The focus of this article is on the taxation of non-liquidating distribution (issuing dividends). That is, the corporation is not dissolving as part of the distribution.
A dividend is a distribution of retained earnings to the stockholders. Dividends are taxed to the extent they come from earnings and profits, anything above are treated as tax free and treated as a capital gain once it exceeds the basis in stock. Earnings and Profits (E&P) is defined as the corporation’s economic ability to pay a dividend without impairing the paid-in capital.
The effect of a dividend differs depending on who is receiving the dividend. An individual can qualify for a lower tax rate on the dividend if: the corporation must be US based and the shareholder must have held the shares for at least 60 days. The tax rate is for individual shareholders is based on their individual tax bracket. Corporate shareholders receive a deduction based on how much control they have over the corporation. Finally a payor corporation (business paying the dividend) receives no deduction because the paying of dividends is done after taxes have already been paid.
Calculating E&P
Step 1: Determine the taxable income of the corporation. Next, step 2: Add in anything that was tax free or deductible but was not already paid out to shareholders. This includes municipal bond interest, life insurance proceeds, federal income tax refunds, and dividends received deduction. Step 3: Subtract certain non-deductible items. That is, subtract items where there was an expense, so there is no cash available to distribute. These include: related-party losses, excess capital losses (greater than capital gains), expenses to produce a tax-exempt income, paid federal income taxes, fines or penalties, and life insurance premiums. Next, step 4: Adjustments (add or subtract) for certain transactions. For example, charitable contributions are to be subtracted in the first year then added back in for any carryover amounts. Finally, step 5: determine what other adjustments were made based on whether the value of acquiring assets are spread throughout the next five or so years.
There is a distinction between current and accumulated E&P. Current is calculated using the process described above and is used for the current year. Accumulated is a combination of the E&P for all prior years subtracting the dividends distributed. The general rule is that dividends are paid out first based on current E&P then accumulated.
Allocating E&P to Distributions
If the E&P of accumulated and current is positive, then distributions are to be made from current then accumulative E&P. However, if the distributions are going to exceed E&P, distributions are going to be made pro rata for current E&P while accumulated is going to be made by chronological order.
If the current E&P is positive and accumulated is negative, distributions are going to be made out of the current, but not accumulative E&P. In other words, keep the numbers separate and independent.
If the accumulative E&P is positive and current is negative, any distributions made is not considered a dividend if the balance is a deficit.
Property Dividends
Property dividend is a dividend paid by the corporation that is anything other than cash (stock, inventory, equipment, etc.).
For individuals, the value of the dividend is the fair market value of the asset (minus any assumed liability by the shareholder). Additionally, the basis of the asset is the fair market value.
For corporations making the distribution, they must recognize any gain but they cannot recognize any loss. These distributions affect E&P by reducing accumulated E&P by the higher of either the fair market value or the basis of the asset (minus any liabilities). Practically speaking, if the asset is going to be a loss, then the corporation is likely to sell the asset, recognize the loss, then distribute the cash to the shareholders.
Constructive Dividends
This is an issue that arises in closely held corporations when the shareholders are also employees. Basically, this occurs when shareholders are receiving dividends without the label of a dividend (with the attempt to make the expense tax deductible). What happens is that the IRS can come in and reclassify the payment as a dividend. As a result, the corporation will loose the deduction but the shareholders are taxed at a lower rate. Types of transactions that will often be deemed a constructive dividend include: grossly excessive compensation, rent payments, below market loans, payment of shareholder expenses, conducting bargain sales with shareholders.
Stock Dividends
Distribution of additional shares of stock in the corporation. This does not count as income to the shareholder if: shareholders maintain the same percentage of ownership (pro rata). However, if the percentage of ownership does change, then the taxable income is the fair market value of the additional shares.
If stock dividends are not taxable, then there is no impact on the E&P. Again, if it is taxable, then the E&P will be reduced by the value of the distributed stock (treated as a property dividend).
As for the basis of the received stock, if the new shares are identical to the existing shares is calculated by mixing in the new with the old. The calculation is: basis equals the cost of the prior stock divided by the total number of shares. That is, the total basis remains the same, but the basis per share will decrease. However, if the new stock is not identical then the calculation becomes a little more complicated. Although the basis will remain the same, the basis is split between the two types based on their relative market value. So, the calculation is: Take the value of one type of stock and divide it by the total value of all the stock. Take that number and multiply it by the total basis. The resulting number will be the basis of that type of stock. Repeat for each unidentical type of stock. Take the basis and divide it by the number of shares to determine the basis per share.
If the stock is taxable, then the basis of the old stock remains the same while the basis of the new stock is the fair market value of the received stock.
Redemption
A redemption is when the corporation buys back stock. There are two ways this can occur: treat the transaction as a dividend (the common method) or treat the transaction as a sale (the preferred method for corporations).
If the transaction is treated as a dividend, then the shareholder is taxed on the gross fair market value received. The basis of the redeemed shares is reallocated to any remaining shares held by the shareholder (meaning the basis per share will increase). Most redemptions are pro rata, meaning the corporation will redeem the same number of shares from each shareholder.
As for the purchase of stock, the shareholder is taxed on the net (not gross) gain. To determine the net gain, subtract the basis of the redeemed shares by the purchase price. To qualify to be taxed on the net gain (not gross), § 302 requires:
- Purchase of all the shareholder’s shares. Meaning there is no interest left; and
- either:
- The transaction is not the equivalent of a dividend (subjective standard); or
- The transaction is disproportionate. To determine if the transaction is disproportionate:
- The shareholder is a minority shareholder (less than 50% of shares); and
- There is a reduction of at least 20% of the ownership percentage. This means, what is your percentage after the transaction divided by your percentage before the transaction? If the number is less than .80, you are in the clear.
Important to note here is that any shares owned by a related party (such as a spouse or child) are attributed to be owned by all related parties. For instance, if a husband and wife own 100 shares each (200 total) and the husband sells 50 for 1,000. It is still treated as if the transaction did not occur because the total shares of the wife did not change. However, a complete termination of interest will qualify (e.g., the husband sells all of his shares) if the related party agrees to not obtain any additional shares or work in any capacity (other than being a creditor) for the corporation for the next 10 years.
