Accounting 6073
Fall, 2010

Lesson 5A--Dividends and Other Non-Liquidating Distributions (In General)

I.  Overview of Distributions Generally

	Corporations exist to feed their shareholders.  They can do so in two ways:

		A.  Payments to shareholders other than in their capacity as shareholders
		 such as 
			1.  Salaries
			2.  Rents 
			3.  Interest
			4.  Royalties etc.

		B.  Distributions to shareholders in their capacity as shareholders (with
		 respect to shareholders' stock)  such as

			1.  one way transfer of property (a dividend)
				a.  cash 
				b.  distributions in kind (other prop, incl corp securities) 
			2.  one way transfer of corp's own stock (stock dividend)
			3.  distribution in exchange for stock 
				a.  treated as a dividend (ord income)
				b.  not treated as a dividend (capital transaction)
			4.  distribution in liquidation
			5.  distribution/exchange of stock and/or other prop in
				a transaction qualifying as a reorganization.

II.  Property Distributions Generally; Distributions of Cash

	A.  Introduction
		1.  Double Taxation exists because corporate income taxed to corporation,
			while dividends are taxable to shareholders.
		2.  Framework for this structure:  IRC 301(a), 301(c), 316
			a.  These sections concerned w/ corporate dist of property
			b.  property includes any item of economic benefit to 
				shareholders, except
				--corporation's own stock
				--stock rights
		3.  Corporate distributions,
			a.  with respect to stock,
			b.  to extent paid from current or accumulated earnings and profits,
	
		are dividends which must be included in shareholder's gross income 
		under 301(c)(1) and 61(a)(7) IRC. “Qualified” Dividends taxed as CGs.

		4.  Distributions not out of current or accumulated e&p:
			a.  first, return of capital, reduce stock basis to 0
			b.  then, capital gain unless out of pre 1913 increase in value.

		5.  Is this fair?
			a.  makes sense that original investors shouldn't pay tax on 
				distributions till corporation makes a profit (and has e&p)

			b. Less clear when another investor has purchased stock from 
				original investor.  Perhaps a dist to this shareholder should
				also be a return of capital. But if corporation has e&p, 
				dividend treatment is mandatory, even if none of the e&p.
				has accumulated since the new investor bought the stock.

			c.  Even less clear, when an investor purchases publicly traded 
				stock, price of shares may be affected by bidding, and may 	
				not accurately reflect future dividend potential, or a 	 
				discount for income taxes to be paid. This may distort pure 	
				economic reality.

		6.  This system treats different taxpayers in different ways
			a.  non corporate shareholders generally prefer non dividend 
				distributions (no basis offset)
			b.  corporate shareholders prefer dividends (DRD)

		7.  Special Rules exist for
			a.  distributions in kind (corporate property other than money)
			b.  distributions of the corporation's own obligations
			c.  distributions of the corporation's own stock or rights
			d. preferred stock bail outs
			e.  distributions in redemption (including liquidations)
			f.  distributions in reorganizations and similar transactions

III.  Dividend:  A Term of Art

	A.  General Rule:  (as above)
		1. To extent distribution is a dividend (IRC 316), include in GI per IRC 61
		2.  Excess, if any is return of capital per IRC 301 (c)(2)	
		3.  Excess, if any, is taxable gain per IRC 301(c)(3).
		4.  Under 316, a distribution is a dividend if out of 
			a.  current year earnings and profits or
			b.  earnings and profits accumulated after 2/28/13.

	B.  Ordering and Tracing Rules
		1.  Under 316(a), two irrebuttable presumptions
			a.  every distribution comes from e&p to extent thereof
			b.  every distribution comes from most recent e&p first

		2. To determine whether a given distribution is from current e&p
			a.  e&p computed at y/e, without reduction for c/y distributions.
			b.  dists. on pref. stock absorb e&p before dists. on common
			c.  if redemptions treated as exchanges reduce e&p, that 
				reduction takes place after dists. on pref. and common.

	C.  Distributions from current earnings
		1.  Problem:  because distributions come first from current earnings, a
			distribution may be a dividend if corp. has current earnings, but
			an accumulated deficit, even if current earnings are insufficient 
			to repair the deficit.

		2.  Can avoid this by waiting till next year to make the distribution.  If no 
			current earnings and still accum deficit, such a distribution would
			be a tax free return of capital.

	D.  Distributions from accumulated earnings
		1.  Generally means e&p accumulated up thru end of preceding year
		2.  Since dividends paid from c/y e&p first, may not need to compute
		3.  But two situations where accumulated e&p on date of dist is relevant:
			a.  where positive accumulated e&p and c/y to date deficit, dist is
				from accumulated e&p, reduced by a pro rata share of 
				current e&p if current year deficit cannot be specifically 
				allocated to a specific part of the year.
			b.  two or more distributions in taxable year reduce e/p in order 
				they occur.  See p. 8-17, e.g. 3.

	E.  Distributions where no current or accumulated e/p
		1.  Dist is return of capital, and is applied against stock basis.
		2.  Any excess is gain from sale or exchange, unless from pre
			1913 increase in value.
		3.  Such gain is capital gain if stock is a capital asset to s/h
		4.  If from pre 1913 increase in value, exempt from tax.
		5.  Distributions only reduce e&p to zero, cannot create deficit in e&p

	F.  See examples pp8-17--8-18.

IV.  Earnings and Profits  

	A.  General Background and Evolution
		1.  Code does not globally define earnings and profits
		2.  Judicially defined at first, but congress has now prescribed how
			some items are treated.
		3.  There is no statute of limitations governing the e&p effect of
			prior transactions, thus, corps should keep records indefinitely.

	B.  Definition and Basic Approach
		1. At first, treasury seemed to view e&p as identical to book surplus
		2.  But because of divergence in financial and tax accounting principles, 
			this approach could not work 
			
			e.g. if "surplus” were the criterion for dividend treatment, a 	
			corporation could sweep its surplus account clean with a  
			contingency reserve or a tax-free stock dividend.  Then it could 
			pay cash to shareholders free of tax.

		3.  E&P is largely an economic concept used to approximate a 
			corporation's power to make distributions that are more 
			than just a return on investment.  See examples on p. 8-21

		4.  Although E&P not identical to book surplus, or aggregate taxable 
			income, there is a relationship among all three.  

		5.  Most common approach is to begin with taxable income.  Note
			that accounting method for computing e&p is the same as 
			that used for tax purposes.

	C.  Certain items excluded from Taxable Income included in E&P
		1.  Income not taxable under Federal Constitution (muni. bond interest)
		2. Income exempt by statute--not clear what this means. Commentators:
a. probably exclude from e&p gifts and bequests (similar to cap contribution)
	
			b.  probably include in e&p 
				life insurance proceeds
				muni bond interest
				compensation for injuries/sickness

		3.  Income deferred in basis derivative non-recognition transaction 
			(e.g. like kind exchange, 351 transaction) is not included in e&p
			 until the gain is recognized.

		4.  Non taxable capital contributions not included in e&p

	D.  Certain deductions in computing taxable income do not reduce E&P
		
		Basically, this category consists of artificially created deductions allowed 
		in computing taxable income, but which do not represent actual expenses
		of the corporation.  For example
	
		1.  Excess of percentage depletion over cost
		2.  Dividend received deduction 
		3.  Net operating loss deduction (since it is a carryover from another year,
			and reduced e&p in the year it arose)

	E.  Timing differences:  Deferred Income and Accelerated Deductions

		In computing e&p, a corporation may not have the benefit of certain
		rules that allow deferral of income or acceleration of deductions for
		tax purposes, such as

1.  MACRS Depreciation—must use straight line or ADR system, for e&p purposes.

		2.  Other items designed to convert taxable to "economic" income   
			a.  no installment sale treatment
			b.  must use percentage of completion for contracts etc.

		3.  Apparently, the resulting increases to e&p are not offset by the 
			increase in income tax that would result if taxable income
			were computed in this manner.

	F.  Certain Items not deductible for tax purposes may reduce E&P

		These items are those which are not allowed as tax deductions, but 
		which clearly deplete the income available for distribution to
		shareholders...for example:

		1.  prior year dividend distributions
		2.  Federal income taxes, net of credits
		3.  expenses of earning tax exempt income
		4.  excess charitable contributions
		5.  recognized but disallowed losses 
			--excess of CL over CG
			--related party losses disallowed by 267IRC
		6.  Travel and entertainment expense not allowed as tax deduction

		7.  Not clear:  how to treat expenses contrary to public policy

	G.  Corporate Distributions and Changes in Capital Structure

		Other financial transactions corporations sometimes engage in 
		may affect e&p, such as

		1.  receipt of tax free distributions from other corporations
		2. distributions by corporation of property in kind, its stock or obligations
		3.  distributions in partial liquidation or redemption

		ETC.

V.  Tax Accounting Principles in Computing E&P and Dividend Income

	A.  Accounting for E&P--Generally follow corporation’s tax accounting method
			
		1.  thus, corporation's basic choice of cash or accrual
			method is binding for computation of E&P

		2.  inventory method and special elections (e.g treatment of 
			research expenses) probably also binding for e&p
			unless use barred by 312(n) IRC.

	B.  Accounting for Dividends

		1.  Distributions with respect to stock reduce e&p by
			a.  amount of cash
			b.  issue price of corp's own obligations
			c. adjusted basis of property, adjusted upward to fmv
				to extent gain is recognized by corp. on the distribution

		2.  Time of distribution
			a.  relevant for determining whether there is current 
				or accumulated e&p

			b.  IRS has ruled that "date of payment" rather than 
				declaration or record date is controlling.  This means
				the date when the payment passes beyond corporation's 
				control e.g. when it is mailed.

			c.  Date of inclusion in s/h's income is date of actual or
				constructive receipt for both cash and accrual basis
				taxpayers.

		3.  Corporations who treat distributions to their shareholders as other 
			than dividends must file special report showing a computation of
			their E&P.

VI.  Assignment of Dividend Income and Related Problems 
	
	A.  Gifts of stock and/or Dividend Rights
		1.  assignment of mere right to receive dividends without 
				transfer of underlying stock doesn't shift taxability
				of dividend to transferee.

		2.  but if stock is also transferred before dividend record
				date, taxability will shift to donee.

	B.  Sales--cannot convert dividend income to CG by selling stock after dividend 
		record date but before payment date.  However, sale after declaration date 
		but before record date usually produces CG in full to seller and dividend 
		income to buyer, unless extreme case.

VII.  S Corporations:  Events Terminating Election:

	A.  Revocation:  A corporation may terminate its S election if and only if 
		shareholders holding > 50% of stock consent.

		1.  Revocation is effective in current year if made by 15th day of 
			third month.

		2.  Otherwise, revocation is effective for succeeding taxable year.

	B.  Disqualification:  If corporation ceases to be a small business corporation
		1.  > 100 shareholders
		2.  non-res. alien shareholder
		3.  s/h who is not an individual, estate, qualified trust
		4.  issuing a second class of stock

	C.  Excess Passive Investment Income--if S corp. has 

		1.  Subchapter C E&P at close of each of three consecutive 
			post-1981 “S” years AND

		2.  more than 25% of its gross receipts for each of those years
			consist of "passive investment income" THEN

		3.  S election automatically terminates at end of 3rd year

		4.  Purpose:  keep S corp from becoming vehicle for investing in 
			items that their shareholders would have invested in had the
			subchapter C e&p been paid out as dividends.

	D.  Inadvertent Terminations
		1.  Termination for disqualification as small business corporation and 
			for excess net passive investment income can be 
			forgiven if

a.	IRS determines termination was inadvertent
b.	Disqualifying event corrected in reasonable time
c.	S/h and corporation agree to treat the election as in effect
				during period of termination.

		2.  Amnesty is to be applied in reasonable manner-no tax
			avoidance is to result from continued S treatment.

E.	Short Taxable Periods:  If S status terminates for less than entire 
		year, it creates two short periods.

		1.  First period, treated as S corp.
2.	Second period, treated as C corp.
a.	income during this period is annualized
3.	All items of income, deduction and credit are allocated
			between the two periods on a daily basis, unless all
			shareholders agree to apply normal accounting rules
			to both periods.

VIII.  S Corporations:  Corporate Level Taxes on Built In Gains and Excess Net Passive Investment Income.

	These taxes have been enacted to curb use of the S election as tax avoidance
	tactic by existing C corporations.

	A.  Tax on Built In Gains

		1. Pass through of capital gains to shareholders has encouraged
			"one shot" election by C corps about to realize a large CG.

			a.  results in only one level of tax on CG, where there would
				otherwise be two levels.

			b.  after distribution, the S corp. would revoke its S election and
				resume C status.

		2.  To discourage, IRC 1374 imposes tax on recognized "built in gains"

			a.  tax is at S corporate level
			b.  applies for 10 year period beginning with first S year
			c.  excludes gains on certain assets
				--those not held by corporation when elected S status
				--gain to extent it exceeds spread between fmv
					and adjusted basis of asset at time asset
					was first held by the corp.
			
			d. in effect, what is left to tax is gain that accrued but was not 
				recognized before corporation's S election was effective. 
				This is what is known as the "built in gain"

		3.  BIG is taxed at maximum corporate rate (35%)--mitigated by
			a.  corps can use former C year attributes (e.g. NOL, C/L c/fs)
			b.  even though computed asset by asset, subject to overall
				ceiling equal to aggregate net built in gain at the
				beginning of S election period.

		4.  See example p. 6-39

		5.  Note that tax applies not only to capital assets but to any property that
			is appreciated, including inventory, a/r and installment obligations.

		6.  "Built in loss" property contributed to corporation in anticipation of
			S election to reduce aggregate net built in gain is subject to 
			"anti-stuffing" rules.

		7.  Tax doesn't apply to corporation that has always been an S, unless it
			acquired assets in a carryover basis transaction from a C corp.

	B.  Tax on Excess Net Passive Income

		1.  As noted earlier, excess NPI for 3 years can cause S termination
		2. But tax applies in ANY year that S corp. has excess NPI
		3. Tax applies if
			a.  S corp. has ANY C corp. e&p at close of taxable year AND
			b.  more than 25% of its gross receipts consist of 
				"passive investment income", which includes income from 
					--  rent
					-- royalties
					-- dividends
					-- interest
					-- annuities
					-- sales or exchanges of stock or securities			

			c.  tax is imposed on "excess net passive income" which is
				defined as the amount that  bears the same ratio to 
				net passive income for the year as (passive investment
				income-25% of gross receipts) bears to total passive
				investment income for the same year.
			d.  rate of tax = 35%
			e.  see example p 6-42
		
		4.  IRS may waive tax if corp. establishes that it determined in good faith
			that it had no e&p, and that it distributed that e&p within a 
			reasonable time after it found that determination to be 
			erroneous.

5.	Again, this tax is n/a if corporation has always been an S, unless it 
	acquired C Corp e&p in a carryover basis transaction.

IX.  Other Comments Regarding S Corporations

	A.  C corps using LIFO inventory method are required to recognize gain
		 to the extent of the difference between the LIFO basis and the 
		FIFO basis of their inventories at the time they make a S election.

	B.  It has been proposed that "large" C corps that convert to S status should 
		undergo a deemed liquidation in which they would recognize built in 
		gains at the corporate level.

		1.  Stated purpose--to harmonize conversion of C corp to S corp
			with conversion of C to partnership

		2.  However, there appears to be little flexibility in these proposed rules
			and this be a very bad result for C corps with appreciated 
			assets.

		3.  Practical effect may be to discourage many C corps from electing S

	C.  Another proposal:  to allow existing S corps to convert tax free to
		 partnership status at the shareholder level.

		1.  But S corp. would have to recognize any built in gains
		2.  Election would not be available if S has any C e&p
3.  This too may discourage S, especially if built in gains are small, because partnership regime is more flexible 
			than S regime.