Corporations: Earnings & Profits and Dividend Distributions

CHAPTER 10 CORPORATIONS: EARNINGS & PROFITS AND DIVIDEND DISTRIBUTIONS SOLUTIONS TO PROBLEM MATERIAL Question/ Problem 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Topic Status: Present Edition Amount of dividend income Modified Amount of taxable income; balance in E & P Unchanged Ethics problem Unchanged Deficit in E & P followed by sale on Unchanged installment method; taxation of dividend distribution Issue recognition Unchanged Amount of dividend income; deficit in current Modified E & P with positive balance in accumulated E&P Cash distributions; determination of taxable Unchanged amount Cash distributions; determination of taxable Modified amount; gain on sale of stock Cash distributions; determination of taxable Unchanged amount Effect of selected transactions in adjusting Unchanged taxable income (for determining E & P) Effect of specified transactions on taxable Unchanged income; on E & P Effect of specified transactions on taxable New income; on E & P Tax treatment to shareholder and to Modified corporation on distribution of property subject to liability in excess of basis Tax treatment to corporate shareholder and to Unchanged distributing corporation of property subject to a liability 10-1 Status: Q/P in Prior Edition 1 2 3 4 5 6 7 8 9 10 11 13 14 Q/P 10-2 Question/ Problem 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 Topic Taxation of dividend when E & P has positive balance but corporation has current loss Property distribution; taxation to shareholder and to corporation Property distribution where FMV is less than adjusted basis Issue recognition Selected factors in determining reasonableness of compensation Constructive dividends Property dividend; liability assumed by shareholder; determination of E & P; distribution of loss property Property distribution to corporate shareholder; basis in excess of FMV; liability assumed by shareholder Effect of specified transactions on taxable income; on E & P Dividend distribution; effect on E & P Dividend distribution; effect on E & P Dividend distribution; effect on E & P Interest free loan to shareholder Basis of nontaxable preferred stock dividend Stock dividend; basis allocation; gain on sale Stock rights; basis allocation; gain on sale How to structure a dividend payment Source of dividend distribution Present Edition in Prior Edition Unchanged 15 Unchanged 16 Unchanged 17 Unchanged Unchanged 18 19 Unchanged Modified 20 21 Unchanged 22 Unchanged 23 Unchanged New New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged 24 27 28 30 31 32 33 Research Problem 1 2 3 4 5 6 Earnings and profits and tax evasion Repayment of unreasonable compensation Dividend in anticipation of corporate sale Corporate deduction of luxury auto & constructive dividend to shareholder Internet activity Internet activity Unchanged Unchanged Unchanged New 1 2 3 Unchanged New 5 PROBLEM MATERIAL 10-3 1. Sylvia and Jerry have ordinary dividend income of $65,000 each [$100,000 (Egret Corporation’s accumulated E & P) + $30,000 (Egret Corporation’s current E & P) ÷ 2]. The remaining $10,000 of the $140,000 distribution reduces the basis (up to $5,000 each) in the shareholders’ stock in Egret Corporation with any excess treated as a capital gain. Sylvia reduces her basis from $24,000 to $19,000. Jerry has a reduction in stock basis from $4,000 to zero and a capital gain of $1,000. pp. 10-2, 10-3, and Example 1 2. a. Vireo reports $300,000 dividends as taxable income but has a dividends received deduction under § 243 of $210,000 (70% X $300,000). None of the other items affect taxable income. Thus, there is a net increase of $90,000 (as a result of the dividends and associated dividends received deduction), or a taxable income of $315,000. b. Vireo Corporation’s E & P as of December 31 is $630,000, computed as follows: $80,000 (beginning balance in E & P) + $315,000 (taxable income) + $210,000 (dividends received deduction) + $50,000 (tax-exempt interest) - $25,000 (interest on indebtedness to purchase tax-exempt bonds). pp. 10-4 to 10-7 3. Playing Games with the Statute of Limitations (page 4-21). Steve is courting disaster, and he could not convert capital gains to ordinary income. An obscure set of Code provisions (§§ 1311-1314) serves to mitigate the effect of the statute of limitations. Based on the concept of equity, these provisions preclude both the IRS and taxpayers from taking current advantage of past errors, the correction of which is no longer possible. These provisions would permit the IRS to reopen tax year 1993 and assess against Steve the tax he would have paid had he properly reported the dividend income. On the other hand, if Steve stays with the basis reduction he originally made, he has not taken an inconsistent position. Therefore, §§ 1311-13114 cannot be used by the IRS. pp. 10-2 and 10-3 4. Nick reports the entire $200,000 as a taxable dividend. The $1,350,000 gain on the sale of the land increases E & P by that amount. Thus, the balance in E & P prior to the $200,000 distribution is $1,080,000 [$1,350,000 (gain) - $90,000 (deficit) - $180,000 (tax loss)]. There is adequate E & P; thus, the entire distribution is a dividend. (If the deficit were sufficient to eliminate E & P, the distribution would still be a dividend because current E & P would be sufficient to cause the entire distribution to be a taxable dividend.) pp. 10-4, 10-5, and Example 6 5. • Is the distribution from corporate earnings? • Is the distribution in partial or complete liquidation of Yellow Corporation? • Does the distribution qualify as a stock redemption for tax purposes? • What is the tax basis of each of the shareholder's stock investment in Yellow Corporation? • What is the E & P of Yellow Corporation? • Has corporate E & P been determined accurately for tax purposes? • How will the distribution affect E & P for Yellow Corporation? 10-4 Another factor that is important is the nature of the shareholder. In the case of a corporate shareholder (Maize Corporation in this situation), dividend treatment would be preferable to a capital gain result since the dividends received deduction is available to corporate shareholders. pp. 10-2 to 10-10 6. Dividend income is $50,000 and $150,000 is a return of capital, of which $135,000 is taxed as a capital gain. To determine the amount of dividend income, the balances of both accumulated and current E & P as of September 30 must be netted because of the deficit in current E & P. Three-quarters of the loss, or $300,000, is deemed to have occurred by September 30; thus, the $350,000 in accumulated E & P is reduced by $300,000. The $50,000 balance remaining in E & P triggers dividend income. p. 10-10 and Example 11 7. Amount Taxable Return of Capital a. $ 70,000 $80,000 Accumulated E & P and current E & P are netted on the date of distribution. There is a dividend to the extent of any positive balance. b. $ 40,000 $50,000 Taxed to the extent of current E & P. c. $220,000 $ -0- Taxed to the extent of current and accumulated E & P. d. $ 80,000 $40,000 Accumulated E & P and current E & P netted on date of distribution. e. $110,000 $10,000 When the result in current E & P is a deficit for the year, the deficit is allocated on a pro rata basis to distributions made during the year. On June 30, E & P is $110,000 [current E & P is a deficit of $30,000 (i.e., 1/2 of $60,000) netted with accumulated E & P of $140,000]. pp. 10-7 to 10-10 8. Amount Taxable Capital Gain a. $120,000 $10,000 Taxed to the extent of current E & P. Capital gain to extent distribution exceeds E & P plus stock basis. b. $100,000 $ -0- Taxed to the extent of current and accumulated E & P. c. $ 70,000 $ -0- Taxed to the extent of current E & P. d. $ 50,000 $20,000 Accumulated E & P and current E & P are netted on the date of distribution. There is a dividend to the extent of any positive balance. e. $ 90,000 $ -0- When the result in current E & P is a deficit for the year, such deficit is allocated on a pro rata basis to distributions made during the year. Thus, on June 30, current E & P is a deficit of $80,000 (i.e., 1/2 of 10-5 $160,000). This is netted with accumulated E & P of $210,000 to cause all of the distribution to be taxed. pp. 10-7 to 10-10 9. The $80,000 in current E & P is allocated on a pro rata basis to the two distributions made during the year; thus, $40,000 of current E & P is allocated to Carrie Lynn’s distribution and $40,000 is allocated to Rajib’s distribution. Accumulated E & P is applied in chronological order beginning with the earliest distribution. Thus, the entire $95,000 is allocated to Carrie Lynn’s distribution. As a result, the distribution of $150,000 to Carrie Lynn on July 1 is taxed as dividend income to the extent of $135,000 ($95,000 AEP + $40,000 current E & P for ½ of the year). The remaining $15,000 reduces the basis in Carrie Lynn’s stock to $35,000. Carrie Lynn then recognizes a capital gain of $165,000 on the sale of the stock [$200,000 (selling price) - $35,000 (remaining basis in the stock)]. The distribution to Rajib of $150,000 is a taxable dividend of $40,000 and a $110,000 reduction in his stock basis. Thus, Rajib’s basis in the Junco stock is $90,000 [$200,000 (original cost) - $110,000 (reduction in basis from the distribution)]. pp. 10-7 to 10-10 10. a. Wren Corporation's taxable income for 2000 is reduced by the amount of gain reported on the collection of the note receivable in determining Wren Corporation's E & P. Wren Corporation's E & P for 1999 would have been increased for the entire amount of the deferred gain on the installment sale; thus, E & P for 2000 should not include any gain attributable to the sale in 1999. b. Wren Corporation's taxable income for 2000 is increased by the amount of the charitable contribution carryover in determining Wren Corporation's E & P for 2000. The excess charitable contributions would have reduced E & P in 1999; so there is no need for further reduction in 2000. c. Wren Corporation's taxable income is reduced by the excess capital loss in determining its E & P. The excess capital loss that cannot be utilized in computing Wren Corporation's taxable income is nonetheless a reduction in its E & P account for the year. d. Gains and losses from property transactions affect the determination of E & P only to the extent that they are recognized for tax purposes. Thus, the deferred gain would also be deferred for purposes of E & P and no adjustment to taxable income would be necessary. e. Wren Corporation's taxable income for 2000 is reduced by the excess charitable contribution deduction in computing its E & P for 2000. f. Wren Corporation’s taxable income for 2000 is increased by 80 percent of the § 179 expense elected (only 20 percent is allowed for E & P purposes). The expense must be spread over five years for E & P purposes. p. 10-7 10-6 11. a. b. c. d. e. f. Taxable Income Increase (Decrease) E&P Increase (Decrease) No effect No effect No effect ($ 20,000) ($ 10,000) $ 30,000 $ 15,000 ($ 15,150) $ 100,000 ($ 10,000) $ 10,000 $ -0- Note: The deduction of the remaining $10,000 charitable contribution in e. is an increase in E & P because taxable income was reduced by that amount while E & P was reduced in the prior year for the additional contribution. E & P is not increased in f. because the $30,000 has already been included in taxable income. The realized gain is not an increase in E & P, only the recognized gain which is included in taxable income. E & P is decreased only $10,000 in d. because the additional $20,000 was already included in taxable income. Concept Summary 10-1 12. Taxable Income Increase (Decrease) a. b. c. d. e. f. g. h. i. No effect ($30,000) $50,000 $ 3,000 No effect ($12,000) No effect ($80,000) No effect E&P Increase (Decrease) ($ 40,000) * $ 26,000 ** $150,000 $ 7,000 *** No effect $ 9,600 † ($ 2,400) †† $ 30,000 ††† $ 60,000 * While the related party loss is not deductible under the income tax, it must be subtracted from E & P. ** Although intangible drilling costs are deductible in full under the income tax, they must be amortized over 60 months when computing E & P. Since $500 per month is amortizable ($30,000/60 months), $4,000 is currently deductible for E & P purposes ($500 X 8 months). Thus, of the $30,000 income tax deduction, $26,000 must be added back to E & P ($30,000 - $4,000 deduction allowed). *** The receipt of a $10,000 dividend will generate a dividends received deduction of $7,000. The net effect on taxable income is an increase of $3,000. For E & P purposes, the dividends received deduction must be added back. † Only 20% of current-year § 179 expense is allowed for purposes of E & P. Thus, 80% of the amount deducted for income tax purposes is added back. †† In each of the four succeeding years, 20% of the § 179 expense is allowed as a deduction for E & P purposes. ††† Only ADS straight-line depreciation reduces E & P; thus, E & P is increased by $30,000, which is the excess of MACRS depreciation taken over the amount allowed under ADS. Concept Summary 10-1 10-7 13. a. Vireo has a gain of $75,000 on the distribution, computed as follows: $195,000 (liability on the property exceeds fair market value) - $120,000 (basis of the property). Vireo’s E & P is increased by the $75,000 gain. In addition, E & P is decreased by $195,000 (representing the deemed fair market value of the property), less the $195,000 liability on the property, or zero. Thus, E & P is $285,000, computed as follows: $210,000 (beginning E & P balance) + $75,000 (gain on distribution). b. Pete has dividend income of zero, computed as follows: $195,000 (value of the property based on liability) - $195,000 (liability on the property). Pete has a basis of $195,000 in the property. pp. 10-11 to 10-14 14. a. Dividend income to Orca is $80,000 [$110,000 (fair market value of the property) $30,000 (liability assumed)]. The amount taxed to Orca is reduced by the dividends received deduction. b. Orca’s basis in the property is $110,000. c. The distribution reduces Penguin’s E & P account by $120,000 [$150,000 (adjusted basis of the property) - $30,000 (liability assumed by Orca)]. pp. 10-11 to 10-14 15. To determine the taxability of the $35,000 distribution, the balance of both accumulated and current E & P as of July 1 must be determined and netted. This is necessary because of the deficit in current E & P. One-half of the $30,000 loss, or $15,000, reduces E & P to $25,000 as of July 1 ($40,000 - $15,000). Thus, of the $35,000 distribution, $25,000 is taxed as a dividend and $10,000 represents a return of capital. p. 10-10 and Example 11 16. Crossbill Corporation recognizes a gain of $140,000 on the distribution. Crossbill’s E & P is reduced by $145,000 [$180,000 (fair market value) - $35,000 (liability)]. Janel has a taxable dividend of $145,000 [$180,000 (fair market value) - $35,000 (liability)]. The basis of the equipment to Janel is $180,000. pp. 10-11 to 10-14 17. Homer has a taxable dividend of $60,000 and a basis in the land of $60,000. Gold Corporation does not recognize a loss on the distribution. Gold’s E & P is reduced by $100,000. pp. 10-11 to 10-14 18. • What basis do Cybil and Sally have in their stock in Copper Corporation after their initial transfers for stock? • Does Sally’s transfer qualify under § 351 of the Code as a nontaxable exchange? • How is Copper Corporation taxed on the property distribution to Cybil? • How do the distributions to Cybil and to Sally affect Copper’s E & P? • How will Cybil and Sally be taxed on the distributions? • What is Cybil’s basis in her stock when she sells it to Dana? • How are Cybil and Dana taxed on the $80,000 distribution to each? pp. 10-2 to 10-10 10-8 19. 20. a. The determination of the reasonableness of compensation paid to an employee who is not a shareholder but is related to the sole owner of the corporate-employer should be made in the same manner as that for salary paid the shareholder-employee. The degree of relationship between the sole owner of the corporation and the employee should be considered initially to determine if, in essence, the salary could be considered as having been paid to the owner. If so, the same factors used to determine the reasonableness of that paid to the owner should be used to determine the reasonableness of that paid to the related employee. b. That the employee-shareholder never completed high school should be relevant only with respect to the nature and scope of the employee's work. Is education beyond high school required for the type of work performed by the employee-shareholder and the salary received for such work? c. The fact that the employee-shareholder is a full-time college student might well cause any salary paid to be deemed excessive. d. If the employee-shareholder was underpaid during the formative period of the corporation, this is evidence of reasonableness of the compensation if a portion thereof is for service rendered in prior years. e. If a corporation has substantial E & P and pays only a nominal dividend each year, a constructive dividend may be found. f. Year-end bonuses would be vulnerable to constructive dividend treatment, particularly if they are related to profit for the year, are paid only to shareholder-employees, and are determined at year-end on an arbitrary basis. pp. 10-15 and 10-16 a. The result of this transaction is, in effect, a realized loss of $7,000 (the difference between basis of $30,000 and fair market value of $23,000) and a constructive dividend of $8,000 (the difference between the $23,000 fair market value and the $15,000 paid for the lot). Due to the application of § 267, Emu cannot recognize the realized loss. However, the loss does reduce Emu’s E & P. The constructive dividend also reduces E & P. Thus, E & P is reduced by $15,000 (the sum of the $7,000 disallowed loss and the $8,000 constructive dividend). b. The loan to Cameron will generate imputed interest since no interest was charged. The amount of imputed interest will be $11,275 [($110,000 X 10% X ½ year) + ($115,500 X 10% X ½ year)]. This amount will be deemed paid as interest from Cameron to the corporation. The deductibility of the interest by Cameron will depend upon how the loan proceeds are used. Emu will have taxable interest income of $11,275. Finally, Emu will be deemed to pay a dividend to Cameron equal to the amount of interest. Emu’s E & P will be increased by the amount of interest income and reduced by the amount of deemed dividend payment. c. Bargain rentals create constructive dividends to shareholders. In the present case, the amount of constructive dividend to both Cameron and Connor equals the fair rental value of the cottage. Thus, both shareholders will receive dividend income of $7,000 ($3,500 X 2 weeks) and Emu’s E & P will be reduced by the same amount. d. The $5,000 excess amount ($12,000 - $7,000) paid to Cameron by Emu over the fair rental value of the truck will be treated as a constructive dividend, taxable to Cameron. The dividend will also reduce Emu’s E & P. pp. 10-15 to 10-17 10-9 21. a. Taxable income to Lea is $20,000 [$100,000 (value of the property) - $80,000 (liability)]. b. Corporate E & P after the distribution is $77,350, computed as follows: Beginning E & P Add: Taxable income $320,000 Proceeds of term life insurance 46,400 Subtract: Federal income tax (108,050) Life insurance premiums (2,000) Property distribution (220,000) * Prior year installment sale income (10,000) E & P of Plover after the distribution * $51,000 26,350 $77,350 E & P is reduced by the greater of the fair market value ($100,000) or adjusted basis of the property ($300,000), less the amount of liability on the property ($80,000). c. The tax basis of the property to Lea is $100,000. d. If Plover had sold the business property at its $100,000 fair market value, it would have recognized a loss of $200,000. This loss would offset $200,000 of taxable income in the current year, creating Federal tax savings of $78,000 ($200,000 X 0.39). After paying off the $80,000 loan, Plover would have a total of $98,000 to distribute to Lea [$78,000 (tax savings) + $100,000 (sales proceeds) - $80,000 (loan balance)]. Immediately following the property sale, Plover’s E & P balance would be: Beginning E & P Add: Taxable income Proceeds of term life insurance Subtract: Life insurance premiums Federal income tax Income from prior year installment sale E & P of Plover after the distribution $51,000 $120,000 46,400 (2,000) (30,050) (10,000) 124,350 $175,350 Thus, Lea recognizes a taxable dividend of $98,000. Plover’s E & P would be reduced to $77,350 after the distribution. Note that this result is superior to a distribution of the property to Lea. In particular, the corporation receives a $200,000 deduction, while Lea’s income is only increased by $78,000. pp. 10-2 to 10-14 22. a. b. Verdigris Corporation has dividend income of $10,000 [$60,000 (fair market value of the land) less $50,000 (liability on the land)]. The $10,000 is subject to the dividends received deduction under § 243 of $8,000, so that only $2,000 is taxed to Verdigris Corporation. Verdigris Corporation has a basis of $60,000 in the land. Rust Corporation may not deduct the loss on the land. Its E & P is reduced by $40,000, the $90,000 basis of the land (which is greater than the fair market value) less the $50,000 liability on the land. 10-10 pp. 10-11 to 10-14 23. Taxable income: Income from services rendered Dividend income Less: Salaries Depreciation ($90,000 cost X 14.29%) Taxable Income before dividends received deduction Less: Dividends received deduction (70% of $40,000) Taxable income $70,000 12,861 $200,000 40,000 $240,000 82,861 $157,139 28,000 $129,139 E & P: Taxable income Add: Tax-exempt income $20,000 Excess of MACRS depreciation over straight-line: Straight-line is $4,500 [($90,000 cost ÷ 10) ÷ 2]. Depreciation under MACRS of $12,861 less $4,500 straight-line 8,361 Dividends received deduction 28,000 Deduct: STCL on sale of stock Estimated Federal income tax E&P $25,000 14,600 $129,139 56,361 $185,500 39,600 $145,900 pp. 10-4 to 10-7 24. The shareholder has a return of capital of $40,000. The $40,000 reduces the basis in the Bunting Corporation stock; any excess over basis is capital gain. There is no taxable dividend because the accumulated E & P account is brought up to date on the date of the sale. On the date of the sale, E & P is a negative $10,000 [$175,000 (beginning balance in accumulated E & P) - $175,000 (existing deficit in current E & P from sale of the asset) - $10,000 (one-half of $20,000 negative E & P not related to asset sale)]; thus, the $40,000 distribution constitutes a return of capital. Generally, deficits are allocated pro rata throughout the year unless the parties can prove otherwise. Here the shareholder can prove otherwise. (If the $195,000 deficit in E & P were prorated throughout the year, there would have been a taxable dividend of $40,000 because E & P would have a positive balance of $77,500 [$175,000 (beginning balance in accumulated E & P) - $97,500 (one-half the $195,000 deficit for the year)]. p. 10-10 and Example 11 25. The shareholder has a taxable dividend of $10,000 and a return of capital of $20,000. Becard Corporation has no accumulated E & P at the time of the distribution. The shareholder is taxed on the current E & P of Becard, which was only $10,000. The balance of the distribution, $20,000, first reduces the adjusted basis of the stock in Becard Corporation. To the extent that the $20,000 exceeds the basis in the stock, a capital gain results. pp. 10-7 ro 10-10 26. Indigo Corporation and Lucy each have a taxable dividend of $70,000. Tanager Corporation’s current E & P is $180,000; thus, the entire distribution is a taxable dividend even though Tanager has no accumulated E & P. Indigo Corporation is entitled to a dividends received deduction of $56,000 (80% X $70,000) because it owns more than 20% of the stock in Tanager Corporation. Thus, Indigo is only taxed on $14,000. Because Lucy is an individual, she pays tax on the entire dividend. 10-11 To determine Tanager Corporation’s accumulated E & P at the end of the year, its current E & P ($180,000) is first reduced by the amount of the distributions ($140,000). The remaining $40,000 is then netted against the accumulated E & P deficit of $250,000, leaving a deficit of $210,000 as of January 1 of the following year. pp. 10-7 to 10-10 27. Wren Corporation is deemed to have paid a dividend to James in the amount of the imputed interest on the loan, determined by using the Federal rate and compounded semiannually. Thus, Wren Corporation is deemed to have paid a dividend to James in the amount of $20,500. Although James has dividend income of $20,500, he may be permitted to offset the income with a $20,500 deemed interest payment to Wren. Wren has deemed interest income of $20,500, but has no corresponding deduction. The deemed payment from Wren to James is a nondeductible dividend. pp. 10-16, 10-17, and Example 23 28. Immediately after the distribution, Hiro has $50,000 worth of Canary stock ($45,000 in common stock and $5,000 in preferred stock). Consequently, the basis of the common stock will equal the ratio of the common stock’s fair market value to the total fair market value times the stock’s basis, or ($45,000/$50,000) X $25,000, or $22,500. Similarly, the basis of the preferred stock will equal $2,500 [($5,000/$50,000) X $25,000]. p. 10-20 and Example 28 29. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 February 20, 2000 Myrtle Adams 14009 Pine Street Dover, DE 19901 Dear Ms. Adams: This letter is in response to your question with respect to your sale of the Petrel Corporation stock you received as a nontaxable stock dividend. Our conclusion is based upon the facts as outlined in your February 10 letter. Any change in facts may cause our conclusion to be inaccurate. You paid $180,000 for 15 shares of stock in Petrel Corporation five years ago. In 1999, a nontaxable stock dividend of 5 additional shares in Petrel Corporation was received. The 5 shares were sold in March of 2000 for $60,000. Your gain on the sale of the 5 shares is $15,000, computed as follows: [$60,000 (selling price) - $45,000 (tax basis in the 5 new shares)]. [The tax basis in the 5 shares is arrived at by dividing your $180,000 cost of the original 15 shares by 20 (to include the 5 new shares). Your basis then would be $9,000 per share ($180,000 ÷ 20)]. The $15,000 gain on the sale is a long-term capital gain. Should you need more information or need to clarify our conclusion, do not hesitate to contact me. Sincerely yours, Marilyn C. Seago, CPA Partner 10-12 February 15, 2000 TAX FILE MEMORANDUM FROM: Marilyn C. Seago SUBJECT: Myrtle Adams Today I conferred with Myrtle Adams as to her February 10 letter. Ms. Adams paid $180,000 for 15 shares of stock in Petrel Corporation five years ago. In November of 1999, she received a nontaxable stock dividend of 5 additional shares in Petrel Corporation. She sold the 5 shares in March of 2000 for $60,000. She inquires as to the gain she has on the sale and how it is taxed. At issue: How is the gain on the sale of shares of stock received as nontaxable stock dividends determined and how is it taxed? Conclusion: The shareholder's basis in the original 15 shares, $180,000, is reallocated to the 20 shares she held after the nontaxable stock dividend of 5 shares. Her basis per share after the stock dividend is $9,000 per share ($180,000 ÷ 20). Her gain on the sale of the 5 shares is $15,000 [$60,000 (selling price) - $45,000 (basis in 5 shares)]. The gain is a long-term capital gain even though Ms. Adams sold the shares less than a year after she received them. The holding period of the original shares tacks on to the shares received as a nontaxable stock dividend. pp. 10-20 and 10-21 30. Because the fair market value of the rights is 15% or more of the value of the old stock, Karen must allocate her basis in the stock between the stock and the stock rights. Karen allocates basis as follows: Fair market value of stock: 100 shares X $80 = Fair market value of rights: 100 rights X $20 = $ 8,000 2,000 $10,000 Basis of stock: $3,000 X 8/10 = $2,400 Basis of rights: $3,000 X 2/10 = $ 600 = $6 per right There is a capital gain on the sale of the rights of $510, computed as follows: Selling price of 40 rights Less: Basis of 40 rights (40 X $6) Long-term capital gain $750 (240) $510 10-13 Basis of the new stock is $3,960, computed as follows: 60 rights X $6 Additional consideration ($60 X 60) $ 360 3,600 $3,960 Holding period of the 60 new shares begins on the date of purchase. pp. 10-21, 10-22, and Example 29 31. Partridge should recognize the loss as soon as possible and immediately thereafter make the cash distribution. For example, assume these two steps took place on January 2. Because current E & P would be a deficit, accumulated E & P would be brought up to date. At the time of the distribution, the combined E & P balance would be zero [$300,000 (beginning balance in E & P) - $300,000 (existing deficit in current E & P)], and the entire $180,000 would be a return of capital. Current deficits are allocated pro rata throughout the year unless the parties can prove otherwise. Here they can. Example 12 32. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 April 15, 2000 Diver Corporation 1010 Oak Street Oldtown, MD 20742 Dear President of Diver Corporation: This letter is in response to your question concerning the tax consequences on the planned distribution of $400,000 to your shareholders over the next four yours. Our conclusion is based upon the facts as outlined in your April 1 letter. Any change in facts may cause our conclusion to be inaccurate. Diver Corporation has a deficit in accumulated E & P of $200,000 as of January 1, 2000. Starting this year, Diver Corporation expects to generate annual E & P of $100,000 for the next four years and would like to distribute this amount to its shareholders. The corporation’s objective is to distribute the $400,000 over the next four years in a manner that would provide the least amount of dividend income to its shareholders. Diver Corporation should not make a distribution in 2000. It should then distribute $200,000 on December 31, 2001. It should again make no distribution in 2002. Then it should distribute the remaining $200,000 on December 31, 2003. By distributing $200,000 every other year, only half of the distribution, or $200,000, is taxed to your shareholders as dividend income. This is because E & P for 2000 of $100,000 is netted with the deficit in E & P of $200,000. At the end of 2000, there will be a deficit in E & P of $100,000. When a distribution of $200,000 is made in 2001, only $100,000 of that amount is taxed as the amount of dividend income is limited to the current E & P of $100,000. This is again the case in 2002 and 2003. On the other hand, if $100,000 is distributed each year, your shareholders are taxed on the entire distribution because the corporation will generate that amount of current E & P. The deficit in E & P does not cause part of the distribution to be nontaxable. Should you need additional information or need to clarify our conclusion, do not hesitate to call on me. 10-14 Sincerely yours, Marilyn C. Seago, CPA Partner April 13, 2000 TAX FILE MEMORANDUM FROM: Marilyn C. Seago SUBJECT: Diver Corporation Today I talked to the president of Diver Corporation with respect to the April 1, 2000, letter. Diver Corporation has a deficit in its accumulated E & P of $200,000 as of January 1, 2000. Starting in 2000, Diver Corporation expects to generate annual E & P of $100,000 for the next four years and would like to distribute this amount to its shareholders. Diver Corporation wants to know how it should distribute the $100,000 over a four year period (for a total distribution of $400,000) to provide the least amount of dividend income to its shareholders (all individuals). At issue: When a corporation has a deficit in accumulated E & P, is it possible to structure a corporate distribution so that a part of the distribution will not constitute dividend income even though current E & P is sufficient to cover the distribution? Conclusion: Yes. If Diver Corporation distributes $100,000 annually to its shareholders, the entire distribution constitutes dividend income because current E & P is sufficient to cover the entire distribution. Thus, Diver’s shareholders have total dividend income of $400,000 over the four year period. However, if Diver Corporation does not make a distribution in 2000 or in 2002, only half of the $400,000 total distribution, or $200,000, constitutes dividend income. This is the case because in 2000 the $100,000 current E & P is netted with the $200,000 deficit in E & P to reduce the deficit in accumulated E & P to $100,000 as of December 31, 2000. In 2001, when Diver Corporation distributes $200,000 to its shareholders, only $100,000 of the distribution is dividend income. This is so because there is a $100,000 deficit in accumulated E & P, but the distribution is taxed to the extent of current E & P. As current E & P is only $100,000, only this amount is dividend income. The remaining $100,000 is a return of capital to the shareholders. After the distribution in 2001, accumulated E & P will remain a deficit of $100,000 since the distribution cannot increase a deficit in E & P. In 2002, Diver Corporation would not make a distribution. Thus, at the end of 2002, accumulated E & P is zero (the $100,000 deficit would be netted with the $100,000 current E & P for 2002). In 2003, Diver Corporation would have current E & P of $100,000. It would then make a distribution of $200,000 to its shareholders, but only $100,000 of the distribution will represent dividend income. The remaining $100,000 will again be a return of capital. Example 13 RESEARCH PROBLEMS 10-15 1. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 November 23, 2000 Mr. Monty Davis 1212 S. Camino Seco Tucson, AZ 85710 Dear Monty: I am writing this letter to provide you with some information that might be relevant to the IRS’s criminal tax evasion charges against Joe and Simone Simpson. Based on my recent telephone conversation with Joe Simpson, I understand that these charges are based on the belief that Joe and Simone intended to evade taxes when they withdrew and hid $250,000 from Spifficar over the last several years. Upon hearing about this situation, I reviewed my files regarding Spifficar and discovered that, over the period in question, the corporation had a deficit in earnings and profits. It occurred to me at that time that the money withdrawn from the corporation probably would not be properly treated as a dividend. Instead, it might be argued that the money should be treated as a tax-free recovery of stock basis (the Simpsons have approximately $300,000 in stock basis; this should be more than sufficient to cover the hidden funds). After investigating this issue further, I found three court decisions that might have some bearing on their case. In U.S. v. D’Agostino, 98-1 USTC ¶50,380, 81 AFTR2d 98-1923, 145 F.3d 69 (CA-2, 1998), the Second Court of Appeals reversed an unreported District Court conviction against a husband and wife who owned two commercial laundromats through wholly owned corporations. The facts in D’Agostino are very similar to those in the current case; over a series of years, the owners took $400,000 home from the laundromats and kept the cash in a kitchen drawer. The money was never reported as taxable income by the taxpayers and the IRS sought criminal tax evasion charges on the basis of evidence suggesting that there existed a clear intent to evade. The taxpayers in the case argued that the diverted income was corporate income received by the shareholders and that the income should only be taxed to the extent that E & P existed. In their case, as in the current situation, the corporation had no E & P, so the distributions would be properly treated as a nontaxable recovery of basis. In D’Agostino, the Second Court of Appeals followed the reasoning in DiZenzo v. Commissioner, 65-2 USTC ¶9518, 16 AFTR2d 5107, 348 F.2d 122 (CA-2, 1965): the lack of E & P precludes taxation to the taxpayers (to the extent of basis in the stock and outstanding loans from shareholders). Thus, the court in D’Agostino concluded that the hidden funds could not constitute taxable income; so no evasion was possible. The decision by the Second Court of Appeals in D’Agostino stands in sharp contrast to an Eleventh Court of Appeals decision, U.S. v. Williams, 89-2 USTC ¶9390, 64 AFTR2d 89-5061, 875 F.2d 846 (CA-11, 1989). In Williams, the Eleventh Court of Appeals held that, in criminal tax evasion cases, the government should not be required to prove that corporate distributions are taxable. Instead, demonstrating that the shareholder has control over the corporate funds is sufficient for criminal tax evasion statutes to apply. Notably, even though the Second Court of Appeals was constrained to follow their decision in DiZenzo, the court 10-16 explicitly rejected the reasoning in the Williams case because it felt that decision had eliminated proof of a tax deficiency—a key requirement for criminal tax evasion in § 7201. Thus, my research indicates that the courts are divided on this issue. Given that the Simpsons reside in the Ninth Court of Appeals, neither case appears to provide direct precedent. While the answer to the Simpson’s problem is unclear, I believe that you should be able to make a strong argument on their behalf by following the reasoning in both D’Agostino and DiZenzo. If you have any additional questions regarding the Simpson case, or if you require additional assistance, please do not hesitate to contact me. Sincerely yours, Jon S. Davis, CPA Partner 2. a. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 November 15, 2000 Mr. Jaime Martinez 509 Maple Street Camden, NJ 08102 Dear Jaime: This letter is in response to your question with respect to the IRS's disallowance of your election to use the option set forth in § 1341 in reporting your repayment, in 1999, of a bonus your employer, Black Corporation, paid you in 1997. Our conclusion is based upon the facts as outlined in your November 1 letter. Any change in facts may cause our conclusion to be inaccurate. You are the president and majority shareholder of Black Corporation. In 1997, you were paid a salary of $50,000 and you received a year-end bonus of $200,000. Upon audit of Black Corporation in 1997, the IRS disallowed $150,000 of the bonus paid to you as being unreasonable. Under a repayment agreement, you reimbursed Black Corporation for the $150,000 in 1999. You included the $150,000 on your 1997 tax return as income. You did not deduct the repayment of the $150,000 in 1999, but rather elected the option set out in § 1341(a)(5) of the Internal Revenue Code. Thus, you claimed a credit for the amount of tax you paid on the $150,000 in 1997. The IRS disallowed your election under § 1341. Because you were in a higher tax bracket in 1997 than you were in 1999, the IRS has calculated a tax deficiency against you for 1999. You should challenge the tax deficiency. In our opinion, you may use the special relief provisions of § 1341, whereby you may either deduct the amount repaid ($150,000) in 1999 or you may claim a credit equal to the decrease in tax for 1997 had you not reported the $150,000 as income in that year. Sincerely yours, Marilyn C. Seago, CPA Partner b. TAX FILE MEMORANDUM November 13, 2000 FROM: Marilyn C. Seago SUBJECT: Jaime Martinez 10-17 Today I talked to Jaime Martinez with respect to his November 1, 2000, letter. Jaime is the president and major shareholder of Black Corporation. He wishes to know whether he may elect to use the option set out in § 1341(a)(5) with respect to his repayment of $150,000 of a $200,000 bonus paid him by Black Corporation in 1997. The IRS denied the corporation a deduction for $150,000 of the $200,000 because the IRS contended that amount was “unreasonable.” Under a repayment agreement, Jaime reimbursed Black Corporation for the $150,000 in 1999. On his 1999 tax return, Jaime deducted none of the repayment, but elected instead the option set forth in § 1341(a)(5). Thus, he claimed a credit for the amount of tax he paid on the $150,000 when he reported it as income on his 1997 return. The IRS did not accept the credit approach but did permit him a deduction of $150,000 for 1999. Because Jaime was in a higher tax bracket in 1997, a deficiency resulted for 1999. At issue: Can Jaime elect the option in § 1341(a)(5) with respect to the repayment of the $150,000 bonus in 1999 and claim a credit against his income tax in 1999 equal to the amount of income tax he paid on the $150,000 when he reported it as income in 1997? Conclusion: The Sixth Court of Appeals has ruled that an employee may use the special relief provisions of § 1341, whereby the taxpayer may either deduct the amount repaid in the year of repayment or may claim a credit equal to the decrease in the year of receipt if the repaid item is not claimed as a tax deduction in the year of repayment. Van Cleave v. U.S., 84-2 USTC ¶ 9620, 52 AFTR2d 84-6071, 718 F.2d 193 (CA-6, 1983). Consequently, Jaime can elect the option in § 1341(a)(5). Note: Shareholder-employees who repay excessive compensation to their corporations have been denied deductions for the repayments when there was no agreement to reimburse the corporation for that portion of the compensation that was disallowed as a deduction to the corporation. George L. Blanton, 46 T.C. 527 (1966). However, if the employment contract or a corporate bylaw requires a corporate employee to return any salary deemed to be excessive, the employee may take a deduction for the salary repayment since the employee then has an obligation to restore the payment. Vincent E. Oswald, 49 T.C. 645 (1968). 3. a. November 20, 2000 Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 Bill Gateson 601 Pittsfield Dr. Champaign, IL 61821 Dear Bill: This letter is to provide you with our firm’s opinion regarding the likely tax consequences of the planned distribution of $4,000,000 of cash and securities from Egret Corporation to Aqua Corporation, followed by sale of Egret for $5,500,000. You expect the distribution to be taxed as a dividend since it is equal to the E & P of Egret Corporation. In addition, you expect to recognize no gain on the sale of Egret, since Aqua’s basis in the Egret stock equals the projected sales price. As you indicated in our phone conversation, the purpose of this plan is to 10-18 (1) reduce the price of Egret stock, thereby facilitating a sale and (2) avoid tax on the sale of Egret. After much research, our firm has identified two cases that are similar to your situation. In the first case, a distribution was made after an offer was received for the subsidiary stock. In that situation, the court held that the dividend was, in substance, part of the sales price received for the subsidiary. Dividend treatment was disallowed and the distribution was taxed as a capital gain to the parent corporation. In the second case, which more closely resembles your situation, a distribution was made to the parent corporation in anticipation of a future sale of the subsidiary (no offer had yet been received). In this context, since no sale was in progress, the court allowed dividend treatment and the parent corporation had no taxable income or gain on the transaction. Provided that you do not publicly announce your intent to sell Egret Corporation or enter into any negotiations regarding a sale until after you make the $4,000,000 distribution, it is our opinion that you will receive the tax treatment you desire. In particular, the distribution will be treated as a dividend subject to the 100% dividends received deduction and no gain will be recognized on subsequent sale of Egret. If you have any additional questions regarding this matter, please do not hesitate to call me. Sincerely yours, Jon S. Davis, CPA Partner TAX FILE MEMORANDUM November 20, 2000 From: Jon S. Davis Subject: Proposed distribution, followed by sale of Egret Corporation Facts: Aqua Corporation is the sole shareholder of Egret Corporation. Aqua’s basis in Egret stock is $5.5 million. Egret has E & P of $4 million. The assets of Egret consist of software patents worth $5 million and cash and marketable securities of $4.5 million. For strategic business reasons, Aqua is planning on selling Egret Corporation sometime in the next two years. In anticipation of the sale, Aqua has considered two possibilities: (1) Sell Egret for its current fair market value of $9.5 million. This would generate a gain on sale of $4 million. Distribute $4 million in cash and securities to Aqua as a dividend. The dividend would (2) be tax free since Aqua is entitled to a 100% dividends received deduction. Then, sell Egret for $5.5 million, resulting in no taxable gain on sale. After considering these two possibilities, Aqua executives have decided the latter is preferable, provided that the expected tax consequences are correct. They have contacted our office to confirm the expected tax treatment of the distribution and subsequent sale. At issue: Is the distribution of $4 million in cash and securities properly treated as a dividend subject to the dividends received deduction, and is the subsequent sale of stock tax free? 10-19 Discussion: Waterman Steam Ship Corporation, 50 T.C. 650 (1968), rev’d by 70–2 USTC ¶9514, 26 AFTR2d 70–5185, 430 F.2d 1185 (CA-5, 1970) involves a similar situation. In Waterman, a corporation received an offer to purchase the stock of its wholly-owned subsidiary. After receiving the offer, the subsidiary paid a dividend equal to the fair market value of the subsidiary’s stock less the parent corporation’s adjusted basis in the stock. The parent corporation argued that the dividend resulted in no taxable income (due to the 100% dividends received deduction under § 243(a)(3)), and no gain was recognized on the sale since the stock was sold at its adjusted basis. The court recast the dividend as sales proceeds and treated it as long-term capital gain using substance over form as a basis for the decision. Several features of the current case differ from the facts in Waterman. First, there is a good business reason for Egret to make a distribution. In particular, distributing assets currently will reduce the corporation’s value, thereby lowering any future sales price; this facilitates a business-motivated future sale. Second, and most important, no offer has yet been made to purchase Egret. Since no offer is outstanding, it would be difficult to argue that the dividend is properly treated as part of the sales price of Egret. Another case, more similar to the Aqua and Egret situation, is Litton Industries, Inc., 89 T.C. 1086 (1987). In Litton, a large dividend was paid before the corporation attempted to sell its subsidiary. In particular, Litton did not announce its intention to sell the subsidiary until two weeks following the distribution. The Tax Court distinguished Litton from Waterman on these grounds and allowed dividend treatment, together with the 100% dividends received deduction. Conclusion: Because the present situation is more similar to the facts in Litton Industries, we believe that Aqua is correct in its assessment of the tax consequences of the proposed transaction. The dividend should be properly offset by the 100% dividends received deduction and no gain should be recognized on the subsequent sale of the Egret stock. 4. Section 162 allows as a deduction all ordinary and necessary business expenses. The term “ordinary” refers to expenses that are common or frequently occurring in the context of the particular business [Deputy v. duPont, 40-1 USTC ¶ 9161, 23 AFTR 808, 60 S.Ct. 363 (USSC, 1940)]. Necessary expenses are those that are appropriate or helpful to the taxpayer’s trade or business [Comm. v. Heininger, 44-1 USTC ¶ 9109, 31 AFTR 783, 64 S.Ct. 249 (USSC, 1943)]. Finally, in order to be deducted, there must be a proximate relationship between the expense and business operations [Henry v. Comm., 36 T.C. 879 (1961)]. The determination of deductibility under each of these three conditions rests on the facts and circumstances of the case. Thus, reference to case law is necessary. A number of cases have some bearing on the question of deductibility for NetBiz. In David M. Connelly, 68 TCM 614, T.C. Memo. 1994-436, a plastic surgeon was the sole officer, shareholder and key employee of a medical corporation. Allegedly to promote and advertise medical services, the corporation leased a Rolls Royce Silver Shadow that was used by the doctor to attend medical conventions and for other business purposes. When disallowing the lease payments as a deduction, the court held in that case that the relation between leasing a Rolls Royce and enhancement of the taxpayer’s skill or reputation was “at best, dubious.” In addition, the court noted that no evidence was introduced suggesting that patients were attracted to the medical practice by virtue of the Rolls Royce. The reasoning in Connelly was followed in a subsequent unpublished decision, Mohan Roy, M.D., Inc. v. Comm., 99-1 USTC ¶ 50,588, 83 AFTR2d 99-2849 (CA-9, 1999). As in Connelly, Dr. Roy owned and was employed by a medical corporation, which purchased a Rolls Royce for his use in order to attract patients. Roy has greater similarity to NetBiz’s fact pattern because the doctor used the car only occasionally, for both business and personal reasons, and he kept the car at his home. In addition, as in the present case, Dr. Roy indicated in testimony that he rarely used the Rolls Royce because he thought it would discourage patient 10-20 referrals. One possible distinction between the facts in Roy and present case is that the taxpayer in Roy failed to provide adequate substantiation required under § 274(d). However, regardless of the substantiation issue, the court noted that Dr. Roy’s testimony regarding the expected negative impact on business, together with the car’s limited use (and personal use) undermined any claim that the automobile was an ordinary and necessary expense. No deduction for expenses related to the Rolls Royce was allowed in the case. In light of the above cases, it will be very difficult to make an argument for deductibility of the Ferrari’s operating expenses and depreciation. In order to do so, at a minimum, NetBiz will need to provide evidence that the Ferrari increased business (and perhaps compare the role played by an exotic car in medical practices and systems consulting). Corey’s belief that clients see the car as ostentatious works against this argument, however. With respect to the amount of constructive dividend received by Corey, the answer is unclear. In Joseph Proctor, 42 TCM 725, T.C. Memo. 1981-436, where a corporation’s automobile expense was disallowed because it was attributable to shareholders’ personal use, the value of the constructive dividend was deemed to be the fair market value of the benefits received (fair rental value plus operating expenses paid for by the corporation). This amount exceeded the amount of disallowed auto expenses. In contrast, in Roy and in Ruth Rodenbaugh, et al., 33 TCM 169, T.C. Memo. 1974-36, the court judged the amount of dividend to be some portion of disallowed expenses. In Rodenbaugh, the amount of operating expenses plus disallowed depreciation was deemed to be a constructive dividend, but no discussion regarding this judgment is provided in the decision. In Roy, the doctor testified that the fair rental value of the Rolls Royce was $85 to $96 per day. The IRS provided expert testimony regarding rental rates for a Rolls Royce, but the rates were several years old. The court rejected both testimonies as uninformative and, instead, used operating expenses (excluding disallowed depreciation) to determine value. Because of the Ferrari 550’s rarity, it will probably be difficult to find appropriate rental rates. Hence, it is likely that the court will find Corey’s dividend to be either operating expenses or operating expenses plus disallowed depreciation. Since Roy is the most similar case, the use of operating expenses as a measure of the dividend is probably reasonable. 5. The Internet Activity research problems require that the student access various sites on the Internet. Thus, each student’s solution likely will vary from that of the others. You should determine the skill and experience levels of the students before making the assignment, coaching them where necessary so as to broaden the scope of the exercise to the entire available electronic world. Make certain that you encourage students to explore all parts of the World Wide Web in this process, including the key tax sites, but also information found through the web sites of newspapers, magazines, businesses, tax professionals, government agencies, political outlets, and so on. They should work with Internet resources other than the Web as well, including newsgroups and other interest-oriented lists. Build interaction into the exercise wherever possible, asking the student to send and receive e-mail in a professional and responsible manner. 6. See the Internet Activity comment above.