Ch 5: Earnings and Profits

General Rule of Corporate Distributions: Distributions from corporate earnings and profits (E&P) are treated as __

Dividend distribution

General Rule of Corporate Distributions: Distributions from corporate earnings and profits (E&P) are treated as dividend distributions which means they are taxed as

ordinary income or preferentially taxed dividend income

When we hear dividends, think:

distributions

What is the tax treatment of distributions in excess of E&P

nontaxable to extent of shareholder basis (return of capital) and taxable gain for sale or exchange in excess of shareholder basis

What are the two parts of E&P?

Current and Accumulated

Represents the Upper limit on amount of dividend income recognized on corporate distributions and corporation’s economic ability to pay dividends without impairing capital

E&P

The amount a corporation can distribute without dipping into its investments (without reducing profit potential)

E&P

an estimate of the corporations economic income for the year

Current E&P

Accumulation of economic income over life of the company less what was paid out to shareholders over time

Accumulated E&P

___ is the tax equivalent of book retained earnings

Accumulated E&P

E&P = Taxable income PLUS Previously excluded income items and certain deductions to taxable income MINUS Non-deductible items from the tax return. What are the additions (4)

Municipal bond interest
Life Insurance Proceeds (in excess of cash surrender value)
Federal Income Tax Refunds
Dividends received deduction

E&P = Taxable income PLUS Previously excluded income items and certain deductions to taxable income MINUS Non-deductible items from the tax return. What are the Subtractions (7)

Portion of meals
Entertainment expenses
Related party losses
Expenses incurred to produce tax-exempt income
Federal income taxes paid
Key employee life insurance premiums (net increase in cash surrender value)
Fines, penalties, and lobbying expenses

Certain E&P adjustments shift effect of transaction from the year of inclusion in, or deduction from, taxable income to year of economic effect. What are the adjustments?

Charitable contribution carryovers
NOL carryovers
CL Carryovers

For E&P, take taxable income and ___ to compute

Make adjustments

If you have positive CEP and negative AEP, you can make a dividend distribution to extend of ___

Positive CEP

If you have a Negative CEP and positive AEP, you can give a dividend distribution to the extent of ___

net AEP and CEP that is positive

If you have negative CEP and AEP, then any distribution will be

decrease in basis or capital gains

If you have positive CEP and AEP then the dividend distribution will:

decrease CEP then AEP

Gains and losses from property transactions generally affect E&P only to the extent:

recognized for tax purposes

How do gains and losses deferred under the like kind exchange provision and deferred involuntary conversion gains affect E&P?

Do not affect UNTIL gain or loss is recognized

Other adjustments are made to E&P because accounting methods for E&P are more conservative than for taxable income. What are some examples of this? (5)

Installment method is not permitted
Alternative depreciation system must be used (ADS prohibits additional first year Dep)
179 expense must be deducted over 5 years
Percentage of completion must be used (no completed contract method)
Cost depletion must be used rather than percentage depletion

We are generally more ___for book than for tax

conservative

What are the other accounting method requirements when calculating E&P?

Amortization of org expenses not allowed
Adj required for changes in LIFO recapture amounts
Intangible drilling costs must be amortized over a period of 60 months
Mine exploration and development costs must be amortized over a period of 120 months

Summary of E&P Adjustments: What is the formula to calculate E&P (includes ALL edge cases and adjustments)

Taxable income
+ TE Income
+ DRD
+ Collection of proceeds from insurance policy on life of corporate employee (in excess of cash surrender value)
+ Deferred gain on installment sale (all gain added in year of sale)
- Future recognition of installment sale gross profit
- Excss charitable contribution (over 10% limit)
- Excess CL in year incurred
+ Deduction of charitable contribution, NOL, CL carryovers in succedding taxable year)
- Federal income taxes paid
- Loss of sale between related parties
- Nondeductible fines/penalties/entertainment/ lobbying expenses
- Nondeductible portion of meal expenses
- Payment of premiums on insurance policy
+ Excess percentage depletion (only cost depletion can reduce E&P)
± Accelerated depreciaion
+ Additional first year depreciation
+ Section 179 exp (80% when elected)
- Section 179 exp (20% each year)
± Increase (decrease) in LIFO recapture amount
+ Intangible drilling costs
+ Mine exploration

If distributions exceed current E&P (and both CEP and AEP are positive) then you must allocate current and Accumulated E&P to each distribution with the following steps:

Allocate current pro rata to each distribution
Apply accumulated in chronological until it runs out

For corporations, dividends received are:

taxed as ordinary income at 21% BUT are allowed DRD

What are the requirements for preferential rate to apply to individuals receiving dividends?

Dividend paid by domestic corp or qualified foreign corp
Shareholder must hold the stock for more than 60 days during the 121 day period beginning 60 days before the ex-dividend day

Qualified corps = those traded on US stock exchange or corp located in a country that has:

Comprehensive income tax treaty with US
Information sharing agreement with US
Is approved by the Treasury

The amount of a property distribution =

FMV of property

Property distributions are treated for tax purposes:

like cash distributions

For property distributions, the amount is decreases by

liabilities assumed by shareholder

The basis of distributed property =

FMV

If the FMV of distributed property is greater than the corps basis in the property results in:

corp recognizing a gain (which increases E&P)

If the property distributed is subject to a liability or the shareholder assumes a liability, then the FMV is deemed:

no less than the liability

If the FMV of the distributed property is less than the corps basis, then the corporation

does not recognize a loss

In a property distribution, the corporation’s E&P is reduced by the greater of:

Adj basis in property - amount of any liab assumed by shareholder
OR
FMV

Distributions cannot generate or increase a ___

deficit (cannot make E&P more negative)

dividends in fact, not form, usually arising in the context of closely held corporations

constructive dividends

Constructive dividends have the same effect as:

cash or property dividends

What are some examples of constructive dividends?

Shareholder use of company property for free or below cost
Bargain sale or rental to a shareholder
Payments for the benefit of a shareholder
Unreasonable compensation
Advances to shareholders that are not bona fide loan

A dividend paid in the form of stock in the cop is considered;

non taxable if they are pro rata

Stock distributions that are ___ do not substantially change the shareholders percentage ownership in the company

pro rata

Basis per share of nontaxable stock dividends where shares received are identical to the shares already held=

original cost / total number of common shares

Basis per share of nontaxable stock dividends where shares received are different from shares already held =

Cost x (FMVcs / FMVcs+ps)

For nontaxable stock dividends, the corporations E&P:

is not reduced

For stock distributions that are nontaxable the holding period for the shareholder:

tacks on

For TAXABLE stock dividends, the shareholders basis in the new shares =

FMV and holding period begins date of distribution

For TAXABLE stock dividends, the shareholders dividend income =

FMV of stock rec’d (like property distribution)

For TAXABLE stock dividends, the corprations E&P

decreases (like property distribution)

For TAXABLE stock dividends the corporation:

does not recognize gain or loss