred to produce tax-exempt income

• Federal income taxes paid

• Key employee life insurance premiums (net of increase in cash

surrender value)

• Fines, penalties, and lobbying expenses

Calculating Earnings & Profits

(slide 3 of 4)

from the year of inclusion in or deduction from

taxable income to year of economic effect, such as:

– Charitable contribution carryovers

– NOL carryovers

– Capital loss carryovers

– Generally affect E & P only to extent recognized for tax

purposes

– Thus, gains and losses deferred under the like-kind

exchange provision and deferred involuntary conversion gains do not affect E & P until recognized

Calculating Earnings & Profits

(slide 4 of 4)

• Other adjustments

conservative than for taxable income, for example:

• Installment method is not permitted

• Alternative depreciation system required

• § 179 expense must be deducted over 5 years

• Percentage of completion must be used (no completed

contract method)

Calculating Earnings & Profits

(slide 4 of 4)

• Other adjustments

conservative than for taxable income, for example:

• Installment method is not permitted

• Alternative depreciation system required

• § 179 expense must be deducted over 5 years

• Percentage of completion must be used (no completed

contract method)

Examples of E & P Adjustments (slide 1 of 2)

Examples of E & P Adjustments (slide 2 of 2)

Current vs Accumulated E & P

(slide 1 of 3)

• Current E & P

Current vs Accumulated E & P

(slide 2 of 3)

• Accumulated E & P

February 28, 1913) reduced by distributions from

E & P

Current vs Accumulated E & P

(slide 3 of 3)

• Distinguishing between current and

accumulated E & P is important

on how current and accumulated E & P are

allocated to each distribution made during year

Allocating E & P to Distributions

(slide 1 of 4)

• If positive balance in both current and

accumulated E & P

& P, then accumulated E & P

current and accumulated E & P to each distribution

• Allocate current E & P pro rata (using dollar amounts)

to each distribution

• Apply accumulated E & P in chronological order

Allocating E & P to Distributions

(slide 2 of 4)

• When the tax years of the corporation and its

shareholders are not the same

current E & P on a timely basis

sufficient to cover every distribution made during the year until the parties can show otherwise

Allocating E & P to Distributions

(slide 3 of 4)

• If current E & P is positive and accumulated E

& P has a deficit

E & P

• Distribution is deemed to be taxable dividend to extent

of positive current E & P balance

The Big Picture – Example 11

Positive Current E & P, Deficit In Accumulated E & P

• Return to the facts of The Big Picture on p 5–1

• Lime Corp had a deficit in GAAP-based retained earnings at

the start of the year and banner profits during the year

– Assume that this translates into an $800,000 deficit in accumulated

E & P at the start of the year and current E & P of $600,000

• In this case, current E & P would exceed the total cash and

property distributed to the shareholders.

– The distributions are treated as taxable dividends.

– They are deemed to be paid from current E & P even though Lime still

has a deficit in accumulated E & P at the end of the year.

Allocating E & P to Distributions

(slide 4 of 4)

• If accumulated E & P is positive and current

E&P is a deficit, net both at date of distribution

return of capital

the extent of the balance

year unless the parties can show otherwise

Cash Distribution Example

A $20,000 cash distribution is made at year end in each

*Since there is a current deficit, current and accumulated

E & P are netted before determining treatment of distribution.

Property Dividends

(slide 1 of 4)

• Effect on shareholder:

• Taxable as dividend to extent of E & P

• Excess is treated as return of capital to extent of basis in

stock

• Any remaining amount is capital gain

Property Dividends

(slide 2 of 4)

• Effect on shareholder (cont’d):

by shareholder

• Corp recognizes gain, but not loss

excess of basis

• Fair market value is treated as not being less than the

amount of the liability

Property Dividends

(slide 4 of 4)

• Effect on corporation’s E & P:

property distributed (i.e., gain recognized)

basis, if greater) less liabilities on the property

or add to a deficit in E & P

• Deficits in E & P can arise only through corporate

losses

The Big Picture – Example 15

Property Dividends - Effect on the Shareholder

• Return to the facts of The Big Picture on p 5–1.

one of its shareholders

– Fair market value $300,000.

– Adjusted basis $20,000

– Subject to a $100,000 mortgage, which Gustavo assumed.

$200,000

– $300,000 (fair market value) – $100,000 (liability).

– The basis of the property to Gustavo is $300,000.

The Big Picture – Example 17

Property Dividends - Effect on the Corporation

• Return to the facts of The Big Picture on p 5–1.

one of its shareholders

– Fair market value of $300,000

– Adjusted basis of $20,000

distribution

Property Distribution Example

Property is distributed (corporation’s basis = $20,000) in each of the following independent situations Assume

Current and Accumulated E & P are both $100,000 in each case:

Constructive Dividend

(slide 1 of 2)

• Any economic benefit conveyed to a

shareholder may be treated as a dividend for tax purposes, even though not formally

declared

Constructive Dividend

(slide 2 of 2)

• Usually arises with closely held corporations

• Payment may be in lieu of actual dividend and

is presumed to take form for tax avoidance

purposes

• Benefit conveyed is recharacterized as a

dividend for all tax purposes

dividends received deduction

Examples of Constructive Dividends

(slide 1 of 3)

• Shareholder use of corporate property at

reduced cost or no cost (e.g., company car to non-employee shareholder)

• Bargain sale of property to shareholder (e.g.,

sale for $1,000 of property worth $10,000)

• Bargain rental of corporate property

Examples of Constructive Dividends

(slide 2 of 3)

• Payments on behalf of shareholder (e.g.,

corporation makes payments to satisfy

obligation of shareholder)

• Unreasonable compensation

Examples of Constructive Dividends

Avoiding Unreasonable Compensation

• Documentation of the following attributes will

help support payments made to an

– Nature and scope of employee’s work

– Size and complexity of business

– Corporation’s salary policy for other employees

Stock Dividends

(slide 1 of 2)

• Excluded from income if pro rata distribution

of stock, or stock rights, paid on common

stock

various disproportionate distribution situations

• Effect on E & P

distribution

Stock Dividends

(slide 2 of 2)

– If nontaxable

• If shares received are identical to shares previously owned, basis =

(cost of old shares/total number of shares)

• If shares received are not identical, allocate basis of old stock

between old and new shares based on relative fair market value

• Holding period includes holding period of formerly held stock

– If taxable, basis of new shares received is fair market value

• Holding period starts on date of receipt

Stock Redemptions

(slide 1 of 3)

• Generally result in dividend income for

shareholder whose stock is redeemed unless shareholder surrenders significant control

• Section 302 allows sale or exchange treatment

where either:

shareholder and owns less than 80% of the interest owned in the corporation before the redemption

Stock Redemptions

(slide 2 of 3)

• When transaction is treated as a dividend,

investor’s basis in redeemed shares does not disappear but attaches to remaining shares

owned

• Other provisions also allow sale or exchange

treatment for a stock redemption

and after the redemption, shares owned by related taxpayers also are counted

Stock Redemptions

(slide 3 of 3)

• The tax consequences for the redeeming

corporation are summarized as follows

shares, the corporation recognizes realized gain (but not loss) on distributed assets

extent of the number of shares redeemed as a percentage of the shares outstanding before the buyback

Liquidations—In General

• Corporation winds up affairs, pays debts, and

distributes remaining assets to shareholders

losses upon distribution of its assets, with certain exceptions

Accumulated Earnings Tax

earnings accumulated without a reasonable business need

– Most businesses are allowed a $250,000 minimum credit– Beyond the minimum credit, earnings can be accumulated

for:

• Working capital needs

• Retirement of debt incurred in connection with the business

• Investment or loans to suppliers or customers , or

• Realistic business contingencies, including lawsuits or

self-insurance

Personal Holding Company (PHC) Tax

(slide 1 of 2)

• Enacted to discourage sheltering income in

corporations owned by individuals with high marginal tax rates

• Imposes a 20% tax

earnings to shareholders

PHC tax and the accumulated earnings tax

Personal Holding Company (PHC) Tax

(slide 2 of 2)

• A company is considered a PHC if:

stock was owned by five or fewer individuals at

any time during the last half of the year, and

corporation’s income is comprised of passive types

of income (dividends, interest, rents, royalties, or certain personal service income)

Refocus On The Big Picture (slide 1 of 4)

• A number of factors affect the tax treatment of Lime

Corporation’s distributions

• The amount of current and accumulated E & P (which differ

from retained earnings) partially determines the tax effect on the shareholders

– Given that Lime Corporation has had a highly profitable year, it is

likely that there is sufficient current E & P to cover the distributions

• If so, they are dividends to the shareholders rather than a return of capital

• Orange Corporation receives $200,000 of dividend income

that is mostly offset by the dividends received deduction

– The amount of the offsetting deduction depends on the ownership

percentage that Orange has in Lime

Refocus On The Big Picture (slide 2 of 4)

$300,000 value of the land less the $100,000

mortgage)

– Assuming that Lime is a domestic corporation and that

Gustavo has held his stock for the entire year, the land is a

qualified dividend

• As a result, the dividend is either tax-free (if Gustavo has a

marginal rate of 10% or 15%) or subject to a 15% (or 20%) tax rate (depending on Gustavo’s marginal tax rate)

– Gustavo’s basis in the land is its fair market value at

distribution, or $300,000.

Refocus On The Big Picture (slide 3 of 4)

distribution of appreciated property creates a deemed gain of $280,000

– $300,000 fair market value of the land less its $20,000

adjusted basis

– While the gain increases Lime’s E & P, the distributions to

the shareholders reduce it by $200,000 for the cash and

$200,000 for the land ($300,000 fair market value reduced

by the $100,000 mortgage).

Refocus On The Big Picture (slide 4 of 4)

What If?

• What if current E & P is less than the cash and land distributed

to the shareholders?

• Current E & P is applied pro rata to the cash and the land.

– Since the amounts received by the two shareholders are equal

($200,000 each), the current E & P applied is taxed as a dividend

– To the extent that the distributions are not covered by current E & P,

accumulated E & P is then applied in a pro rata fashion.

• However, Lime probably has a deficit in accumulated E & P

• As a result, the remaining amounts distributed to the two

shareholders are:

– First a tax-free recovery of stock basis, and

– Any excess is taxed as a sale of the stock (probably classified as capital

gain).

© 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 50

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PowerPoint Presentation for South-Western Federal

Taxation, please contact:

Dr Donald R Trippeer, CPA trippedr@oneonta.edu

SUNY Oneonta