Chapter 12 Corporations Effects on Retained Earnings and the Income Statement Solution Manual by cft13762

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									                                       CHAPTER 5

                    CORPORATIONS: EARNINGS & PROFITS AND
                          DIVIDEND DISTRIBUTIONS

                       SOLUTIONS TO PROBLEM MATERIALS




                                                                      Status:    Q/P in
Question/                                                             Present     Prior
Problem                             Topic                             Edition    Edition

    *1      Taxation of corporate distributions                      Unchanged     1**
     2      Definition of earnings and profits                       Unchanged     2**
     3      Effect of selected transactions in adjusting             Unchanged     3**
               taxable income (for determining E & P)
    4       Comparison of accounting methods under E & P and         Unchanged     4**
               income tax
    5       Effect of selected situations in adding to or            Unchanged     5**
               generating a deficit in E & P
    6       Effect of distribution, taxable dividend or return       Unchanged     6**
               of capital, in selected situations
    7       Planning corporate distributions: beginning or end of    Unchanged     7**
               tax year
    8       Rationale for reduced tax rate on dividends              Unchanged     8**
   *9       Factors affecting tax treatment of distribution          Modified     14**
   10       Requirements for qualified dividend tax rates            Unchanged     9**
   11       Purpose of property dividend versus cash dividend        Unchanged    10**
   12       Property distribution: choice of property                Unchanged    11**
   13       Effect of property dividend on distributing              Unchanged    12**
               corporation
   14       Impact of property distributions on E & P                New
   15       Necessity of dividend distribution to meet state legal   Unchanged    15**
               requirements in determining tax treatment
  *16       Reasonable compensation and constructive                 Unchanged    16**
               dividends
   17       Selected factors in determining reasonableness of        Unchanged    17**
               compensation
   18       Choice between dividend and deductible payment           Modified     18**
   19       Unreasonable compensation                                Unchanged    19**
   20       Unreasonable compensation; ways to draw funds            Modified     20**
               from corporation


                                            5-1
5-2                   2007 Corporations Volume/Solutions Manual


                                                                           Status:    Q/P in
Question/                                                                  Present     Prior
Problem                               Topic                                Edition    Edition

      21    Election to receive common or preferred stock                 Unchanged    21**
               dividend
      22    Rationale underlying tax treatment of stock                   Unchanged    22**
               distributions
      23    Explain tax effects of nontaxable stock rights;               Unchanged    23**
               taxable stock rights
      24    Amount of dividend income                                     Unchanged    24**
      25    Amount of taxable income; balance in E & P                    Unchanged    25**
      26    Deficit in E & P followed by sale on installment              Unchanged    26**
               method; taxation of dividend distribution
      *27   Compute E & P                                                 New
      *28   Effect of specified transactions on taxable income; on        New
               E&P
      *29   Effect of specified transactions on taxable income; on        Modified     42**
               E&P
      30    Amount of dividend income; deficit in current E & P with      Unchanged    27**
               positive balance in accumulated E & P
       31   Dividend distribution; effect on E & P                        Modified     43**
       32   Dividend distribution; effect on E & P                        Modified     44**
       33   Dividend distribution; effect on E & P                        Modified     45**
      *34   Cash distributions; determination of taxable amount           Unchanged    28**
       35   Cash distributions; determination of taxable amount           Unchanged    29**
       36   Choosing low tax on dividend or investment                    Unchanged    32**
               interest expense deduction
      37    Holding period requirement for qualified dividend             New
      38    Property distribution; effect of gain, loss, liability, and   Unchanged    33**
               differing basis
      39    Tax treatment to shareholder and to corporation on            Unchanged    34**
               distribution of property subject to liability
               in excess of basis
      40    Tax treatment to individual shareholder and to                Unchanged    35**
               distributing corporation of property subject to a
               liability
      41    Taxation of dividend when E & P has positive                  Unchanged    36**
               balance but corporation has current loss
      42    Property distribution where FMV is less than                  Unchanged    37**
               adjusted basis
      *43   Effect of distributions                                       Unchanged    38**
      *44   Property dividend; liability assumed by shareholder;          Unchanged    40**
               determination of E & P; distribution of loss
               property
      45    Property distribution to corporate shareholder;               Unchanged    41**
               basis in excess of FMV; liability assumed by
               shareholder
       46   Interest free loan to shareholder                             Unchanged    46**
       47   Constructive dividends                                        Modified     39**
       48   Basis of nontaxable preferred stock dividend                  Unchanged    47**
       49   Stock dividend; basis allocation; gain on sale                Unchanged    48**
      *50   Stock rights; basis allocation; gain on sale                  Unchanged    49**
       51   Choosing between a dividend and a deductible                  Unchanged    50**
               payment
      52    Source of dividend distribution                               Unchanged    51**
           Corporations: Earnings & Profits and Dividend Distributions                       5-3


                                                                        Status:           Q/P in
Research                                                                Present            Prior
Problem                            Topic                                Edition           Edition

   1       Salary reimbursement (Oswald) agreement                    Unchanged            1**
   2       Effect of large dividend on individual shareholder         Unchanged            2**
   3       Dividend in anticipation of corporate sale                 Modified             3**
   4       Distribution of corporate note                             New
   5       Internet activity                                          Unchanged            5**
   6       Internet activity                                          Unchanged            6**
   7       Internet activity                                          New

            *The solution to this problem is available on a transparency master.
           **Refers to the Solution Manual materials for Chapter 4 in the 2006 Edition.
5-4                     2007 Corporations Volume/Solutions Manual


                                        CHECK FIGURES

24.     Ordinary dividend income $65,000         38.c.   Violet $7,000 gain; Taylor $3,000
        each, Cindy reduces basis in stock               dividend; ending E & P $39,000;
        to $6,000, George reduces stock                  Taylor land basis $25,000.
        basis to zero and capital gain $3,000.   38.d.   Taylor $25,000 dividend and
25.a.   $500,000.                                        $25,000 land basis; Violet ending
25.b.   $1,025,000.                                      E & P $7,000.
26.     $300,000 taxable dividend.               38.e.   Violet $5,500 taxable gain; Taylor
27.     $319,850.                                        $6,000 dividend and $6,000
28.a.   $10,000; no effect.                              furniture basis; ending E & P
28.b.   ($24,000); $22,400.                              $32,500.
28.c.   No effect; $120,000.                     39.a.   $75,000.
28.d.   $6,000; $14,000.                         39.b.   $0.
28.e.   ($45,000); $45,000.                      40.     Raptor reduces E & P by
28.f.   ($100,000); $80,000.                             $190,000; Jaime taxable dividend
28.g.   No effect; ($20,000).                            $165,000 and land basis $225,000.
28.h.   ($80,000); ($10,000).                    41.     $29,000 dividend and $9,000
28.i.   No effect; ($80,000).                            return of capital.
29.     $330,568; $263,000.                      42.     Tyler dividend $120,000 and basis
30.     $45,000 taxable dividend, $60,000                in land $120,000; Plover $0 loss
        capital gain.                                    recognized and E & P reduced
31.     Return of capital $50,000.                       $200,000.
32.     Taxable dividend $40,000 and             44.a.   $42,000.
        return of capital $20,000.               44.b.   $100,250.
33.a.   Taxable dividend $40,000 each.           44.c.   $120,000.
33.b.   ($190,000) accumulated                   44.d.   $100,500 taxable dividend; E & P
        E & P balance.                                   is $100,250.
34.a.   $70,000; $60,000.                        45.a.   Dividend income $10,000,
34.b.   $140,000; $70,000.                               dividends received deduction
34.c.   $150,000; $0.                                    $8,000, basis $60,000 in land.
34.d.   $80,000; $50,000.                        45.b.   $40,000.
34.e.   $100,000; $30,000.                       48.     Common stock basis is $30,000;
35.     Marie dividend income $145,000,                  preferred stock is $10,000.
        $15,000 reduces basis in stock           49.     $7,000 long-term capital gain.
        and capital gain $125,000 on sale;       50.     Long-term capital gain on sale
        Juan dividend $45,000 and                        $1,319.40 and new stock basis
        $115,000 reduction in basis.                     $4,271.40.
37.     $1,000 ordinary income.                  51.a.   $1,950.
38.a.   Violet $7,000 gain; Taylor $25,000       51.b.   $5,100.
        dividend, $25,000 land basis;            51.c.   Ivana is better off with bonus;
        ending E & P $17,000.                            Robin is better off with bonus.
38.b.   Violet $7,000 gain; Taylor $7,000        51.d.   Pay bonus.
        dividend, $3,000 capital gain,
        $25,000 land basis; ending E & P $0.
               Corporations: Earnings & Profits and Dividend Distributions                       5-5


DISCUSSION QUESTIONS

1.   At least six factors impact the tax treatment of corporate distributions. These factors are:

     l    The availability of earnings to be distributed.

     l    The basis of the stock in the hands of the shareholder.

     l    The character of the property being distributed.

     l    Whether the shareholder gives up ownership in return for the distribution.

     l    Whether the distribution is liquidating or nonliquidating in character.

     l    Whether the assets distributed are subject to any liabilities or whether the shareholder
          assumes any liabilities in the distribution.

     l    Whether the distribution is a ‘‘qualified dividend.’’

     p. 5-2

2.   ‘‘Earnings and profits’’ is the factor that fixes the upper limit on the amount of dividend
     income shareholders recognize as a result of a distribution from the corporation. It repre-
     sents the corporation’s economic ability to pay a dividend without impairing its capital.
     ‘‘Earnings and profits’’ is similar to the accounting concept of ‘‘retained earnings.’’ However,
     E & P and retained earnings differ because E & P is computed using tax rules while
     retained earnings is computed using financial accounting rules. For example, a stock divi-
     dend that decreases the retained earnings account does not decrease E & P. E & P is
     increased for all items of income. It is decreased for deductible and nondeductible items,
     such as capital losses, income taxes, and expenses incurred to produce tax-exempt
     income. p. 5-3 and Concept Summary 5-1

3.   a.       To determine current E & P for 2006, taxable income is increased by the interest
              received on municipal bonds.

     b.       Taxable income for 2006 is increased by the amount of the net operating loss carry-
              over because the net operating loss already reduced E & P in 2005.

     c.       Gains and losses from involuntary conversions affect the determination of E & P
              only to the extent that they are recognized for tax purposes. Thus, no adjustment to
              taxable income is necessary.

     d.       Taxable income is reduced by the loss on sale between related parties.

     e.       Taxable income is reduced by the Federal income tax paid when computing its
              E & P for 2006.

     f.       In any year § 179 is elected, 80% of the resulting expense must be added back to
              taxable income to determine current E & P.

     pp. 5-3 to 5-6 and Concept Summary 5-1

4.   The accounting methods employed when computing E & P are considerably more conserv-
     ative than the methods allowed when computing taxable income. First, rather than allowing
5-6                       2007 Corporations Volume/Solutions Manual


      the taxpayer to carry forward NOLs, capital losses, and charitable contributions, these
      deductions are accelerated to the year realized. Second, the computation of E & P does
      not allow use of the installment method. Third, more conservative depreciation methods
      are used—in particular, ADS depreciation rather than MACRS is mandated and no addi-
      tional 50 percent (or 30 percent) first-year depreciation is allowed. A portion of § 179
      expense is deferred when computing E & P (only 20% of the expense is allowed as a
      deduction each year over a five-year period). A variety of other more conservative account-
      ing methods are required when computing E & P (e.g., cost depletion, percentage of com-
      pletion for long-term contracts, and capitalization and amortization of mining exploration
      and development costs and intangible drilling costs). pp. 5-4 to 5-6

5.    a.        A dividend distribution cannot generate or add to a deficit in E & P.

      b.        An operating loss can both generate and add to a deficit in E & P. Deficits can only
                arise through corporate losses.

      p. 5-15

6.    a.        If a distributing corporation has a deficit in accumulated E & P and a positive
                amount in current E & P, a distribution during the year is a taxable dividend to the
                extent of current E & P.

      b.        If the corporation has a positive amount in accumulated E & P and a deficit in current
                E & P, a distribution either is a taxable dividend or a return of capital, depending on
                the resulting balance in E & P when current and accumulated E & P are netted. The
                accounts are netted at the date of distribution. If the resulting balance is zero or a
                deficit, the distribution results in a tax-free recovery of basis or capital gain. If a
                positive balance results, the distribution represents a dividend to that extent. For
                netting purposes, current E & P is determined as of the date of the distribution by
                ratably allocating the loss over the entire year, unless the loss can be shown to
                have otherwise occurred.

      c.        If there is a deficit in both current and accumulated E & P, a corporate distribution is
                treated as a return of capital to the extent of the shareholder’s basis in his or her
                stock. Any excess is a capital gain.

      d.        If there is a positive amount in both current and accumulated E & P, to the extent of
                the positive balance in both amounts, the distribution is a taxable dividend.

      pp. 5-6 to 5-10 and Concept Summary 5-2

7.    This is not a valid statement. Any current E & P (determined at the end of the year) is
      deemed to be available when the distribution occurs, on January 1. p. 5-9

8.    The reduced tax on dividends is intended to lessen the effect of several existing distortions
      and to stimulate the economy. The distortions arise from the double tax on corporate income
      and include (1) an incentive to invest in non-corporate businesses rather than corporations,
      (2) an incentive for corporations to finance operations through debt rather than equity, and
      (3) an incentive to retain more earnings than necessary. It has been estimated that reducing
      the tax on dividends will stimulate the economy significantly, leading to gains of up to
      $25 billion annually (if the tax were dropped completely). Because debt financing would not
      be as heavily relied upon, the reduced tax on dividends should make the economy more
      robust in economic downturns. The competitiveness of the U.S. in the international markets
      should also be improved. This comes about because most of our trading partners do not
      impose a double tax on corporate source earnings. pp. 5-10 and 5-11
               Corporations: Earnings & Profits and Dividend Distributions                       5-7


9.    A variety of factors should be considered, including:

      l    What is the E & P of Falcon Corporation?

      l    Has E & P been accurately determined for tax purposes?

      l    How much E & P is allocated to each shareholder’s distribution?

      l    How will the distribution affect Falcon Corporation’s E & P?

      l    Is the distribution in partial or complete liquidation of Falcon Corporation?

      l    Does the distribution qualify as a stock redemption for tax purposes?

      l    What is the tax basis to the shareholders of Falcon Corporation stock?

      Also important is the nature of the shareholder. In the case of a corporate shareholder
      (Hawk Corporation in this situation), a dividends received deduction is available. In con-
      strast, individual shareholders may qualify for the 15%/5% rates.

      pp. 5-2 to 5-15 and Chapters 2 and 6

10.   To qualify for the reduced 15%/5% tax rates, a dividend must be paid to an individual
      shareholder by a qualifying corporation (U.S. corporations and certain eligible foreign
      corporations). In addition, the shareholder cannot hold both long and short positions in the
      stock at the time the dividend is paid. Finally, the shareholder must hold the stock for
      60 days during the 121 day period beginning 60 days before the ex-dividend date. pp. 5-11
      and 5-12

11.   A corporation may distribute a property dividend for various reasons. The shareholders
      could want a particular property that is held by the corporation. The corporation may be
      strapped for cash but does not want to forgo distributing a dividend to its shareholders.
      p. 5-13

12.   Distributing machine A triggers a taxable gain of $6,000 for Crow Corporation, while
      distributing C produces a nondeductible loss of $3,000. To preserve the loss on C and
      avoid recognizing a gain on A, Crow should consider selling C and then distributing cash to
      the second shareholder. Crow should also distribute machine B because there will be no
      gain on distribution and no nondeductible loss. p. 5-14

13.   Probably not, unless the corporation has some capital losses it cannot use. In the case of
      corporations, capital gains are taxed the same as ordinary income. See the discussion in
      Chapter 2.

14.   Distributions of property reduce E & P by the greater of the fair market value or the adjusted
      basis of the property distributed, less the amount of any liability on the property. E & P is
      increased by any gain recognized on the distribution. Examples 18, 19, and 20

15.   A distribution by a corporation to its shareholders can be treated as a dividend for Federal
      income tax purposes even though it is not formally declared or designated as a dividend.
      Also, it need not be issued pro rata to all shareholders. Nor must the distribution satisfy the
      legal requirements of a dividend as set forth by applicable state law. The key factor
      determining dividend status is a measurable economic benefit conveyed to the
      shareholder. This benefit, when described as a constructive dividend, is distinguishable
      from actual corporate distributions of cash and property in form only. p. 5-15
5-8                      2007 Corporations Volume/Solutions Manual


16.   Because of Jacqueline’s relationship with Edward, the IRS may argue that any excessive
      compensation paid to Jacqueline or Edward is properly treated as a constructive dividend.
      Imputed interest on the loan to Edward may also be treated as dividend income. The
      following issues are relevant.

      l    Are the salary payments to Edward and Jacqueline reasonable?

      l    What are Edward’s and Jacqueline’s qualifications?

      l    What are the nature and scope of Edward’s and Jacqueline’s work?

      l    How does the overall salary paid to Edward and Jacqueline compare with gross and
           net income?

      l    What is the corporation’s salary policy towards all employees?

      l    Regarding the advance to Edward, was it a bona fide loan?

      l    Was it evidenced by a written instrument?

      l    Was collateral or other security provided?

      l    What is Edward’s financial capacity to repay the loan?

      l    How did Edward use the proceeds of the loan?

      l    What is Kingfisher’s dividend paying history?

      l    What is the amount of ‘‘imputed interest’’ on the loan?

      pp. 5-15 to 5-18

17.   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 sal-
             ary could be considered as having been paid to the owner. If so, the same factors
             used to determine the reasonableness of salary paid to the owner should be used
             to determine the reasonableness of salary 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 cor-
             poration, 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.
               Corporations: Earnings & Profits and Dividend Distributions                        5-9


      f.     Year-end bonuses would be vulnerable to constructive dividend treatment, particu-
             larly 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.

      p. 5-17 and Example 30

18.   Adam would prefer a dividend because he would have $21,250 after tax [$25,000 dividend À
      ($25,000 Â 15% tax rate)]. If he were paid a bonus, only $18,000 after tax [$25,000 bonus À
      ($25,000 Â 28% tax rate)] results. However, this ignores the effect of the payments on
      Sparrow Corporation. If Sparrow paid Adam a deductible bonus, it would save $8,500
      ($25,000 deduction for bonus payment  34% tax rate) in taxes. (There is no tax savings
      with a dividend payment.) Since Adam is $3,250 better off with a dividend ($21,250 after
      tax from a dividend À $18,000 after tax with a bonus) and Sparrow is $8,500 better off with
      a bonus, the two parties taken together are $5,250 better off with a bonus ($8,500 benefit
      from bonus for Sparrow À $3,250 benefit from a dividend for Adam). As Adam is the sole
      shareholder of the corporation, he should choose the bonus alternative. Examples 28 and 29

19.   The salaries paid to Sam and Jennifer are vulnerable to constructive dividend treatment
      since neither shareholder appears to have earned them.

      There is also a problem regarding the $400,000 salary payment to Walter. Why is he
      receiving $350,000 more than Richard when it appears they share equally in the operation
      of the corporation? Although Walter is not a shareholder, his relationship to Sam and Jenni-
      fer is enough of a tie-in to raise the unreasonable compensation issue.

      Peregrine Corporation has distributed only one small dividend during the past ten years
      although it has substantial E & P. Given the dividend history and the salary disparities, the
      IRS might successfully argue that all of the salary paid to Sam and Jennifer is unreason-
      able compensation and that $350,000 of the salary paid to Walter is unreasonable.

      Example 30

20.   There would be a problem if Katrina makes the pledge because Condor Corporation will
      have satisfied Katrina’s obligation. Condor’s payment to the charity may be treated as indi-
      rect compensation to her. Thus, Katrina should not have made the pledge. Instead have
      the corporation make the contribution directly. In determining whether Condor has paid
      Katrina ‘‘unreasonable’’ compensation, both the direct compensation of $500,000 and the
      indirect payment of $150,000 made on her behalf will be considered. Examples 31 and 32

21.                      Hoffman, Raabe, Smith, and Maloney, CPAs
                                   5191 Natorp Boulevard
                                     Mason, OH 45040

      November 17, 2006

      Eagle Corporation
      4376 Pine View Drive
      Madison, WI 53717

      Dear President of Eagle 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 14
      letter. Any change in facts may cause our conclusion to be inaccurate.
5-10                      2007 Corporations Volume/Solutions Manual


       Your shareholders will have taxable income equal to the fair market value of the stock divi-
       dend. 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 17, 2006

       FROM:          Jon S. Davis

       SUBJECT:       Eagle Corporation

       Based on the facts summarized in a letter (dated November 14) from the president of Eagle
       Corporation, the following occurred. Eagle Corporation declared a dividend permitting its
       shareholders to elect to receive either 15 shares of cumulative preferred stock or 5 addi-
       tional shares of Eagle common stock for every 20 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 divi-
       dends are not taxable if they represent pro rata distributions on common stock. However,
       this general rule has five exceptions, one of which applies in the current situation. In partic-
       ular, a distribution of preferred stock to some common shareholders and of common stock
       to other common shareholders is a taxable event.

       Conclusion: The shareholder will have taxable income equal to the fair market value of the
       stock dividend.

       pp. 5-18 and 5-19

22.    The rules that determine the tax treatment of stock distributions are based on the
       proportionate interest concept. Stock distributions are generally excluded from income
       because the proportionate ownership interest of the shareholder is not changed by the
       distribution. Thus, § 305, which is based on this doctrine, excludes from gross income pro
       rata distributions of stock or stock rights paid on common stock. Conversely, stock divi-
       dends are taxable when shareholders’ proportionate interests in the corporation may
       change as a result of the stock distribution. This is the case for each of the five exceptions
       listed in § 305(b). pp. 5-18 and 5-19

23.    If stock rights are nontaxable and the value of the rights is less than 15% of the value of the
       old stock, the basis of the rights is zero unless the shareholder elects to have some of the
       basis in the formerly held stock allocated to the rights. If the fair market value of the rights is
       15% or more of the value of the old stock and the rights are exercised or sold, the
       shareholder must allocate some of the basis in the formerly held stock to the rights.
               Corporations: Earnings & Profits and Dividend Distributions                    5-11


      Taxable stock rights produce taxable income to the shareholder to the extent of the fair
      market value of the rights. The fair market value then becomes the shareholder’s basis in
      the rights.

      If the rights are exercised, the holding period for the new stock is the date the rights
      (whether taxable or nontaxable) are exercised. The basis of the new stock is the basis of
      the rights plus the amount of any other consideration given.

      pp. 5-19 to 5-21

PROBLEMS

24.   George and Cindy have ordinary dividend income of $65,000 each {[$85,000
      (accumulated E & P) + $45,000 (current E & P)] ‚ 2}. The dividend income will be subject
      to the 15%/5% tax rates on dividends. The remaining $20,000 of the $150,000 distribution
      reduces the basis ($10,000 each) in the shareholders’ stock with any excess treated as a
      capital gain. George has a reduction in stock basis from $7,000 to zero and a capital gain
      of $3,000. Cindy reduces her basis from $16,000 to $6,000. Example 1

25.   a.     Blue Jay reports the $500,000 dividend as taxable income but has a dividends
             received deduction under § 243 of $350,000 (70% Â $500,000). None of the other
             items affect taxable income. Thus, taxable income is $500,000 ($350,000 taxable
             income before dividends + $500,000 dividend À $350,000 dividends received
             deduction).

      b.     Blue Jay Corporation’s E & P as of December 31 is $1,025,000, computed as follows:
             $125,000 (beginning balance in E & P) + $500,000 (taxable income) + $350,000
             (dividends received deduction) + $75,000 (tax-exempt interest) À $25,000 (interest
             on indebtedness to purchase tax-exempt bonds).

      pp. 5-3 and 5-4

26.   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 2006. The E & P balance prior to the $300,000 distribu-
      tion is $150,000 [$550,000 (gain on sale) À $280,000 (accumulated deficit) À $120,000
      (current year deficit)]. Current E & P before the distribution is $430,000 [$550,000 (gain on
      sale) À $120,000 (current year deficit)]. Since there is adequate current E & P, the entire
      distribution is a dividend. pp. 5-4, 5-9, and Example 6

27.   Tern Corporation’s current E & P is computed as follows:

      Taxable income                                                                 $320,000
      Federal income tax liability                                                   (108,050)
      Interest income from tax-exempts                                                  4,000
      Disallowed portion of meal and entertainment expenses                            (1,000)
      Life insurance premiums paid, net of increase in
         cash surrender value ($2,500 À $600)                                           (1,900)
      Proceeds from life insurance policy, net of cash
         surrender value ($120,000 À $15,000)                                         105,000
      Excess capital losses                                                           (11,000)
      Excess of MACRS depreciation over E & P
         depreciation ($24,000 À $14,000)                                               10,000
      Allowable portion of 2005 § 179
         expenses (20% Â $90,000)                                                      (18,000)
      Organizational expense amortization                                                  467*
      Dividends received deduction (70% Â $20,000)                                      14,000
5-12                     2007 Corporations Volume/Solutions Manual


        LIFO recapture adjustment                                                      9,000
        Installment sale gain                                                         (2,667)**
        Current E & P                                                               $319,850

        *[($7,000 organizational expenses/180 months) Â 12 months]

       **{[($30,000 sales price À $22,000 basis)/$30,000 sales price] Â $10,000}

        Concept Summary 5-1

28.                          Taxable Income                    E & P Increase
                           Increase (Decrease)                   (Decrease)
       a.                        $10,000                         No effect
       b.                       ($24,000)                         $22,400*
       c.                       No effect                        $120,000
       d.                         $6,000                          $14,000**
       e.                       ($45,000)                         $45,000
       f.                      ($100,000)                         $80,000***
       g.                       No effect                        ($20,000) 
       h.                       ($80,000)                        ($10,000)  
       i.                       No effect                        ($80,000)

        *Although mining exploration costs are deductible in full under the income tax, they must
         be amortized over 120 months when computing E & P. Since $200 per month is amortiz-
         able ($24,000/120 months), $1,600 is currently deductible for E & P purposes ($200 Â 8
         months). Thus, of the $24,000 income tax deduction, $22,400 must be added back to
         E & P ($24,000 À $1,600 deduction allowed).
       **The receipt of a $20,000 dividend will generate a dividends received deduction of
         $14,000. The net effect on taxable income is an increase of $6,000. For E & P purposes,
         the dividends received deduction must be added back.

       ***Only 20% of current-year § 179 expense is allowed for E & P purposes. 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.
         ADS straight-line depreciation is allowed for E & P purposes; thus, E & P is decreased by
         $10,000 (the excess of ADS depreciation over the amount allowed under MACRS).
        Concept Summary 5-1

29.     Taxable income:
          Income from services rendered                                                $400,000
          Dividend income                                                                40,000
                                                                                       $440,000
            Less: Salaries                                                $70,000
                  Depreciation ($80,000 Â 14.29%)                          11,432       (81,432)
            Taxable income before dividends received deduction                         $358,568
            Less: Dividends received deduction (70% Â $40,000)                          (28,000)
            Taxable income                                                             $330,568
                Corporations: Earnings & Profits and Dividend Distributions                      5-13


      E & P:
        Taxable income                                                                    $330,568
        Add:
             Tax-exempt income                                               $24,000
             Excess of MACRS over straight-line:
               Straight-line is $4,000 [($80,000 ‚ 10) ‚ 2]
             MACRS depreciation of $11,432 less
               $4,000 straight-line                                            7,432
             Dividends received deduction                                     28,000        59,432
                                                                                          $390,000
           Deduct:
               STCL on sale of stock                                        $ 17,000
               Estimated Federal income tax                                  110,000      (127,000)
           E&P                                                                            $263,000

      pp. 5-3 to 5-7 and Concept Summary 5-1

30.   Dividend income is $45,000, a tax-free recovery of basis is $40,000, and capital gain is
      $60,000. To determine the amount of dividend income, the balances of both accumulated
      and current E & P as of June 30 must be netted because of the deficit in current E & P. As
      one half of the loss (or $185,000) is deemed to have occurred on June 30, the $230,000 in
      accumulated E & P is reduced by $185,000. The $45,000 balance in E & P triggers divi-
      dend income. The remaining $100,000 of the distribution is a recovery of capital, reducing
      basis to zero and then triggering capital gain. Example 11

31.   The shareholder has a return of capital of $50,000. The $50,000 reduces the basis in the
      Teal Corporation stock; any excess over basis is capital gain. There is no dividend income
      because of the absence of E & P. On the date of the sale, E & P is a negative $20,000
      [$225,000 (beginning balance in accumulated E & P) À $225,000 (existing deficit in current
      E & P from sale of the asset) À $20,000 (one-fourth of the $80,000 negative E & P not
      related to asset sale)]; thus, the $50,000 distribution constitutes a return of capital. Gener-
      ally, deficits are allocated pro rata throughout the year unless the parties can prove other-
      wise. Here the shareholder can prove otherwise. Note: If the $305,000 deficit in E & P were
      prorated throughout the year, there would have been a taxable dividend of $50,000
      because E & P would have a positive balance of $148,750 at the date of distribution
      [$225,000 (beginning balance in accumulated E & P) À $76,250 (one-fourth the $305,000
      deficit for the year)]. Examples 11 and 26

32.   Bunting Corporation has no accumulated E & P at the time of the distribution. The share-
      holder has a taxable dividend equal to the current E & P determined at year-end, which
      was $40,000. The balance of the distribution, $20,000, reduces the adjusted basis of the
      stock, and any excess over basis results in capital gain. pp. 5-6 to 5-10

33.   a.       Woodpecker Corporation and Tim each have a taxable dividend of $40,000. Cor-
               morant Corporation’s current E & P is $90,000; thus, the entire distribution is a tax-
               able dividend even though Cormorant has no accumulated E & P. Woodpecker
               Corporation is entitled to a dividends received deduction of $32,000 (80% Â
               $40,000). Thus, Woodpecker is only taxed on $8,000. Because Tim is an individual,
               he pays tax on the entire dividend. If the dividend is qualifying, it is subject to the
               preferential 15%/5% tax rates.

      b.       To determine Cormorant Corporation’s accumulated E & P at the end of the year,
               its current E & P ($90,000) is reduced by the amount of the distributions ($80,000).
               The remaining $10,000 is then netted against the deficit in accumulated E & P of
               $200,000, leaving a net deficit of $190,000.

      pp. 5-6 to 5-11
5-14                     2007 Corporations Volume/Solutions Manual


34.              Dividend     Return of
                 Income        Capital
       a.        $ 70,000      $60,000       Taxed to the extent of current E & P.
       b.        $140,000      $70,000       Accumulated E & P and current E & P netted on the
                                             date of distribution.

       c.        $150,000      $    –0–      Taxed to the extent of current and accumulated E & P.
       d.        $ 80,000      $50,000       Accumulated E & P and current E & P are netted on
                                             the date of distribution. There is a a dividend to the
                                             extent of any positive balance.
       e.        $100,000      $30,000       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 $100,000 [current E & P is a deficit
                                             of $20,000 (i.e., 1/2 of $40,000) netted with
                                             accumulated E & P of $120,000].

       The dividend income will qualify for the 15%/5% tax rates if the shareholder is an individual.

       pp. 5-6 to 5-10

35.    The $90,000 in current E & P is allocated on a pro rata basis to the two distributions made
       during the year; thus $45,000 of current E & P is allocated to Marie’s distribution and
       $45,000 is allocated to Juan’s distribution. Accumulated E & P is applied in chronological
       order beginning with the earliest distribution. Thus, the entire accumulated E & P balance
       of $100,000 is allocated to Marie’s distribution. As a result, $145,000 ($100,000 AEP +
       $45,000 current E & P for one-half of the year) of Marie’s July 1 distribution is taxed as divi-
       dend income. The remaining $15,000 of the $160,000 distribution reduces Marie’s stock
       basis to $25,000 ($40,000 original basis À $15,000 recovery of capital). Marie then recog-
       nizes a capital gain of $125,000 on the sale of the stock [$150,000 (sales price) À $25,000
       (remaining stock basis)]. Of the $160,000 distributed to Juan, $45,000 will be treated as a
       dividend. The remaining $115,000 will reduce Juan’s stock basis to $35,000 [$150,000
       (original cost) À $115,000 (reduction in basis from the distribution)]. pp. 5-6 to 5-10

36.    If Becca does not include the dividend in net investment income, her tax on the dividend
       will be $600 ($4,000 dividend  15% tax rate). In addition, $3,500 of investment interest
       expense will carry forward and be deductible next year, generating a tax benefit of $1,225
       (35% Â $3,500). Thus, excluding the dividend from net investment income yields a current
       year tax of $600 and a tax savings next year of $1,225.

       If she were to elect to treat the dividend as net investment income this year, ordinary
       income of $4,000 results from the dividend and $3,500 of additional offset from investment
       interest expense. As a result, her tax liability would be $175 [($4,000 dividend income À
       $3,500 interest expense) Â 35%].

       Ignoring a discount factor for time value, Becca should retain qualifying (15% tax rate)
       treatment for the dividend. Using this approach, she will save a total of $625 in taxes over
       the next 2 years ($1,225 taxes saved next year À $600 of tax paid this year). In contrast,
       including the dividend in net investment income would trigger a tax liability of $175 in the
       current year. Even with a substantial discount rate for the time value of money, Becca
       would be better off with qualified dividend treatment.

       p. 5-12
               Corporations: Earnings & Profits and Dividend Distributions                        5-15


37.   The $1,000 dividend will be taxed to Alexis as ordinary income. Because she did not hold the
      stock for more than 60 days during the 121 day period beginning 60 days before the
      ex-dividend date, the dividend does not qualify for the preferential 15%/5% tax rates. Example 12

38.   a.      Violet recognizes a gain on the distribution of the land to Taylor. The amount of gain
              is $7,000 ($25,000 fair market value À $18,000 adjusted basis). Since Violet’s gain
              increases its E & P, it will have $7,000 of current E & P and $35,000 of accumulated
              E & P available to apply to the distribution. The entire value of the land ($25,000) is
              a dividend to Taylor, leaving $17,000 of accumulated E & P ($42,000 total E & P at
              year-end À $25,000 distribution) as the beginning balance for next year. Taylor’s
              basis in the land is its fair market value ($25,000).

      b.      The distribution triggers $7,000 of gain to Violet and creates $7,000 of current
              E & P. Consequently, the distribution generates a $7,000 dividend to Taylor (to the
              extent of current E & P). The remaining $18,000 of the value of the land decreases
              Taylor’s stock basis from $15,000 to zero and is a tax-free recovery of capital. The
              remaining $3,000 is taxed as capital gain (assuming Taylor’s stock is a capital
              asset). Taylor’s basis in the land is $25,000.

      c.      Violet recognizes $7,000 of gain and increases current E & P by $7,000. The
              amount deemed distributed in this case is the fair market value of the land, net of
              the mortgage, or $3,000 ($25,000 fair market value À $22,000 mortgage). Since
              there is $7,000 of current E & P and $35,000 of accumulated E & P, the entire
              $3,000 distribution is taxed as a dividend. Current E & P is reduced by the $3,000
              distribution, leaving accumulated E & P with a beginning balance for the following
              year of $39,000 ($35,000 accumulated E & P + $7,000 current E & P À $3,000 dis-
              tribution). Taylor’s basis in the land is its fair market value ($25,000).

      d.      While Violet realizes a $3,000 loss, none of the loss is recognized on the distribu-
              tion. Taylor receives a $25,000 dividend and he takes a basis of $25,000 in the
              land. Violet has accumulated E & P at the beginning of the following year of $7,000
              [$35,000 accumulated E & P À $28,000 (greater of $28,000 adjusted basis of the
              land or $25,000 fair market value)].

      e.      Violet recognizes gain on the distribution of $5,500 for income tax purposes
              ($6,000 fair market value À $500 adjusted basis for income tax purposes). Current
              E & P is increased by $3,500 ($6,000 fair market value À $2,500 adjusted basis for
              E & P). Taylor receives a $6,000 dividend and takes a $6,000 basis in the furniture.
              Violet’s E & P is reduced by $6,000, leaving $32,500 of accumulated E & P at the
              start of the following year ($35,000 accumulated E & P + $3,500 current E & P À
              $6,000 distribution).

      pp. 5-13 and 5-14

39.   a.      Pelican has a gain of $75,000 on the distribution, computed as follows: $225,000
              (liability on the property exceeds fair market value) À $150,000 (basis of the prop-
              erty). 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 prop-
              erty), 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) À $225,000 (liability on the property). Ginger has a basis
              of $225,000 in the property.
      pp. 5-13 to 5-15
5-16                    2007 Corporations Volume/Solutions Manual


40.    Jaime has a taxable dividend of $165,000 [$225,000 (fair market value of the land) À
       $60,000 (liability assumed)]. The dividend, if qualifying, will be subject to the 15%/5% tax
       rates. Jaime’s basis in the land is $225,000. Raptor Corporation does not recognize a loss
       on the distribution, but the distribution will reduce its E & P account by $190,000 [$250,000
       (adjusted basis of the land) À $60,000 (liability assumed by Jaime)]. pp. 5-11 to 5-14

41.    To determine the taxability of the $38,000 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 $34,000 loss, or $17,000, reduces accumu-
       lated E & P to $29,000 as of July 1 ($46,000 À $17,000). Thus, of the $38,000 distribution,
       $29,000 is taxed as dividend and $9,000 represents a return of capital. Example 11

42.    Tyler has a taxable dividend of $120,000 and a basis in the land of $120,000. Plover
       Corporation does not recognize a loss on the distribution, and its E & P is reduced by
       $200,000. pp. 5-13 to 5-15

43.    l    What basis do Cybil and Sally have in their stock in Copper Corporation after their ini-
            tial transfers for stock?

       l    Does Sally’s transfer qualify under § 351 of the Code as a nontaxable exchange?

       l    How is Copper Corporation taxed on the property distribution to Cybil?

       l    How do the distributions to Cybil and to Sally affect Copper’s E & P?

       l    How will Cybil and Sally be taxed on the distributions?

       l    What is Cybil’s basis in her stock when she sells it to Dana?

       l    How are Cybil and Dana taxed on the $80,000 distribution to each?

       pp. 5-2 to 5-15 and Chapter 4

44.    a.     Taxable income to Juan is $42,000 [$120,000 (value of the property) À $78,000
              (liability)].

       b.     Corporate E & P after the distribution is $100,250, computed as follows:

              Accumulated E & P at start of year                                     $ 63,000
              Add:
                     Taxable income                                   $300,000
                     Proceeds of term life insurance                    54,300
              Subtract:
                     Federal income tax                               (108,050)
                     Life insurance premiums                            (3,000)
                     Property distribution                            (192,000)*
                     Prior year installment sale income                (14,000)        37,250
              E & P of Petrel after the distribution                                 $100,250

              *E & P is reduced by the greater of the fair market value ($120,000) or adjusted ba-
               sis of the property ($270,000), less the amount of liability on the property
               ($78,000).
              Corporations: Earnings & Profits and Dividend Distributions                       5-17


      c.     The tax basis of the property to Juan is $120,000.

      d.     If Petrel had sold the business property at its $120,000 fair market value, it would
             have recognized a loss of $150,000. This loss would offset $150,000 of taxable
             income in the current year, creating Federal tax savings of $58,500 ($150,000 Â
             0.39). After paying off the $78,000 loan, Petrel would have a total of $100,500 to
             distribute to Juan [$58,500 (tax savings) + $120,000 (sales proceeds) À $78,000
             (loan balance)]. Immediately following the property sale and distribution of cash,
             Petrel’s E & P balance would be:

             Accumulated E & P at start of year                                         $ 63,000
             Add:
                    Taxable income (reduced by $150,000 loss)            $150,000
                    Proceeds of term life insurance                        54,300
             Subtract:
                    Federal income tax                                    (49,550)
                    Life insurance premiums                                (3,000)
                    Cash distribution                                    (100,500)
                    Prior year installment sale income                    (14,000)        37,250
             E & P of Petrel after the distribution                                     $100,250

             Thus, Juan recognizes a taxable dividend of $100,500. Petrel’s E & P would be
             reduced to $100,250 after the distribution. Note that this result is better than distri-
             bution of the property to Juan. In particular, the corporation receives a $150,000
             deduction, while Juan’s income is only increased by $58,500.

      Concept Summary 5-1 and Examples 2, 14, and 20

45.   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 divi-
             dends 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.

      Examples 14 and 20

46.   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. Example 22

47.   a.     The result of this transaction is a realized loss of $50,000 (the difference between
             basis of $250,000 and fair market value of $200,000) and a constructive dividend of
             $25,000 (the difference between the $200,000 fair market value and the $175,000
             paid for the office building). Due to the application of § 267, Blackbird cannot recog-
             nize the realized loss. However, the loss does reduce Blackbird’s E & P. The con-
             structive dividend also reduces E & P. Thus, E & P is reduced by $75,000 (the sum
             of the $50,000 disallowed loss and the $25,000 constructive dividend).
5-18                      2007 Corporations Volume/Solutions Manual


       b.     The loan to Patrick generates imputed interest since no interest was charged. The
              amount of imputed interest is $6,000 ($150,000 Â 8% Â 1/2 year). This amount is
              deemed paid as interest from Patrick to the corporation. The deductibility of the
              interest by Patrick depends on how the loan proceeds are used. Blackbird has tax-
              able interest income of $6,000 and will be deemed to pay a dividend to Patrick
              equal to the amount of interest. Blackbird’s E & P is 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 Dan and Patrick equals the fair rental
              value of the airplane. Thus, Dan has dividend income of $16,000 (80 hours  $200
              hourly rental rate) and Patrick has dividend income of $24,000 (120 hours  $200
              hourly rental rate). Blackbird’s E & P is reduced by the same amount.

       d.     The $4,000 excess amount ($15,000 À $11,000) paid to Dan by Blackbird over the
              fair rental value of the equipment is treated as a constructive dividend taxable to
              Dan and reduces Blackbird’s E & P.

       pp. 5-15 to 5-18

48.    Immediately after the distribution, John has $80,000 worth of Partridge stock ($60,000 in
       common stock and $20,000 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 $60,000/$80,000 Â $40,000, or $30,000. Similarly, the
       basis of the preferred stock will equal $10,000 ($20,000/$80,000 Â $40,000). Example 24

49.                        Hoffman, Raabe, Smith, and Maloney, CPAs
                                     5191 Natorp Boulevard
                                       Mason, OH 45040

       February 21, 2006

       Julie Swanson
       3737 Canyon Drive
       Minneapolis, MN 55434

       Dear Ms. Swanson:

       This letter is in response to your question with respect to the sale of the Great Egret Corpo-
       ration 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 conclu-
       sion to be inaccurate.

       Originally, you paid $12,000 for 5,000 shares of stock in Great Egret Corporation and last
       year a nontaxable stock dividend of 1,000 additional shares was received. The 1,000
       shares were sold in the current year for $9,000. The 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 $12,000 cost by 6,000 (5,000 original
       shares plus 1,000 new shares). This results in a basis of $2 per share ($12,000 ‚ 6,000).
       Your gain of $7,000 is computed as follows: $9,000 (selling price) À $2,000 (tax basis in
       the 1,000 new shares). The $7,000 gain on the sale is a long-term capital gain. The gain is
       long term because the original Great Egret stock has been held for more than one year.

       Should you need more information or need to clarify our conclusion, do not hesitate to
       contact me.
               Corporations: Earnings & Profits and Dividend Distributions                   5-19


      Sincerely yours,

      Jon S. Davis, CPA
      Partner

      TAX FILE MEMORANDUM

      February 15, 2006

      FROM:         Jon S. Davis

      SUBJECT:      Julie Swanson

      Today I conferred with Julie Swanson regarding her letter of February 10. Two years ago,
      Ms. Swanson purchased 5,000 shares of Great Egret Corporation for $12,000. Last year,
      she received a nontaxable stock dividend of 1,000 additional shares. She sold the 1,000
      shares this year for $9,000 and has asked me to determine the tax consequences of the sale.

      At issue: How is the gain on the sale of shares of stock received as nontaxable stock divi-
      dends determined and how is it taxed?

      Conclusion: The shareholder’s basis in the original 5,000 shares ($12,000) is reallocated
      to the 6,000 shares held after receiving the stock dividend. Her basis after the stock divi-
      dend is $2 per share ($12,000 ‚ 6,000 shares). Her gain on the sale of the 1,000 shares is
      $7,000 [$9,000 (selling price) À $2,000 (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.

      pp. 5-18 and 5-19

50.   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  $100 =           $20,000
      Fair market value of rights: 100 rights  $45 =             4,500
                                                                $24,500

      Basis of stock: $6,000 Â $20,000/$24,500 = $4,898
      Basis of rights: $6,000 Â $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:
      Sales price of 30 rights                                 $1,650.00
      Less: Basis of 30 rights (30 Â $11.02)                     (330.60)
      Long-term capital gain                                   $1,319.40
5-20                    2007 Corporations Volume/Solutions Manual


       Basis of the new stock is $4,271.40, computed as follows:
       70 rights  $11.02                                       $ 771.40
       Additional consideration ($50 Â 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.

       Example 25

51.    a.     If Ivana were paid a bonus, she would receive $10,800 after tax [$15,000 bonus À
              ($15,000 Â 28% tax rate)]. If she received a dividend, she would receive $12,750
              after tax [$15,000 dividend À ($15,000 Â 15% tax rate)]. Thus she would be $1,950
              better off ($12,750 À $10,800) with a dividend.

       b.     If Robin Corporation paid Ivana a $15,000 bonus, it would receive a deduction for
              the payment. This would reduce Robin’s tax liability. The net after-tax cost of the
              bonus would be $9,900 [$15,000 bonus À $5,100 tax savings (34% tax rate Â
              $15,000)]. In contrast, a dividend payment is not deductible, so no taxes would be
              saved by Robin. The cost of the dividend would be $15,000. Therefore, Robin
              would be $5,100 [$15,000 (cost of a dividend) À $9,900 (cost of a bonus)] better off
              if it paid a bonus.

       c.     If Robin paid Ivana a $20,000 bonus, she would receive $14,400 after tax [$20,000
              bonus À ($20,000 Â 28% tax rate)]. This would be better than receiving a $15,000
              dividend, which would provide $12,750 after tax. A $20,000 bonus would cost
              Robin Corporation $13,200 after tax [$20,000 bonus À (34% tax rate  $20,000)].
              This is less expensive than a nondeductible $15,000 dividend.

       d.     Since both Robin Corporation and Ivana are better off with a $20,000 bonus than
              they are with a $15,000 dividend, the corporation should pay a bonus.

       Examples 28 and 29

52.                      Hoffman, Raabe, Smith, and Maloney, CPAs
                                   5191 Natorp Boulevard
                                     Mason, OH 45040

       April 14, 2006

       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 years. 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, 2006.
       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 corpora-
         Corporations: Earnings & Profits and Dividend Distributions                      5-21


tion’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 2006. It should then distribute $200,000
on December 31, 2007. It should again make no distribution in 2008. Then it should distribute
the remaining $200,000 on December 31, 2009. 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 2006 of $100,000 is netted with the deficit in accumulated E & P
of $200,000. At the end of 2006, there will be a deficit in E & P of $100,000. When a distri-
bution of $200,000 is made in 2007, 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
2008 and 2009. 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.

Sincerely yours,

Jon S. Davis, CPA
Partner

TAX FILE MEMORANDUM

April 14, 2006

FROM:            Jon S. Davis

SUBJECT:         Diver Corporation

Today I talked to the president of Diver Corporation with respect to the April 1, 2006, letter.
Diver Corporation has a deficit in its accumulated E & P of $200,000 as of January 1, 2006.
Starting in 2006, 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 Corpora-
tion wants to know how it should distribute the $400,000 over a four year period 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 2006
or in 2008, only half of the $400,000 total distribution, or $200,000, constitutes dividend
income. This is the case because in 2006 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 De-
cember 31, 2006. In 2007, when Diver Corporation distributes $200,000 to its sharehold-
ers, 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 remain-
ing $100,000 is a return of capital to the shareholders. After the distribution in 2007, accu-
mulated E & P will remain a deficit of $100,000 since the distribution cannot increase a
5-22                     2007 Corporations Volume/Solutions Manual


       deficit in E & P. In 2008, Diver Corporation would not make a distribution. Thus, at the end of
       2008, accumulated E & P is zero (the $100,000 deficit would be netted with the $100,000
       current E & P for 2008). In 2009, 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 27




The answers to the Research Problems are incorporated into the 2007 Corporations Volume of
the Instructor’s Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: CORPO-
RATIONS, PARTNERSHIPS, ESTATES & TRUSTS.

								
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