CHAPTER 10 CORPORATIONS: EARNINGS & PROFITS AND DIVIDEND DISTRIBUTIONS SOLUTIONS TO PROBLEM MATERIAL Status: Q/P Question/ Present in Prior Problem Topic Edition Edition 1 Amount of dividend income Unchanged 1 2 Amount of taxable income; balance in E & P Unchanged 2 3 Ethics problem Unchanged 3 4 Deficit in E & P followed by sale on Unchanged 4 installment method; taxation of dividend distribution 5 Effect of selected transactions in adjusting Unchanged 5 taxable income (for determining E& P) 6 Amount of dividend income; deficit in current Unchanged 6 E & P with positive balance in accumulated E&P 7 Cash distributions; determination of taxable Unchanged 7 amount 8 Cash distributions; determination of taxable Unchanged 8 amount; gain on sale of stock 9 Cash distributions; determination of taxable Unchanged 9 amount 10 Effect of specified transactions on Unchanged 10 taxable income; on E & P 11 Effect of specified transactions on taxable Unchanged 11 income; on E & P 12 Tax treatment to shareholder and to New corporation on distribution of property subject to liability in excess of basis 13 Effect of specified transactions on taxable New income; on E & P 14 Tax treatment to corporate shareholder and to Unchanged 13 distributing corporation of property subject to a liability 10-1 10-2 2003 Entities Volume/Solutions Manual Status: Q/P Question/ Present in Prior Problem Topic Edition Edition 15 Taxation of dividend when E & P has positive Unchanged 14 balance but corporation has current loss 16 Unreasonable compensation, ways to draw New 15 funds from corporation 17 Issue recognition Unchanged 17 18 Constructive dividends Unchanged 18 19 Selected factors in determining reasonableness Unchanged 19 of compensation 20 Property dividend; liability assumed by share- Unchanged 20 holder; determination of E & P; distribution of loss property 21 Property distribution to corporate Unchanged 21 shareholder; basis in excess of FMV; liability assumed by shareholder 22 Dividend distribution; effect on E & P Unchanged 22 23 Dividend distribution; effect on E & P New 24 Basis of nontaxable preferred stock dividend New 25 Election to receive common or preferred Unchanged 24 stock dividend 26 Stock dividend; basis allocation; gain or sale Unchanged 26 27 Stock rights; basis allocation; gain on sale Unchanged 27 28 How to structure a dividend payment Unchanged 28 29 Meaningful reduction test in a not essentially Unchanged 29 equivalent redemption 30 Disproportionate redemption; consequences Unchanged 32 to shareholder and effect of redemption on E & P 31 Redemption of stock to pay death taxes; Unchanged 31 estate sale of property received 32 Disproportionate redemption [[§ 302(b)(2)]; Unchanged 30 family attribution 33 Complete termination redemption New [§ 302(b)(3)]; family attribution waiver Bridge Discipline Problem 1 Total return and dividend yield of corporate Unchanged 1 stock Research Problem 1 Earnings and profits and tax evasion Unchanged 1 2 Repayment of unreasonable compensation Unchanged 2 3 Dividend in anticipation of corporate sale Unchanged 3 4 Corporate deduction of luxury auto & Unchanged 4 constructive dividend to shareholder 5 Internet activity Unchanged 5 6 Internet activity Unchanged 6 7 Internet activity New Corporations: E & P and Dividend Distributions 10-3 PROBLEM MATERIAL 1. George and Albert have ordinary dividend income of $130,000 each [$200,000 (Swan Corporation’s accumulated E & P) + $60,000 (Swan Corporation’s current E & P) ÷ 2]. The remaining $20,000 of the $280,000 distribution reduces the basis (up to $10,000 each) in the shareholders’ stock in Swan Corporation with any excess treated as a capital gain. George reduces his basis from $48,000 to $38,000. Albert has a reduction in stock basis from $8,000 to zero and a capital gain of $2,000. 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. Steve is courting disaster. 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 1994 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. Buck reports $300,000 as a taxable dividend. The $550,000 gain on the sale of the land increases E & P by that amount in 2002. Current E & P before the distribution is $430,000 [$550,000 (gain on sale) - $120,000 (current year deficit)]. Since there is adequate current E & P, the entire distribution is a dividend. pp. 10-4, 10-5, and Example 6 5. a. To determine current E & P for 2002, Oriole Corporation's taxable income is increased by the entire amount of the deferred gain on the installment sale. b. Oriole Corporation's taxable income for 2002 is increased by the amount of the capital loss carryover in determining Oriole Corporation's E & P for 2002. As the excess capital losses would have reduced E & P in 2001, there is no need for further reduction in 2002. c. Oriole Corporation's taxable income is reduced by the excess charitable contributions in determining its E & P. The excess charitable contributions that cannot be utilized in computing Oriole 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. 10-4 2003 Entities Volume/Solutions Manual e. Oriole Corporation's taxable income for 2002 is reduced by the Federal income taxes paid in computing its E & P for 2002. f. For E & P purposes, § 179 expenses are deducted over a five-year period. Consequently, one-fifth of the § 179 deduction in 2000 would be subtracted from taxable income in 2002 to determine current E & P. 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 Return of Taxable 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 Corporations: E & P and Dividend Distributions 10-5 8. Amount Capital Taxable 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 $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. Taxable Income E&P Increase (Decrease) Increase (Decrease) a. $20,000 ($20,000) b. No effect ($27,000) c. No effect ($ 7,500) d. No effect ($43,000) e. No effect ($ 8,500) f. $25,000 $ -0- Note: E & P is not increased in f. because the $25,000 has already been included in taxable income. The realized gain is not an increase in E & P, only the recognized gain that is included in taxable income. p. 10-7 10-6 2003 Entities Volume/Solutions Manual 11. Taxable Income E&P Increase (Decrease) Increase (Decrease) a. No effect ($ 40,000) * b. ($30,000) $ 26,000 ** c. $50,000 $150,000 d. $ 3,000 $ 7,000 *** e. No effect No effect f. ($12,000) $ 9,600 † g. No effect ($ 2,400) †† h. ($80,000) $ 30,000 ††† i. No effect $ 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 12. a. Pelican has a gain of $75,000 on the distribution, computed as follows: $225,000 (liability on the property exceeds fair market value) - $150,000 (basis of the property). Pelican’s E & P is increased by the $75,000 gain. In addition, E & P is decreased by $225,000 (representing the deemed fair market value of the property), reduced by the $225,000 liability on the property, or zero. Thus, E & P is $375,000, computed as follows: $300,000 (beginning E & P balance) + $75,000 (gain on distribution). b. Ginger has dividend income of zero, computed as follows: $225,000 (value of the property based on liability) - $225,000 (liability on the property). Ginger has a basis of $225,000 in the property. pp. 10-11 to 10-15 Corporations: E & P and Dividend Distributions 10-7 13. Taxable income: Income from services rendered $300,000 Dividend income 50,000 $350,000 Less: Salaries $80,000 Depreciation ($80,000 cost X 14.29%) 11,432 (91,432) Taxable income before dividends received deduction $258,568 Less: Dividends received deduction (70% X $50,000) (35,000) Taxable income $223,568 E & P: Taxable income $223,568 Add: Tax-exempt income $25,000 Excess of MACRS depreciation over straight-line: Straight-line is $4,000 [($80,000 cost 10) 2]. MACRS depreciation of $11,432 less $4,000 straight-line 7,432 Dividends received deduction 35,000 67,432 $291,000 Deduct: STCL on sale of stock $20,000 Estimated Federal income tax 15,400 (35,400) E&P $255,600 pp. 10-3 to 10-7 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 10-15 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. There would be a problem. Amethyst Corporation will have satisfied Fiona’s obligation. Amethyst Corporation's payment to the charity may be treated as indirect compensation to her. In determining whether Amethyst Corporation has paid Fiona ―unreasonable‖ compensation, both the direct payment of $300,000 and the indirect $50,000 will be considered. Fiona should not have made a pledge to the charity. She should have just permitted the corporation to make the contribution directly. p. 10-17 10-8 2003 Entities Volume/Solutions Manual 17. 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. 10-7 to 10-15 18. a. Redwing has a realized loss of $15,000 (the difference between basis of $33,000 and fair market value of $18,000) and a constructive dividend of $13,000 (the difference between the $18,000 fair market value and the $5,000 paid for the parking lot). Due to the application of § 267, Redwing cannot recognize the realized loss. However, the loss does reduce Redwing’s E & P. The constructive dividend also reduces E & P. Thus, E & P is reduced by $28,000 (the sum of the $15,000 disallowed loss and the $13,000 constructive dividend). b. The loan to Royce will generate imputed interest since no interest was charged. The amount of imputed interest will be $9,000 ($200,000 X 9% X ½ year). This amount will be deemed paid as interest from Royce to the corporation. The deductibility of the interest by Royce will depend upon how the loan proceeds are used. Redwing will have taxable interest income of $9,000. Finally, Redwing will be deemed to pay a dividend to Royce equal to the amount of interest. Redwing’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 Mike and Royce equals the fair rental value of the yacht. Thus, both shareholders will receive dividend income of $30,000 ($7,500 X 4 weeks) and Redwing’s E & P will be reduced by the same amount. d. The $7,000 excess amount ($20,000 - $13,000) paid to Mike by Redwing over the fair rental value of the equipment will be treated as a constructive dividend taxable to Mike. The dividend will also reduce Redwing’s E & P. pp. 10-16 to 10-19 19. 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 Corporations: E & P and Dividend Distributions 10-9 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. 10-17 and 10-18 20. 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 $51,000 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) 26,350 E & P of Plover after the distribution $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. 10-10 2003 Entities Volume/Solutions Manual 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 $51,000 Add: Taxable income $120,000 Proceeds of term life insurance 46,400 Subtract: Life insurance premiums (2,000) Federal income tax (30,050) Income from prior year installment sale (10,000) 124,350 E & P of Plover after the distribution $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 10-15 21. a. 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. b. 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. pp. 10-11 to 10-15 22. 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 Corporations: E & P and Dividend Distributions 10-11 23. The shareholder has a taxable dividend of $20,000 and a return of capital of $30,000. Teal Corporation has no accumulated E & P at the time of the distribution. The shareholder is taxed on the current E & P of Teal, which was only $20,000. The balance of the distribution, $30,000, first reduces the adjusted basis of the stock in Teal Corporation. To the extent that the $30,000 exceeds the basis in the stock, a capital gain results. pp. 10-7 to 10-10 24. Immediately after the distribution, Stan has $60,000 worth of Robin stock ($50,000 in common stock and $10,000 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 basis, or $50,000/$60,000 X $30,000, or $25,000. Similarly, the basis of the preferred stock will equal $5,000 ($10,000/$60,000 X $30,000). p. 10-21 25. Smith, Raabe, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 November 1, 2002 Cormorant Corporation 6730 Pima Drive Madison, WI 53708 Dear President of Cormorant Corporation: This letter is in response to your question with respect to the stock dividend distributed to your shareholders. 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. Your shareholders will have taxable income in the amount of the fair market value of the stock dividend. Distributions of preferred stock to some common shareholders and of common stock to other common shareholders is a taxable event. Should you need more information or need to clarify our conclusion, do not hesitate to contact me. Sincerely yours, Jon S. Davis, CPA Partner TAX FILE MEMORANDUM November 1, 2002 FROM: Jon S. Davis SUBJECT: Cormorant Corporation Today I conferred with the President of Cormorant Corporation with respect to his November 1 letter. The corporation asked whether their shareholders would have any taxable gain on the receipt of a stock dividend. Cormorant Corporation declared a dividend permitting its shareholders to elect to receive either 8 shares of cumulative preferred stock or 2 additional 10-12 2003 Entities Volume/Solutions Manual shares of Cormorant common stock for every 10 shares of common stock held at the time of the dividend declaration. Two of the shareholders elected to receive preferred stock while all other shareholders chose the common stock dividend. At issue: Is the distribution of a stock dividend taxable if some of the shareholders elect to receive preferred stock while others elect to receive common stock? Analysis: Section 305 governs the taxability of stock dividends. It provides that stock dividends are not taxable if they represent pro rata distributions on common stock. However, this general rule has five exceptions. One of the exceptions applies in the current situation. In particular, a distribution of preferred stock to some common shareholders and of common stock to other common shareholders is a taxable event. Conclusion: The shareholders will have taxable income equal to the fair market value of the stock dividend. pp. 10-21 26. Smith, Raabe, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 February 20, 2002 Sarah Beckert 1822 N. Sarnoff Rd. Tucson, AZ 85710 Dear Ms. Beckert: This letter is in response to your question with respect to your sale of the Grebe 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 $10,000 for 3,000 shares of stock in Grebe Corporation two years ago. Last year, a nontaxable stock dividend of 1,000 additional shares in Grebe Corporation was received. The 1,000 shares were sold in the current year for $8,000. Your gain on the sale of the 1,000 shares is determined by subtracting your basis in the shares sold from the sales price. The tax basis in the 1,000 shares is determined by dividing the $10,000 cost of the original 3,000 shares by 4,000 (to include the 1,000 new shares). Your basis then would be $2.50 per share ($10,000 4,000). Your gain of $5,500 would then be computed as follows: [$8,000 (selling price) - $2,500 (tax basis in the 1,000 new shares)]. The $5,500 gain on the sale is a long-term capital gain. The gain is long term because you have held your original Grebe stock for more than one year. Should you need more information or need to clarify our conclusion, do not hesitate to contact me. Sincerely yours, Jon S. Davis, CPA Partner Corporations: E & P and Dividend Distributions 10-13 TAX FILE MEMORANDUM February 15, 2002 FROM: Jon S. Davis SUBJECT: Sarah Beckert Today I conferred with Sarah Beckert regarding her letter to me dated February 10. Two years ago, Ms. Beckert purchased 3,000 shares of Grebe Corporation for $10,000. Last year, she received a nontaxable stock dividend of 1,000 additional shares in Grebe. She sold the 1,000 shares this year for $8,000. She asked me to determine the tax consequences of the stock sale. 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 3,000 shares, $10,000, is reallocated to the 4,000 shares she held after receiving the nontaxable stock dividend. Her basis per share after the stock dividend is $2.50 per share ($10,000 4,000 shares). Her gain on the sale of the 1,000 shares is therefore $5,500 [$8,000 (selling price) - $2,500 (basis in 1,000 shares)]. The gain is a long-term capital gain because the holding period of the original shares tacks on to the shares received as a nontaxable stock dividend. Example 27 27. Because the fair market value of the rights is 15% or more of the value of the old stock, Cindy must allocate her basis in the stock between the stock and the stock rights. Cindy allocates basis as follows: Fair market value of stock: 200 shares X $100 = $20,000 Fair market value of rights: 100 rights X $45 = 4,500 $24,500 Basis of stock: $6,000 X $20,000/$24,500 = $4,898 Basis of rights: $6,000 X $4,500/$24,500 = $1,102 Basis per right: $1,102 100 rights = $11.02 There is a capital gain on the sale of the rights of $1,319.40, computed as follows: Selling price of 30 rights $1,650.00 Less: Basis of 30 rights (30 X $11.02) (330.60) Long-term capital gain $1,319.40 Basis of the new stock is $4,271.40, computed as follows: 70 rights X $11.02 $ 771.40 Additional consideration ($50 X 70 shares) 3,500.00 Basis of newly-acquired stock $4,271.40 Holding period of the 70 new shares begins on the date of purchase.pp. 10-21, 10-22, and Example 28 10-14 2003 Entities Volume/Solutions Manual 28. 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 29. a. Shonda must report the $60,000 as dividend income. The redemption does not qualify as a not essentially equivalent redemption. Shonda owned 55% of the stock of Hawk Corporation prior to the redemption (110 ÷ 200). After the redemption, Shonda owns 50% of the stock of Hawk [90 (Shonda's remaining shares in Hawk) ÷ 180 (remaining outstanding shares in Hawk)]. Shonda still has the dominant control of Hawk; thus, there has not been a ―meaningful reduction‖ in her interest in Hawk. Further, her remaining ownership interest fails the 50% test of a disproportionate redemption. b. The basis in the 20 shares redeemed attaches to Shonda’s remaining stock. Shonda’s basis in her remaining 90 shares is therefore $110,000. c. Since the redemption is treated as an ordinary dividend distribution, Hawk’s E & P is reduced to $140,000 ($200,000 – $60,000). pp. 10-22 and 10-23 30. a. Ann would have a capital gain of $55,000 [$80,000 - $25,000 (basis in the 25 shares)]. The redemption qualifies as a disproportionate redemption. Ann had a 50% (50 shares 100 shares) ownership in Teal Corporation prior to the redemption and a 33.33% (25 shares 75 shares) ownership after the redemption. Both the 50% and the 80% tests are met. b. E & P of Teal Corporation will be $90,000 after the redemption: $100,000 (accumulated E & P) + $20,000 (current E & P) - $30,000 [25% (the percentage stock redemption) X $120,000 (the balance in E & P)]. pp. 10-22 and 10-23 31. Losses are not recognized in nonliquidating corporate distributions; thus, Red Corporation will not recognize the $200,000 loss inherent in the land distributed to the estate. Red Corporation’s E & P is reduced by $800,000 (limited to 20% X $4 million) as a result of the distribution. The estate will have a basis in the land equal to its fair market value, or $1,000,000. When it sells the land for $1,000,000, the estate will recognize no gain. pp. 10-22 and 10-23 Corporations: E & P and Dividend Distributions 10-15 32. Smith, Raabe, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 May 10, 2002 Lana Pierce 1000 Main Street Oldtown, MN 55166 Dear Lana: This letter is in response to your question concerning the tax consequences of the redemption of 100 shares of stock you own in Stork Corporation. You were paid $45,000 for the shares and you have a tax basis of $10,000 in the stock. Your mother, Lori, owns 100 shares in Stork, and the remaining shares are owned by an unrelated individual. Our conclusion is based upon the facts as outlined in your May 5 letter. Any change in facts may cause our conclusion to be inaccurate. You will have a capital gain of $35,000 on the redemption. Stork Corporation redeemed 100 of the 200 shares you owned in the corporation. For purposes of this transaction, you are deemed to own all of Lori’s 100 shares. Prior to the redemption, you had a 30% ownership (20% direct ownership + Lori’s 10% constructively owned) in the corporation as Stork Corporation had 1,000 shares outstanding. After the redemption you have only a 22.22% ownership [200 (your remaining 100 shares in Stork + Lori’s 100 shares) ÷ 900 (remaining outstanding shares in Stork)]. Because, after the redemption, you owned less than 50% of the stock in Stork Corporation and less than 80% of your original ownership [22.22% is less than 24% (80% X 300 shares/1,000 shares)], the redemption qualifies for capital gain treatment. Should you need additional information or need to clarify our conclusion, do not hesitate to call on me. Sincerely, Marilyn C. Jones, CPA Partner TAX FILE MEMORANDUM DATE: May 8, 2002 FROM: Marilyn C. Jones SUBJECT: Lana Pierce Today I talked to Lana Pierce with respect to her May 5 letter. She received a cash payment of $45,000 from Stork Corporation in exchange for 100 of the 200 shares she owned in the corporation. Lana’s mother, Lori, owns 100 shares of Stork, and the remaining shares are owned by an unrelated individual. She wants to know the tax consequences of the redemption. At issue: Will the stock redemption qualify for capital gain treatment or will the $45,000 be treated as a taxable dividend? 10-16 2003 Entities Volume/Solutions Manual Conclusion: Lana Pierce has a capital gain of $35,000. Lana is deemed to own Lori’s 100 shares before and after the redemption. Lana's percentage ownership in Stork Corporation was 30% (300 shares/1,000 shares) before the redemption and 22.22% (200 shares/900 shares) after the redemption. Because the 80% and 50% tests set out in § 302(b)(2) are met, the stock redemption qualifies for capital gain treatment. pp. 10-22 and 10-23 33. a. The redemption cannot qualify as a complete termination redemption. Jacque is deemed to own Monique’s 800 shares or 67% (800/1,200) of the remaining shares outstanding. The family attribution waiver does not apply because Jacque holds a prohibited interest in Thrush Corporation (i.e., directorship) immediately after the redemption. b. The redemption can qualify as a complete termination redemption. Monique’s position as a director does not constitute a prohibited interest for Jacque. Thus, if the other requirements for the family attribution waiver are satisfied (e.g., Jacque files the required agreement with the IRS), the redemption completely terminates Jacque’s ownership interest in Thrush. c. The redemption cannot qualify as a complete termination redemption. To qualify for the family attribution waiver, the former shareholder cannot acquire a stock ownership interest in the corporation (other than by bequest or inheritance) during the 10 years following the redemption. BRIDGE DISCIPLINE PROBLEM 1. Answers will vary by student. RESEARCH PROBLEMS 1. Smith, Raabe, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 November 23, 2002 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. Corporations: E & P and Dividend Distributions 10-17 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 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 10-18 2003 Entities Volume/Solutions Manual 2. Smith, Raabe, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 November 15, 2002 Ms. Julie Preston 1803 E. Monroe Street Madison, WI 53706 Dear Julie: I am writing this letter to describe the tax consequences of the compensation proposal you suggested at our last board of directors meeting. In particular, you proposed that PLS set your 2002 compensation at $2.5 million, to be funded with the $500,000 in legal fees due in 2002 from the class action suit, the $1.3 million in cash currently held by the corporation, and a loan from you for $700,000. It is anticipated the PLS will pay back your loan using the Federal tax refund it will receive from carrying back the current year $2 million net operating loss to 2000. There are two important tax issues that need to be addressed before we move ahead with your plan. First, for PLS to deduct the compensation, § 162(a) requires that the payment is reasonable in amount. On the basis of practices in other professional service firms, I believe we can make a strong argument that your compensation is reasonable. It is common in professional service firms to adopt compensation practices similar to ours (where fees in excess of expenses are paid out in full to the professional employees in the firm). While we do not follow this practice precisely (we will pay out considerably more in compensation this year than will be received in fees), this should not be a problem. With $2.5 million in compensation this year, the aggregate compensation to you over the last three years will be $5,850,000, which is less than the fees that you generated over the same period. Thus, our position will be that compensation for 2002 is provided, in part for services rendered in prior years. A similar, multi-year perspective was taken by the judge in Richard Ashare, P.C., 78 TCM 348, T.C. Memo 1999–282, where compensation in a law firm was paid in years following the years in which legal fees were generated. The reasonableness of your compensation is further supported by the factors elaborated in Mayson Manufacturing Co. v. Comm., 49-2 USTC ¶ 9467, 38 AFTR 1028, 178 F.2d 115 (CA–6, 1949). In particular, your role in PLS is vital to the conduct of the company’s business; the business is complex and highly specialized and you are unique in your level of expertise. Furthermore, the revenues generated by PLS are attributable in full to your efforts. Based on your success in the class action case, I believe we have prima facie evidence that the proposed amount of compensation to be paid in 2002 is reasonable, especially in light of the increasing emphasis on the reasonable investor standard [e.g., see Alpha Medical, Inc. v. Comm., 99–1 USTC ¶ 50,461, 83 AFTR2d 99–697, 172 F.3d 942 (CA–6, 1999)]. A second issue that may arise as a result of your proposal pertains to the motivation for the compensation payment. The IRS may suggest that the increase in compensation ($2 million over fees received) this year is motivated primarily by the desire to recapture the taxes PLS paid in 2000 (via a net operating loss carryback) rather than to compensate you for services. If such an argument stands, then the compensation payment would not be deductible. Again, our case is substantially similar to the facts in Ashare. In that case, the attorney/sole shareholder was paid compensation in excess of revenues, generating a net operating loss carryback. The compensation was funded in part by the refund received as a result of the carryback. The judge Corporations: E & P and Dividend Distributions 10-19 in Ashare indicated that, since compensation was reasonable and paid for services rendered in the past, evidence supported a motivation for compensating the sole employee over a tax-driven motive. If you have any further questions about the tax consequences of PLS’s 2002 compensation proposal, please do not hesitate to contact me. Sincerely yours, Jon S. Davis, CPA Partner 3. a. Smith, Raabe, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 November 20, 2002 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 (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, 10-20 2003 Entities Volume/Solutions Manual Jon S. Davis, CPA Partner TAX FILE MEMORANDUM November 20, 2002 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. (2) Distribute $4 million in cash and securities to Aqua as a dividend. The dividend would 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? 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 Corporations: E & P and Dividend Distributions 10-21 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 referrals. One possible distinction between the facts in Roy and the 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 10-22 2003 Entities Volume/Solutions Manual 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. 7. See the Internet Activity comment above.
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