Explain the basic tax law framework that applies to property distributions from a corporation to a shareholder.
Subchapter C of the Internal Revenue Code provides guidelines and rules for determining the tax status of distributions from a taxable ("C") corporation to its shareholders.
When a corporation distributes property to persons in their capacity as shareholders without receiving any property or services in return, the shareholder must determine if the amount received is a dividend.
If the distribution is of property other than cash, the distributing corporation recognizes gain but not loss on the distribution.
Compute a corporation's earnings and profits and calculate the dividend amount received by a shareholder.
The IRC defines a dividend as any distribution of property made by a corporation to its shareholders out of its current or accumulated earnings and profits (E&P).
Earnings and profits is the tax equivalent of financial accounting retained earnings, although the computations can be significantly different.
A corporation must keep two E&P accounts: Current E&P and accumulated E&P.
The IRC and the related regulations list four basic types of adjustments that a corporation must make to its taxable income to compute current E&P.
Inclusion of income that is excluded from taxable income.
Disallowance of certain expenses that are deducted in computing taxable income.
Deduction of certain expenses that are excluded from the computation of taxable income.
Deferral of deductions or acceleration of income due to separate accounting methods required for E&P purposes.
The shareholder computes the dividend amount to include in gross income as the sum of cash received plus the fair market value of property received less any liabilities assumed.
The distributing corporation recognizes gain, but not loss, on the distribution of noncash property in a dividend distribution.
A corporation reduces its E&P by the amount of cash distributed, the E&P basis of unappreciated property distributed, and the fair market value of appreciated property distributed, net of any liability assumed by the shareholders.
Identify situations in which a corporation may be deemed to have paid a "constructive dividend" to a shareholder.
A transaction between a shareholder and a corporation that does not take the form of a dividend may be treated by the IRS as a constructive dividend. Examples include:
Unreasonable compensation paid to shareholder/employees.
A bargain lease or uncompensated use of corporate property by a shareholder.
An excess purchase/lease price paid to a shareholder.
"Loans" to a shareholder who has no intent to repay the loan.
Corporate payments on a shareholder's behalf.
Unlawful diversions of corporate income to shareholders.
Comprehend the basic tax rules that apply to stock dividends.
The general rule is that a stock dividend is not taxable.
The basis of the "new" stock received is computed by allocating basis from the existing stock based on relative fair market value.
The holding period of the new stock includes the holding period of the existing stock on which the new stock was distributed.
Non-pro rata stock dividends usually are treated as taxable dividends to the recipients.
Comprehend the different tax consequences that can arise from stock redemptions.
If a redemption is treated as an exchange, the shareholder computes gain or loss by comparing the amount realized (money and property received) with the tax-adjusted basis of the stock surrendered.
The character of the gain or loss is capital.
The basis of noncash property received is its fair market value.
The holding period of the property received begins at the date of receipt.
If the transaction is treated as a dividend, the shareholder has gross income in an amount equal to the cash and fair market value of other property received to the extent of the corporation's E&P.
The basis of the property received is its fair market value.
The IRC treats redemptions as exchanges in transactions in which the shareholder's ownership interest in the corporation has been "meaningfully" reduced relative to other shareholders as a result of the redemption.
There are three change-in-stock-ownership tests that entitle the shareholder to exchange treatment in a redemption.
The IRC states that a redemption will be treated as an exchange if the redemption is "not essentially equivalent to a dividend."
This is a facts and circumstances determination (subjective).
To satisfy this requirement, the courts or IRS must conclude that there has been a "meaningful" reduction in the shareholder's ownership interest in the corporation as a result of the redemption (usually below 50 percent stock ownership).
The IRC states that a redemption will be treated as an exchange if the redemption is "substantially disproportionate with respect to the shareholder," defined as follows:
Immediately after the exchange the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote.
The shareholder's percentage ownership of voting stock after the redemption is less than 80 percent of his or her percentage ownership before the redemption.
The shareholder's percentage ownership of the aggregate fair market value of the corporation's common stock (voting and nonvoting) after the redemption is less than 80 percent of his or her percentage ownership before the redemption.
The IRC holds that a redemption will be treated as an exchange if the redemption is in "complete redemption of all of the stock of the corporation owned by the shareholder."
In determining whether the change-in-stock-ownership tests are met, each shareholder's percentage change in ownership in the corporation before and after a redemption must take into account constructive ownership (attribution) rules.
The attribution rules cause stock owned by other persons to be treated as owned by (attributed to) the shareholder for purposes of determining whether the shareholder has met any of the change-in-stock-ownership tests to receive exchange treatment.
Family attribution. Individuals are treated as owning the shares of stock owned by their spouse, children, grandchildren, and parents.
Attribution from entities to owners or beneficiaries.
Partners are deemed to own a pro rata share of their partnership's stock holdings (i.e., a partner who has a 10 percent interest in a partnership is deemed to own 10 percent of any stock owned by the partnership).
Shareholders are deemed to own a pro rata share of their corporation's stock holdings, but only if they own at least 50 percent of the value of the corporation's stock.
Attribution from owners or beneficiaries to entities.
Partnerships are deemed to own 100 percent of stock owned by partners (i.e., a partnership is deemed to own 100 percent of stock owned by a 10 percent partner)
Attribution to a corporation only applies to shareholders owning 50 percent or more of the value of the corporation's stock.
Option attribution. A person having an option to purchase stock is deemed to own the stock that the option entitles the person to purchase.
Shareholders can waive the family attribution rules in a complete redemption of their stock if certain conditions are met.
The shareholder has not retained a prohibited interest in the corporation immediately after the exchange (for example, as a shareholder, employee, director, officer, or consultant).
The shareholder does not acquire a prohibited interest within 10 years after the redemption, unless by inheritance (the 10-year look-forward rule).
The shareholder agrees to notify the IRS district director within 30 days if she acquires a prohibited interest within 10 years (sign a triple i agreement).
If the redemption is treated as a dividend by the shareholder, the corporation generally reduces its E&P by the cash distributed and the fair market value of other property distributed.
If the redemption is treated as an exchange by the shareholder, the corporation reduces E&P at the date of distribution by the percentage of stock redeemed (i.e., if 50 percent of the stock is redeemed, E&P is reduced by 50 percent), not to exceed the fair market value of the property distributed.
Contrast a partial liquidation from a stock redemption and describe the difference in tax consequences to the shareholders.
For a distribution to be a partial liquidation, it must either be "not essentially equivalent to a dividend" (as determined at the corporate level, not the shareholder level) or is the result of the termination of a "qualified trade or business."
The tax treatment of a distribution received in partial liquidation of a corporation depends on the identity of the shareholder receiving it.
All noncorporate shareholders get exchange treatment.
All corporate shareholders are subject to the stock redemption change in ownership rules, which usually results in dividend treatment because partial liquidations are almost always pro rata distributions.