Nonliquidating Distributions 1

Chapter 4 Nonliquidating Distributions Dividends - i.e., “operating” distributions IRC §301(a) - Subchapter C, Part A. Alternative dividend classification systems: 1) Federal income tax– income tax; e&p 2) Financial accounting – GAAP/SEC rules 3) Regulatory - utility rate-making 4) State income taxation/franchise taxation 5) State corporate law/creditors’ protection rules 9/30/2011 (c) 1 Dividend Payment Alternatives for Corp. A. Ordinary course of business 1. cash 2. property - appreciated/depreciated capital gain/ordinary income property installment obligations 3. distribution of corporation's own notes 4. distribution of corporation's own stock B. Extraordinary course of business 9/30/2011 (c) 2 Tax Definition of a “Dividend” p.160 §301(c) Income Tax Ordering Rules 1) §301(c)(1) - dividend distributions. 2) §301(c)(2) - recovery of tax basis. 3) §301(c)(3) - realization of capital gain. §316 - Dividend distribution sourcing: 1) accumulated “earnings & profits,” or 2) current “earnings and profits” (i.e., the "nimble dividend" rule). 9/30/2011 (c) 3 Dividend Taxation to the Individual Shareholder p.162 §1(h)(11) - taxation at capital gains rates (15%) to the individual dividend recipient. Must be “qualified dividend income”, i.e., received from: (1) domestic corporation, or (2) foreign corporation (if satisfying specified criteria). §1(h)(11)(C)(i)(II) & Notice 2011-64. Must satisfy a holding period requirement. “Dividends” from a “money market fund”? Not eligible for 15% rate. 9/30/2011 (c) 4 Corporate Dividend Policy p.164 Why pay (or not pay) dividends? - Retain earnings for future investments? - Reduce borrowing costs through retention of earnings? - Pay out earnings for closely held corp. shareholders but only in a deductible form? - Institutional shareholders do not pay taxes. Cf., better use of capital after distributions have been made to shareholders? 9/30/2011 (c) 5 Defining “Earnings and Profits” for Tax Purposes Code §312 concerns E&P concepts. Objective: Identify a cash equivalent amount available for distribution to owners/shareholders; premised upon true economic results, not on taxable income base. Choices for identifying “dividend” status: 1) Taxable 2) E&P 3) Earned surplus; income GAAP concepts (federal tax) 9/30/2011 (c) 6 Adjustments to Taxable Income for E&P Amount I. E&P Additions for Income Items - municipal bond income - life insurance proceeds (above tax basis?) - federal tax refunds II. Deduction Addback Items to E&P - dividends to the corporate shareholder previously protected by a dividends received deduction (DRD) for FIT purposes. 9/30/2011 (c) 7 E&P adjustments, continued III. Nondeductible amounts which do reduce the E&P amount - Federal income taxes paid by the corp. - Disallowed losses - §265 and §267. - Charitable contributions above % limit. - Disallowed T& E expense - §274. These are “cash out of pocket” items but are not deductible for FIT purposes. 9/30/2011 (c) 8 E&P adjustments, continued §312(k)&(n) IV Timing Adjustments for E&P A. Income components, e.g., §453 or the “completed contract” method. B. Depreciation components, e.g., §312(k)(3)(A) & §168(g)(2). Use the alternative depreciation system. Also, §179. C. Inventory – FIFO method; not LIFO No statute of limitations on an E&P determination. 9/30/2011 (c) 9 Problem p.169 Income &E&P Determinations I. Determining Taxable Income Gross income Sales profits Dividends Long-term capital gain Total gross income 9/30/2011 (c) 20,000 5,000 2,500 27,500 10 Net Income Determination continued, p.169 Deductions Employee salaries DRD - 70% of $5,000 (§243) Depreciation LTCL (limited to gain) Total deductions Total taxable income (27,500 less 19,050) 9/30/2011 (c) 10,250 3,500 2,800 2,500 19,050 8,450 11