Accounting 6073
Fall, 2010

Lesson 5B--Distributions In Kind and Constructive Distributions 

I.  Distributions in Kind--Introduction

	A.  Issues and Stakes--More complex than cash distributions in that 
		property distributions create additional issues

		1.  Main issue:  does corp. recognize income on distribution of 
			appreciated property?

		2.  Others
			a.   Does corp. recognize loss when it distributes depreciated prop?
			b.  effect of property distributions on e&p?
			c.  basis of distributed prop in the hands of shareholders

	B.  Pre 1954 History:  Judicial Non recognition--The "General Utilities" Doctrine

		1.  Courts generally held that the general rules requiring recognition
			of income on sale or exchange of property didn't apply 
			when corps distributed property in kind as dividends.
			Since corp. received nothing of value in exchange, courts found
			that no exchange was present and therefore no "disposition"
			that would trigger recognition of gain or loss.

		2.  Treasury argued in many cases that this result was incorrect because
			it allowed easy avoidance of corporate level tax on appreciated
			property.

		3.  Finally, congress sided with the treasury by enacting the predecessors
			of 311(a)(2) IRC (applicable to non liquidating distributions) and 
			336 (applicable to liquidating distributions).

	C.  1954-1986:  Rise and Fall of General Utilities

		1.  Original 311(a)(2) contained general principle of non recognition
			(codifying General Utilities), with some exceptions

		2.  Over time, congress enacted more exceptions

	D.  1986-present

		1.  In 1986, general principle of non recognition was changed to general
			principle of recognition, with enactment of 311(b) IRC
			(repealing General Utilities).

		2.  More culmination of a process than a reversal of course.

II.  Corporate Gain or Loss on Distributions of Property

	A.  Introduction:

		1.  Basic rule:  for non liquidating distributions of appreciated
			 property after 1986, corporations recognize gain as if the
			 property were sold for fair market value, unless
			 in a tax free reorganization or similar transaction.

		2.  Does not apply to transactions with shareholders in their capacity as
			debtors, creditors, employees etc, where the fact that such
			person or entity is also a shareholder is incidental to the 
			transaction.

	B.  Treatment of Losses 

		1.  New 311(a)(2) supersedes the general recognition rules in the
			case of distributions of depreciated property.  Therefore,
			in general, corps do not recognize loss when using 
			depreciated property to pay dividends.

		2.  Corps wishing to transfer depreciated property to shareholders
			and avoid 311(a)(2) must now sell prop to third persons
			who then sell to shareholders. (But may be attacked as 
			step transaction)

		3.    Direct sale would not work because of 267 IRC, and its
			 attribution rules.  

		4.  Best way to avoid--corp. sells prop directly at a loss and distributes
			proceeds to its shareholders.

	C.  Treatment of Gains

		1.  New 311(b) as noted above, requires corps to recognize gain
			on distributions of appreciated property to shareholders	
			with respect to their stock.

		2.  On dist of sub to parent, consolidated return rules will act to defer
			the gain.

		3.  If distributed property subject to a liability, fmv of property will
			be treated as not less than amount of liability.  This rule
			applied asset by asset (see e.g. p 8-81).

III.  Taxability of Distributions in Kind to Shareholders

	A.  Amount of Distribution and Basis Effects to Shareholders

		1.  Amount of distribution:  fmv of property
		2.  If distribution covered by current or accum e&p:  dividend equal
			to prop's fmv at date of distribution.

		3.  If fmv of distributed prop is in excess of e&p, reduces basis
			of s/h stock to zero, then excess is (probably)  CG.

		4.  NOTE:  distribution of appreciated property by corp. will create
			additional e&p and make dividend characterization 
			more likely.(see e.g. pp 8-83-84)

		5.  FMV of property distributed determined by corporation's 
			reasonable valuation efforts.

		6.  FMV of property distributed is reduced by any liability assumed
			or to which property is subject immediately before and 
			immediately after the distribution.

		7.  Shareholder takes FMV basis in distributed property
			a.  this basis is not reduced by any debt assumed, BUT
			b.  basis is limited to value of property if value is less
				than related debt assumed.

			c.  see e.g. p 8-85.
			d.  holding period begins with date of distribution

	B.  Effect of distribution on earnings and profits (IRC 312 (b))

		1.  In general--distribution of property whose fmv exceeds its adjusted 
			basis (using e&p principles):  see e.g. 3 p. 8-87

			a.  e&p first increased by the amount of such excess, then
			b.  e&p reduced by property's fmv, but not below zero.
			c.  any corporate tax on gain would reduce "interim" e&p
				--note cash and accrual may differ on this
			d.  see e.g. p 8-86
	
		2.  Distributions of depreciated property:  
			a.  no reduction of e&p due to unrecognized loss
			b.  fmv of dist is a dividend up to amount of e&p
			c.  e&p decreased by adjusted basis of prop distributed
			d.  see e.g. 2, p 8-86

		3.  One slight advantage of distribution of loss property is that
			it will sweep from e&p an amount in excess of its fmv.

4    Liabilities to which distributed property is subject or which are assumed by distributee cause an upward adjustment in corporate e&p.  See e.g. 4 on p. 8-87.

IV.  Constructive Distributions

	A.  In General
		1.  Dividend rules come into play (i.e. IRC 301) only if a distribution
			is paid to a shareholder in his/her capacity as a shareholder.

			a.  many kinds of payments to shareholders won't fall
				into this category (e.g. salary, interest, rent)

			b.  but if distribution paid to shareholder in that capacity,
				it is subject to dividend treatment even if not 
				formally declared as such.

			c.  This situation common in cases of closely held corps.

		2.  Hallmark of constructive distribution:  Value (or sufficiently 
			specific economic benefit) passes from corporation to 
			shareholder, for which the shareholder does not give
			equivalent value in exchange.

			a.  disproportionate transfers less vulnerable to constructive
				dividend treatment than pro rata ones.

			b.  not every corporate action that is beneficial to s/hs constitutes
				a constructive distribution.

		

		3.  Tax Issues and Stakes

			a.  Most disputes driven by desire of shareholders to extract dollars
				from corp. on a tax deductible basis.

b. Characterization of transaction as deductible expense or constructive distribution affects:
				i.  e&p computations,
ii. how recipient reports the amount received (income or ROC),
				iii. whether corporate recipient gets DRD.

			c. Note that transfers to shareholder's relatives may be constructive 
				distribution to shareholder.

	B.  Transactions That Are Vulnerable to Constructive Dividend Treatment
		
		1.  Excessive Salaries paid to shareholder and/or relatives
a.  If found to be unreasonable under IRC 162, corp. may not deduct	amount found to exceed "reasonable allowance."

b. If "service" rendered in shareholder capacity--treated as distribution.

			c.  If compensation paid to relatives exceeds reasonable allowance
given services performed--constructive dividend to shareholder(who may be in higher tax bracket).

d.  What is reasonable compensation?  Usually based on analysis of factors (case law on this).

		2.  Bargain Purchase of Corporate Property By Shareholders

			a. If sale of corporate property to shareholders for less than fmv, 
				there is a distribution under IRC 301 equal to difference 
				between fmv of property and amount shareholder paid.

			b. Same principle applies to bargain lease or uncompensated use
				of corporate property by shareholder.

				-- estimating the fair rental value--courts sometimes
				treat depreciation and maintenance charges
				as equal to fair rental value.

c.  Corporate issued option to purchase corporate property:  shareholder will have income equal to spread between option price and fmv of property when option exercised, unless option can be valued when received by shareholder.  In such case, distribution would equal the fmv of the option.

		3.   Excessive Payments by Corp for Purchase or Lease of S/H property: 

			Critical Test:  Are terms of the sale or lease ARM'S LENGTH??

		4.  Corporate Advances to Shareholders

			a.  Key issue here:  Is there an intent to create a bona fide debtor-
				creditor relationship?

				i.  This is a matter of facts and circumstances
				ii.  fairly common transaction in closely held corps, thus
				iii.  litigation is frequent in this area

			b.   Debt-Equity characterization principles are relevant here, thus
				failure to provide interest, or below market interest 
				makes transactions labeled as loans look more like 
				equity, and shareholder withdrawals more like dividends.

			c.  "Open account" loans with no provision for interest, and no 
				ascertainable maturity date are vulnerable here.

d.  If advance determined to be loan, imputed interest rules (IRC 7872) can create a constructive distribution if stated interest is below market.

e. A corporate guarantee of s/h debt becomes constructive distribution if corporation performs on the guarantee.

		5.  Corporate Payments on Loans By Shareholders

		  	If a shareholder advances money to a corporation, and that advance
		 	determined under debt-equity classification principles to be equity,
		 	"interest" payment to s/h will' be treated as a distribution.

		6.  Corporate Payments for Shareholders' Benefit

a.  Key issue:  Is the corporate expenditure incurred primarily for the benefit of the corporation's trade or business or the
				personal benefit of the shareholder?

			b.  Unless the payment is satisfaction of shareholder debt ( a clear 
				case where payment is primarily for shareholder's benefit),
				it may not be easy to determine the primary beneficiary. 
				Payments can encompass both elements:  e.g. entertainment 
				expenses paid by corp.)

		7.  Unlawful diversion of Corporate Income by Shareholder

			a.  This might include shareholder interception of payments meant
for corporate accounts, collection of kickbacks from suppliers.  These payments are often treated as constructive dividends.

			b.  IRS may try to have these payments taxed under IRC 61a, 
				since they are then ordinary income without regard to 
				corporation's earnings and profits. BUT

			c.  Tax court has held that such payments must be treated as 
				constructive distributions, and not automatically as
gross income under section 61.  See James v Truesdell 89 TC 1280 (1987) (acq.).

		8.  Triangular Distributions (Corps under common control)

a.  Transactions between two corporations under common control can be treated as constructive distribution to controlling shareholder even though nothing passes directly to s/h.

			b.  Bargain element may be distribution to controlling shareholder
followed by contribution to capital of benefiting corporation.  See e.g. p 8-57.

			c.  May include such transactions as purported loans, purported 
				purchases of assets, purported business expenses, 
				purported. purchases of assets, and pure diversions.

			d.  When transactions between affiliates are arm's length, there 
				should be no constructive distribution problem.

			e.  If no discernible economic benefit to parent, may not be 
				a constructive distribution to parent, but reallocation may 
				still occur under inter-company pricing rules of IRC 482.