SOLUTIONS TO CHAPTER 3 PROBLEM MATERIALS DISCUSSION QUESTIONS

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1 SOLUTIONS TO CHAPTER 3 PROBLEM MATERIALS DISCUSSION QUESTIONS 3-1 Although not expressly stated in the text, corporate distributions generally fall into two main categories: liquidating and nonliquidating. Nonliquidating distributions result when the shareholder does not surrender part of his or her interest (i.e., stock). The treatment of these distributions is governed by 301 and 316, which provide that a corporate distribution must be included in the shareholder s gross income as a dividend to the extent it represents a distribution of the corporation s earnings and profits. To the extent that the distribution is not out of corporate earnings and profits, it is treated as a return of capital to the shareholder to be applied against, and in reduction of, the adjusted basis of his or her stock. These general rules apply with some variation to distributions of cash, property, and the corporation s own obligations. Falling within the broad scope of nonliquidating distributions are distributions of a corporation s own stock: stock dividends. Under 305, stock dividends are generally nontaxable unless they result in a change of the shareholders proportionate interests in the corporation. Liquidating distributions are those when the shareholder relinquishes all or a portion of his or her interest in the corporation in exchange for a distribution of corporate property. This exchange is referred to as a redemption. Redemptions generally are covered in 302, which grants the shareholder sale treatment, assuming the distribution is not essentially equivalent to a dividend. These redemptions often occur during the normal course of business, and there is no change in the level of business operations by the corporation. When a termination of a portion of the business prompts the liquidating distribution, the distribution is treated as a redemption in partial liquidation and is subject to special rules of 302(b)(4). Similarly, when the corporation ceases to conduct business, the redemption distribution falls under the complete liquidation rules of 331. Distributions of stock of a subsidiary receive special attention since these result in some type of corporate division: so-called spin-offs, split-offs, and split-ups. Because the corporation continues to carry on its business and the shareholders maintain their interest in the new corporate arrangement, these distributions are normally tax free. These are covered in Chapter 7. The principal objectives underlying the rules contained in the various provisions governing corporate distributions are to set up a framework by which returns of capital can be distinguished from returns on capital. In effect, the whole thrust of these provisions is aimed at determining whether the shareholder has surrendered part of his or her interest, and thus should be granted sale or exchange treatment, or, alternatively, should be treated as having received his or her share of the corporation s earnings and profits. The stakes in making this determination historically have been high since sale treatment has generally resulted in favorable capital gain treatment, while an alternative finding resulted in dividends and ordinary income. It should be emphasized, however, that when the shareholder is a corporation, dividend treatment usually is far more favorable than capital gain because of the dividend received deduction. (See pp. 3-1 and 3-2.) 3 1

2 2 Corporate Distributions: Cash, Property, and Stock Dividends 3-2 a. Earnings and profits represent the amount that a corporation can distribute without impairing its capital. As calculated, earnings and profits represents the amount a corporation can distribute to its shareholders to be included in their ordinary income as dividends. Distributions that exceed earnings and profits are considered a return of capital and reduce basis. (See pp. 3-3 and 3-4.) b. Under the laws of most states, a corporation is generally restricted to making distributions to its shareholders out of its earned surplus. Alternatively, in many states, the language of older statutes is phrased in terms of a prohibition against impairment of capital or capital stock. Earned surplus is a legal term that represents the amount under state corporate law, which the company is permitted to distribute. Thus, it is a term that is construed under the laws of the individual states. Its major purpose is to afford a certain degree of protection to creditors. Although the interpretation of the term often follows modern accounting principles, it often deviates from them. Retained earnings is a term used in financial accounting (although earned surplus is still used by some corporations) to represent the corporation s cumulative net income (loss) for its lifetime, as adjusted for payments of dividends, appropriations, and other items. It is important to understand that earnings and profits often differ from retained earnings. All too often tax decisions have been based on the retained earnings balance, which often differs greatly from the true earnings and profits balance. As a result, decisions once thought appropriate become disastrous. Consequently, the differences between retained earnings and earnings and profits should always be kept in mind when reviewing the financial statements for purpose of tax decision-making. No doubt the biggest degree of variation in the two is attributable to depreciation since retained earnings normally reflects accelerated methods that are not permitted for earnings and profits purposes. Other differences concern appropriations. Although appropriations are permitted in financial accounting, they do not exist for tax purposes. (See pp. 3-3 and 3-4.) 3-3 Under 301, the amount of the distribution must be included in the shareholder s income to the extent it represents a dividend (as defined in 316). A distribution is considered a dividend to the extent it is from earnings and profits. All distributions are considered as first coming from earnings and profits to the extent of the balance of earnings and profits. The remaining distribution is a return of capital and reduces basis. Any distribution in excess of the shareholder s basis is treated as gain from the sale of stock. (See Example 1 and p. 3-2.) 3-4 The line concerning nontaxable distributions refers to distributions that are not from the corporation s earnings and profits but represent a return of the shareholder s capital, a nontaxable recovery of basis. The line concerning capital gain distributions refers to distributions or dividends paid by regulated investment companies, mutual funds, and real estate investment trusts that shareholders should treat as capital gains. (See p. 3-2.) 3-5 a. The general formula for calculating earnings and profits is contained in Exhibit 3-1 as follows: Current taxable income (or net operating loss) + Exempt and nondeferrable income - Items not deductible in computing taxable income + Deductions not permitted in computing earnings and profits = Current earnings and profits (or deficit) (See Exhibit 3-1 and p. 3-4.) b. Accumulated earnings and profits is the cumulative sum of each year s current earnings and profits adjusted for distributions. (See p. 3-3.) c. Current and accumulated earnings and profits are viewed as two separate and distinct pools of earnings from which a distribution might come. All distributions made during the year are viewed as containing their pro rata share of current earnings and profits. Accumulated earnings and profits, however, is allocated chronologically to distributions. Consequently, a corporation can have a dividend distribution

3 Solutions to Problem Materials 3 despite the fact it may have a large deficit in accumulated E&P. (See Example 7 and pp. 3-9, 3-10 and 3-11.) 3-6 a. True (although debatable whether there is no need). Few corporations actually maintain detailed records of earnings and profits. Normally, the calculation is required when the corporation is involved in a unique transaction, such as an extraordinary distribution, a reorganization, or conversion to S status. b. True. Distributions constitute dividends included in gross income only to the extent they are from earnings and profits. (See Example 1 and p. 3-3.) c. False. If the corporation has a loss during the second year, the loss reduces accumulated earnings and profits on a daily basis to determine whether the distribution is from accumulated earnings and profits. If the loss is so great as to exceed accumulated earnings and profits of $50,000 as of the date of distribution, the distribution is nontaxable. In contrast, if it had been distributed in the previous year, it would have been taxable from current earnings and profits. (See Example 9 and pp through 3-12.) d. False. A distribution is a dividend to the extent it is from current earnings and profits. A deficit in accumulated E&P is irrelevant where current E&P exists. (See Example 10 and pp through 3-12.) e. False. Current E&P is allocated equally to all distributions, i.e., 25 percent (e.g., $10,000/$40,000) to each. (See Example 7 and pp through 3-12.) f. True. Although current E&P is allocated equally to all distributions, accumulated E&P is allocated chronologically. Thus, all distributions will represent the same amount of current E&P. However, the first distribution will have a greater portion of accumulated E&P than the last. In this case, the first distribution consists of $2,500 current E&P and $5,000 accumulated E&P. The last distribution consists solely of $2,500 current E&P. (See Example 7 and pp through 3-12.) 3-7 The amount of the distribution for both noncorporate and corporate shareholders is the fair market value of the property reduced by any liability. (See p ) 3-8 The thrust of 311 (governing the effect of a property distribution for the distributing corporation) is to require the distributing corporation to recognize gain, but not loss, on the distribution of property. In computing the gain, the distributing corporation is treated as selling the property to the distributee shareholder for its fair market value. This rule applies to distributions other than those in complete liquidation (discussed in Chapter 5). It should be noted that 311(a) provides that the distributing corporation recognizes no gain or loss on the distribution of property. Section 311(b) creates the exception requiring the distributing corporation to recognize gain on the distribution of appreciated property. (See Example 12 and pp and 3-15.) When property is distributed and the corporation is relieved of a liability, a special rule must be observed. If the liability exceeds both the value and the basis of the property, the value is treated as being no less than the amount of the liability. (See Example 13 and p ) 3-9 a. False. The shareholder must reduce the amount of the distribution by the amount of the liability, but not below zero. This reduction is consistent with the fact that the taxpayer is better off only to the extent of the net value of the distribution. [See Example 11, p. 3-14, and 301(b)(2).] b. True. The shareholder s basis for any property distributed is the property s fair market value. The value is not reduced by the liability. In effect, the law takes the approach that the taxpayer purchases the property for its value by reporting income equal to the net value of the property received (i.e., the value - the liability) and by assuming responsibility for the liability. Note that the rule under 311 treating the value of the property as being no less than the amount of any liability distributed in conjunction with the property is inapplicable here under 301. (See Example 11 and p ) c. True. When a taxpayer is relieved of a liability, it is equivalent to having received cash. Thus, the taxpayer must recognize a gain. Consistent with this concept, when a corporation distributes property and is relieved of a liability, E&P is increased. This is easily explained by using debits and credits; upon the distribution, the liability is charged and the corresponding credit is to E&P. (See Example 17 and p )

4 4 Corporate Distributions: Cash, Property, and Stock Dividends 3-10 a. When a corporation distributes appreciated property the distributing corporation must recognize gain. Consequently, E&P is increased for the amount of gain recognized and subsequently reduced by the fair market value of the property. Note that the required increase in E&P for the gain recognized creates E&P that must be considered in determining the extent of the dividend. (See Example 15 and p ) b. Under the general rule of 312(a), E&P is reduced by the adjusted basis of any property distributed. This is true even when appreciated property is distributed. For example, assume property worth $10 and having a basis of $6 is distributed. In such case, E&P is increased by the gain of $4 and decreased by the $10 value of the property. The net effect is a reduction in E&P of $6 ($10 - $4), the same as the adjusted basis of the property. (See p ) c. As illustrated above, the net effect of property distributions (regardless of whether the property has appreciated or declined in value) is, ignoring taxes, to reduce E&P by the adjusted basis of the property. If the property is subject to a liability, the reduction must be decreased by the amount of the liability. When a corporation distributes its own securities, E&P is reduced by the fair market value of the securities. (See pp through 3-18.) 3-11 The corporation need not formally authorize a dividend distribution in order for the shareholder to be charged with a distribution. In those cases in which the corporation informally provides a benefit (such as a loan, pays an expense of the shareholder, or allows the shareholder to use company property), the IRS often imputes or constructs a dividend. These so-called constructive distributions are taxed in the same manner as formally authorized distributions. (See p ) 3-12 a. Stock dividends are usually nontaxable since the shareholder s proportionate interest in the corporation is unchanged. (See p ) b. Distributions of stock are normally taxable when the shareholder s interest in the corporation changes as a result of the distribution. For example, distributions in which some shareholders elect to receive cash and others receive stock ultimately change the shareholders interest and, consequently, are taxable. (See p ) c. Distributions of rights to purchase stock are treated in the same manner as stock distributions. (See p ) PROBLEMS 3-13 a. Taxable income is computed as follows: Income: Gross profit ($575,000 - $175,000) $400,000 Interest income: corporate bonds 20,000 Dividends received 10,000 Installment sale 14,000 Total income $444,000 Deductions: Selling and administrative expense $ 90,000 Amortization of organized expense 500 Depreciation 50,000 Dividends-received deduction (80% $10,000) 8,000 Net operating loss deduction 60,000 Total deductions (208,500) Taxable income $235,500 Tax liability (2002 rate schedule) $ 75,095 Note that the interest income from the municipal bonds and the life insurance proceeds are excluded in computing taxable income. Similarly, the capital loss and fines are not deductible in computing taxable income.

5 Solutions to Problem Materials 5 b. E&P is computed below. Taxable income $ 235,500 + LIFO reserve ($175,000 - $150,000) 25,000 + Interest income: municipal bonds 9,000 + Dividends-received deduction 8,000 + Installment sale ($100,000 - $30,000 - $14,000) 56,000 + Life insurance proceeds 50,000 + Amortization of organization expenses Excess depreciation ($50,000 - $37,000) 13,000 + Net operating loss carryover 60,000 - Fines (1,000) - Long term capital loss (3,000) - Taxes (75,095) = Current E&P $ 377,905 Note that current E&P is computed before distributions. (See Exhibits 3-1 and 3-2, pp. 3-3 through 3-9, and 312.) 3-14 E&P is computed below. Taxable income $ 600,000 + Excess depreciation 50,000 - Short term capital loss (30,000) + Dividends-received deduction (80%) 80,000 + Interest on municipal bonds 13,000 - Excess charitable contributions (9,000) - Taxes (34% $600,000) (204,000) = Current E&P (before distributions) $ 500,000 Distributions are not subtracted in computing current E&P. (See Exhibits 3-1 and 3-2, pp. 3-3 through 3-9, and 312.) 3-15 Distributions are made first from current E&P without regard for the balance in accumulated E&P. Thus, the entire $25,000 cash distribution by P Inc. is dividend income to P s shareholders. P s balance in accumulated E&P at the beginning of the following year is a deficit of $35,000 computed as: Beginning AE&P $(40,000) Current E&P $30,000 Distribution (25,000) Net Increase for year 5,000 Ending E&P $(35,000) A deficit balance in current E&P is prorated on a daily basis and is netted with a positive balance in accumulated E&P as of the day of distribution. This gives Q Inc. an accumulated E&P of $10,000 ($40,000 - $30,000). Thus, $10,000 is from accumulated E&P and $15,000 is a return of capital. Q s shareholders have $10,000 dividend and $15,000 reduction of basis. If any shareholder s portion of return of capital exceeds his basis, the excess is capital gain. (See Examples 1, 2, 9, and 10 and pp. 3-2 and 3-10 through 3-12.)

6 6 Corporate Distributions: Cash, Property, and Stock Dividends 3-16 a. $36,000 dividend, $12,000 tax-free return of capital, $2,000 capital gain. H s basis in her stock is zero. (See Example 8 and p ) b. $15,000 dividend, $12,000 tax-free return of capital, $23,000 capital gain. H s basis in her stock is zero. A deficit in AE&P does not reduce CE&P. Thus, a dividend may be paid even though a deficit in AE&P exceeds CE&P. (See Example 10 and p ) c. The entire $50,000 is a dividend out of accumulated E&P. The deficit in current E&P is allocated on a daily basis (31/365 $25,550 = $70 per day) and netted against accumulated E&P as follows: Accumulated E&P $60,000 - Deficit in current E&P (31/365 $25,550 = $2,170) (2,170) = Accumulated E&P available on February 1 $57,830 (See Example 9 and p ) d. $12,000 tax-free return of capital, $38,000 capital gain. H s basis is reduced to zero. Dividends can result only when CE&P or AE&P exists. (See p ) 3-17 a. As determined below, C reports dividend income of $40,000 ($30,000 + $10,000) and capital gain of $15,000 while D reports dividend income of $20,000 and capital gain of $10,000. Note also that C would report a $10,000 capital gain from the sale of the stock to D since his basis was reduced to zero by the distribution on May 1. Current Accumulated Return of Capital Distribution E&P* E&P Capital Gain $ 60,000 $30,000 $10,000 ** $ 5,000 $15,000 40,000 20,000 10,000 10,000 $100,000 $50,000 $10,000 *Allocation of current E&P is computed as follows: $50,000 $60,000/($60,000 + $40,000) = $30,000 $50,000 $40,000/($60,000 + $40,000) = $20,000 **AE&P is allocated chronologically. Consequently, the entire $10,000 is allocated to the first distribution in May. (See Example 7 and p ) b. As determined below, C reports dividend income of $30,000 and capital gain of $25,000, while D reports dividend income of $20,000 and capital gain of $10,000. *Same as above (See Example 10 and p ) Current Accumulated Return of Capital Distribution E&P* E&P Capital Gain $ 60,000 $30,000 $ $ 5,000 $25,000 40,000 20,000 10,000 10,000 $100,000 $50,000 $

7 Solutions to Problem Materials 7 c. As determined below, C reports dividend income of $60,000, while D reports dividend income of $22,850. Current Accumulated Return of Capital Distribution E&P* E&P Capital Gain $ 60,000 $ $60,000 $ 0 $ 40,000 22,850 10,000 7,150 $100,000 $ 0 $82,850 *Accumulated E&P is determined as follows: Beginning accumulated E&P $ 95,000 - Deficit in current E&P to April 30 (120/365 $18,250) (6,000) = Accumulated E&P at May 1 $ 89,000 - Distribution (60,000) - Deficit in current E&P from May 1 to August 31 (123/365 $18,250) (6,150) = Accumulated E&P available at September 1 $ 22,850 Alternatively, the calculation of accumulated E&P available for the distribution on September 1 could be made as follows: Beginning accumulated E&P $ 95,000 - Distribution on May 1 (60,000) - Deficit in current E&P from January 1 to August 31 (243/365 $18,250) (12,150) = Accumulated E&P available at September 1 $ 22,850 (See Example 9 and p ) 3-18 a. The $30,000 distribution is considered to be first from current E&P and then from accumulated E&P: Beginning Ending Balance Dividend Balance Current E&P $22,000 - $22,000 $ 0 Accumulated E&P 32,000-8,000 24,000 Since E&P exceeds the cash payment, all of the $30,000 distribution is dividend income. M s share of dividend income is $3,000 (10% $30,000). b. Current E&P is divided, pro rata, among all distributions made during the year. In contrast, accumulated E&P is allocated among distributions in chronological order. Quarters Total Total distribution $12,000 $12,000 $18,000 $18,000 $60,000 Current E&P (1) 4,400 4,400 6,600 6,600 22,000 Remaining distribution $ 7,600 $ 7,600 $11,400 $11,400 $38,000 Accumulated E&P (2) 7,600 7,600 11,400 5,400 32,000 Return of capital $ 0 $ 0 $ 0 $ 6,000 $ 6,000 (1) $12,000/$60,000 = 20% $22,000 = $4,400 and $18,000/$60,000 = 30% $22,000 = $6,600 (2) $32,000 - ($7,600 + $7,600 + $11,400 = $26,600) = $5,400

8 8 Corporate Distributions: Cash, Property, and Stock Dividends M s 10 percent share of dividend income is $1,200 for the first and second quarter, $1,800 for the third quarter, and $1,200 ($6,600 + $5,400 = $12,000 10%) for the fourth quarter. Thus, her total dividend income is $5,400 ($1,200 + $1,200 + $1,800 + $1,200 = $5,400, which is the same as $22,000 + $32,000 = $54,000 10% = $5,400). Any estimated tax payments, however, will be lower for the last quarter because $600 ($6,000 10%) of the fourth quarter distribution is a return of capital, which reduces her basis to $7,400 ($8,000 - $600). (See Examples 7 and 8 and pp through 3-12.) 3-19 a. A s income increases by the amount of the dividend, $20,000. The amount of a property dividend is the fair market value of the property received, in this case the value of the land, $20,000. When property is distributed to a shareholder, the amount of the distribution is the fair market value of the property reduced by any liabilities. (See Example 11 and p ) b. A s basis in the land is $20,000. A shareholder s basis for property received is the property s fair market value. Liabilities have no effect on the property s basis. (See Example 11 and p ) c. XYZ must recognize a gain on the distribution of the property of $17,000 ($20,000 - $3,000). The gain is computed as if the corporation had sold the property to its distributee shareholder. [See Example 12, p. 3-14, and 311(b).] Note that a distributing corporation does not recognize loss on the distribution of property that has declined in value. d. XYZ s E&P decreases by $3,000 determined as follows: Increase E&P by gain recognized $17,000 Decrease E&P by value of the property (20,000) Net decrease in E&P $ (3,000) (See Example 15 and p. 3-16) e. All of the answers are the same except for part a. As revised in 1988, the amount of the distribution is the value of the property, regardless of whether the shareholder is a corporate or noncorporate taxpayer. However, a corporation is entitled to the dividend-received deduction in computing its net taxable dividend. Because A owns 100 percent of XYZ corporation, the dividends-received deduction is 100 percent. Thus, A corporation s taxable income will not be changed by the distribution a. A s income increases by the amount of the $13,000 dividend, which is the fair market value of the land less the mortgage ($20,000 - $7,000). When property is distributed to a shareholder, the amount of the distribution is the fair market value of the property reduced by any liabilities. (See Example 11 and p ) b. A s basis in the land is $20,000. A shareholder s basis for property received is the property s fair market value. Liabilities have no effect on the property s basis. (See Example 11 and p ) c. The corporation must recognize a 1231 gain of $17,000, the excess of the property s value ($20,000) over the property s adjusted basis ($3,000). As long as the property s value exceeds the liability, the liability is ignored in determining the distributing corporation s gain. (See Example 12 and p ) d. The corporation must increase E&P by $4,000, determined as follows: Increase by gain recognized $17,000 Decrease by fair market value (20,000) Reduce reduction by amount of liability 7,000 Net increase in E&P $ 4,000 (See Example 18 and p ) e. The answers are the same if the shareholder is a corporation. However, for all of the above distributions, the corporation would be entitled to a 100 percent dividends-received deduction because A is the sole stockholder a. (a) Distribution of land actively used in business since its purchase in 1983, value $5,000 (basis $1,000):

9 Solutions to Problem Materials 9 1. $5,000 dividend. For both corporate and noncorporate shareholders, the amount of the dividend is the value of the property reduced by any liability. (See Example 11 and p ) 2. $5,000 basis. The basis is computed in the same manner, except the liability is ignored. In this case, there are no liabilities, so the amount and basis are the same. (see Example 11 and p ) 3. $4,000 gain. The corporation must recognize gain when it distributes appreciated property. (See Example 12 and p ) 4. ($1,000) decrease. E&P is increased by the gain recognized and then reduced by the value of the property as follows: Increase by gain recognized ($5,000 - $1,000) $ 4,000 Decrease by fair market value (5,000) Net decrease in E&P $(1,000) (See Example 15 and p ) a. (b) Distribution: same as (a) except the land is subject to a liability. Several calculations must be adjusted because of the $3,500 liability. Most importantly, the amount of the distribution is reduced. 1. $1,500 dividend. The amount of the distribution is the fair market value of the land reduced by the liability: $1,500 ($5,000 - $3,500). (See Example 11 and p ) 2. $5,000 basis. The basis is the fair market value of the property and is not affected by liabilities. (See Example 11 and p ) 3. $4,000 gain. The entire amount of appreciation must be recognized as it was in (a). 4. $2,500. E&P is increased by the gain recognized and then decreased by the property s fair market value. This reduction must be further reduced because of the liability. Increased by gain recognized $4,000 Decrease by fair market value (5,000) Reduce reduction by amount of liability 3,500 Net increase in E&P $2,500 (See Example 19 and p ) a. (c) Distribution: business equipment worth $3,000 and basis $7,000 ($8,000 - $1,000). 1. $3,000 dividend. 2. $3,000 basis. 3. $ -0- loss. A distributing corporation recognizes gain, but not loss, on the distribution of property. In this case, the property had a built-in loss of $4,000 ($7,000 basis - $3,000 value), which is not recognized. (See Example 12 and p ) 4. ($7,000). E&P is reduced by the adjusted basis of the property: $7,000 ($8,000 cost - $1,000 depreciation). (See Example 14 and p ) a. (d) Distribution: MDI 10-year, 4 percent, $10,000 bond worth $8,500. The amount and basis of a distributed note are always equal to its fair market value whether the shareholder is a noncorporate or corporate shareholder. Earnings and profits is reduced by the fair market value of the note. 1. $8,500 dividend 2. $8,500 basis 3. none 4. (8,500) (See Example 20 and p )

10 10 Corporate Distributions: Cash, Property, and Stock Dividends b. The answers are identical for corporate shareholders, except that as the sole shareholder of the stock of MDI, the corporation would be entitled to a 100 percent dividends-received deduction. Thus, a corporate sole shareholder would not have an increase in income for any of the distributions.

11 Solutions to Problem Materials For all shareholders, the amount of the distribution is the property s fair market value reduced by any liability related to the property. The basis of the property is its fair market value. a. 1. $70,000 dividend; 2. $70,000 basis. b. 1. $40,000 dividend ($70,000 - $30,000); 2. $70,000 basis. c. 1. $60,000 dividend; 2. $60,000 basis. [See Example 11, p. 3-14, and 301(b).] 3-23 The amount of the distribution to a corporate shareholder is the same as it is for a noncorporate shareholder, the value of the property reduced by any liability related to the property. Thus, the answers are identical to those in Problem However, F Corporation would be entitled to a 100 percent dividends-received deduction and thus, have no increase in taxable income as a result of the distributions The distributing corporation must recognize gain, but not loss, on the distribution of property. This rule applies regardless of whether the distributee shareholder is a corporate or noncorporate shareholder. (See Examples 12 and 13 and pp and 3-15.) a. Gain recognized is $50,000 ($70,000 - $20,000). b. Gain recognized is $50,000 ($70,000 - $20,000). The liability is ignored as long as it is less than the value of the property. c. The built-in loss of $30,000 ($60,000 value - $90,000 basis) is not recognized The E&P of the corporation is generally reduced by the adjusted basis of the property distributed. If a liability associated with the property is also distributed, the reduction by the basis of the property is decreased by the amount of the liability. When appreciated property is distributed, E&P is increased by the amount of the gain recognized and then decreased by the fair market value of the property distributed. In the computations below, the increase in E&P due to gain recognition is determined by referring to the answers for question 22. (See Examples 14 through 21 and pp through 3-18.) a. Increase by gain recognized $ 50,000 Decrease by fair market value (70,000) Net decrease in E&P $ (20,000) b. Increase by gain recognized $ 50,000 Decrease by fair market value (70,000) Reduce reduction by amount of liability 30,000 Net increase in E&P $ 10,000 c. Decrease by adjusted basis of $90, All gains and losses are computed on an asset-by-asset basis. a. Gains but not losses are recognized on property distributions. Thus, the $10,000 realized loss on the preferred stock ($40,000 - $50,000) is not recognized and the stock s $50,000 basis is used to decrease E&P. (See Examples 12 and 14 and pp and 3-15.) b. Recognized gain on the equipment is $5,000 ($30,000 - $25,000). E&P is (1) increased by this $5,000 gain and (2) decreased by the $30,000 market value of the equipment, for a net decrease of $25,000. (See Examples 12 and 15 and pp and 3-16.)

12 12 Corporate Distributions: Cash, Property, and Stock Dividends c. Since the $34,000 mortgage exceeds both the $32,000 market value and $28,000 basis, the recognized gain is $6,000 ($34,000 - $28,000). E&P is increased by the $6,000 recognized gain, decreased by the greater of the $34,000 mortgage or the $32,000 market value of the property, and increased by the $34,000 reduction of debt. Thus, the net increase to E&P is $6,000 ($6,000 - $34,000 + $34,000). (See Examples 13 and 19 and pp through 3-17.) A recap of the property distributions (with the Federal income tax effect) is as follows: L s Gain Current or Loss E&P Beginning balance $90,000 a. Preferred stock $ 0 (50,000) b. Equipment 5,000 (25,000) c. Land 6,000 6,000 $11,000 $21,000 Federal income tax 34 % $ 3,740 (3,740) Ending balance $17, a. If these loans are not repaid in a timely manner, it is likely that the Service will treat them as dividends. In any event, in light of 7872 concerning interest-free and below-market loans, if the loans do not bear adequate interest at the applicable Federal rate, F is treated as having paid the proper amount of interest to SDF, which SDF in turn repays to F. F may be entitled to a deduction for interest expense and probably has dividend income in the same amount because of the shareholder-employee relationship. SDF has interest income but is not entitled to an offsetting deduction, assuming the payment to F is treated as a dividend. Section 7872 does not apply if the loans do not exceed $10,000. (See Example 22 and pp and 3-21.) b. Payments of a shareholder s personal expenses are generally treated as dividends. (See p ) c. Unless S reimburses the company for his personal use of the car, SDF has effectively paid for such personal expenses, and such payments would probably be treated as dividends or compensation. (See p ) d. The $12,000 payment appears to be substantially greater than what such services are worth. S may be treated as having received a dividend and then making a gift to his daughter. e. F has made a bargain purchase in that he paid $3,500 for the porch for which the corporation normally charges $4,550 (130% $3,500). He has dividend income of $1,050. (See p ) f. The corporation has paid $25,000 more than the land is worth. F has dividend income of $25, a. None. Distributions of preferred on common are nontaxable since the proportionate interests of all the shareholders are unchanged. (See Example 24 and pp and 3-27.) b. R s basis in the preferred is $1,250 or $25 per share as determined below: $5,000 Original basis of common stock ( 50 shares _ $100 /share ) FMVof preferred FMVreceived + preferred ( $50 _ common 50 shares ) = ( $50 _ 50 ) + ( $150 _ 50 ) = $1,250 The remainder of the $5,000 original basis, $3,750 ($5,000 - $1,250), is allocated to the common. Thus, the basis of each common share is $75 ($3,750/50 shares).

13 Solutions to Problem Materials 13 c. Common: Sales price $4,375 Basis - 1,875 (25 $75) Gain $2,500 Long-term Preferred: Sales price $1,875 (25 $75) Basis (25 $25) Gain $1,250 Long-term The holding period of the preferred begins on the same date on which the holding period of the common begins, and, therefore, begins in (See Exhibit 3-9, Example 24, and pp through 3-25.) 3-29 Distributions of stock dividends on common stock are nontaxable events with a few exceptions discussed on p. 3-27, which are not included in this problem. In contrast, all stock dividends on preferred stock are taxable. a. Common stock received as a dividend on common stock owned is nontaxable with the $5,000 original basis allocated among all 1,100 shares (1, ). Thus, the per share basis is $4.54 ($5,000/1,100). The holding period for all 1,100 shares begins on 5/18/93. (See Example 23 and pp and 3-23.) b. Preferred stock received as a dividend on common stock owned also is nontaxable with the $5,000 original basis allocated between common and preferred, according to relative market values. The market value is $1,500 for common (100 $15), $500 for preferred (50 $10), and $2,000 for all shares ($1,500 + $500). The basis for common stock is $7.50 per share ($1,500/$2,000 = 75% $1,000 = $750/100) and for preferred is $5.00 per share ($500/$2,000 = 25% $1,000 = $250/50). The holding period for all 150 shares begins on 10/3/96. (See Exhibit 3-9, Example 24, and pp through 3-25 and 3-27.) c. Preferred stock received as a dividend on preferred stock owned is taxable at its market value of $150 (2 $75). Its basis is $150 and its holding period begins on the current date of distribution. (See p ) 3-30 a. None. b. A portion of the stock s basis must be allocated to the rights if the value of the rights is equal to at least 15 percent of the value of the stock. This condition is satisfied in this case, as computed below FMV of rights = $500 ($0.50/right 1,000 rights) FMV of stock = $1,500 ($1.50/share 1,000 shares) 15 % test: $500/$1,500 = 33% The basis allocated to the rights is $5,000, as computed below. Original basis of stock (1,000 shares $20/share) $20,000 FMV of stock (1,000 shares $1.50/share) $ 1,500 FMV of rights (1,000 rights $0.50/share) 500 Total value of stock and rights $ 2,000 FMV of rights FMV of stock and rights _ Original basis of stock = Basis of rights received $500 $2,000 _ $20,000 = $5,000 Basis per right ($5,000/1,000 rights) = $5 per right The gain on the sale of the rights is computed as follows:

14 14 Corporate Distributions: Cash, Property, and Stock Dividends Sales price $175 Basis of 100 rights (-500) (100 $5/right) Loss ($325) Long-term The holding period for the rights begins on the same date on which the holding period of the common begins. (See Exhibit 3-9, Examples 25 through 28, and pp through 3-26.) c. None. d. $19,000 [$20,000 - $1,000 ($500 allocated to the 100 rights sold + $500 allocated to the 100 rights exercised)] a. The receipt of stock rights is a nontaxable event. The $300 market value of the rights is less than 15 percent of the $25,000 market value of the stock ($25,000 15% = $3,750). Since no election is made, no basis is transferred from the stock to the rights. The gain on the sale of the 25 rights is $87.50 ($ basis). The basis of the purchased shares is the purchase price of $1,250. The unexercised rights have no tax impact because they have no basis. b. A portion of the $18,000 common stock basis is allocated to the stock rights according to relative market values: ($300/$25,300) $18,000 = $213.44/100 rights = $2.1344; 25 rights = $53.36; and 50 rights = $ The gain on the sale of 25 rights is $34.14 ($ $53.36). The basis of the purchased shares is $1, ($1,250 + $106.72). The unexercised rights have no tax impact because no basis is allocated to rights that are allowed to lapse. (See Examples 25 through 28 and pp and 3-26.) 3-32 a. Yes. The corporation must reduce E&P by the Federal income taxes of $25,000. The Federal income taxes are not reflected in current taxable income since they are not deductible. However, since they reduce the amount of the corporation s economic income and the amount that can be distributed, E&P must be reduced. There is no adjustment for the state income taxes since they are deductible in computing current taxable income. (See p. 3-8.) b. Yes. The corporation must increase E&P by the tax-exempt interest income of $5,000. Such income is not included in current taxable income but does represent economic income, which is distributable to shareholders. (See p. 3-5.) c. Yes. The corporation must increase E&P by the amount of the dividends received deduction that was claimed in computing taxable income, $7,000 (70% $10,000). The dividends-received deduction is an artificial deduction that has no effect on the amount that a corporation can distribute. (See Example 4 and p. 3-8.) d. Yes. Limited expensing is not allowed in computing E&P. The corporation may only claim 1/5 of the cost of the asset; thus, 4/5 of the $9,000 deduction, or $7,200, must be added to E&P. (See Exhibit 3-2 and p. 3-5.) e. No. Section 1245 only provides that the character of income is ordinary; the entire gain is already included in taxable income. f. Yes. Although the capital loss was not deducted in computing taxable income in the prior year, it was deducted in computing E&P. Therefore, the loss of $7,000 must be added back to taxable income to arrive at current E&P, since it was deducted in computing taxable income this year. (See Example 5 and p. 3-9.) 3-33 a. Yes. The penalty is not deductible in computing taxable income but does reduce the amount that can be distributed to shareholders. (See Exhibit 3-2 and p. 3-9.) b. No. In the case of a nontaxable exchange, the gain realized that is not recognized ($6,000 in this case) is only added to E&P when it is recognized. (See p. 3-5.) c. No. Distributions have no effect on the determination of current E&P. Under 316, current E&P is determined without diminution for distributions during the year. In computing accumulated E&P, there is a reduction for the amount of the distribution. d. Yes. The taxpayer must use the percentage of completion method in computing E&P. Thus, E&P has already been increased by 80 percent of the income or $56,000. Since current taxable income includes the entire $70,000, E&P must be reduced by the previously recognized profit of $56,000. (See p. 3-5.)

15 Solutions to Problem Materials 15 e. Yes. E&P must be reduced by the amount of the contribution that was paid but not deducted, $2,000. (See p. 3-8.)

16 16 Corporate Distributions: Cash, Property, and Stock Dividends 3-34 For E&P purposes, depreciation must be computed using the alternative depreciation system (ADS). A light duty truck is 5-year property, and the depreciation for such property under ADS is $1,000. (See Exhibit 3-5 and p. 3-7.) Therefore, E&P must be increased by the excess depreciation of $1,000 ($2,000 - $1,000). (See Example 3 and p. 3-7.) ACRS depreciation (Appendix H) $2,000 (20% $10,000) ADS depreciation (1,000) (10% $10,000) Increase in E&P $1, For E&P purposes, the current year s depreciation, as well as the gain on the sale, will differ from that used in computing taxable income. In this case, ADS depreciation would be $1,000 ($10,000 20% straight-line ½ year). Because taxable income has been reduced by $1,600, there must be a positive adjustment to taxable income of $600 to arrive at E&P, as shown below. ACRS depreciation $1,600 ADS depreciation (1,000) (20% $10,000 ½) Increase in E&P $ 600 As computed below, the gain on the sale for regular tax purposes would be $2,600, while the gain on the sale for E&P purposes would be $1,000 since $1,600 less depreciation has been claimed for E&P purposes. Consequently, E&P must be decreased by $1,600. Note that if no adjustments have been made to E&P for depreciation, there would be no need to adjust the amount of the gain. (See Exhibit 3-5 and p. 3-7.) Amount realized $9,000 Adjusted basis: Cost $10, ACRS (2,000) 2003 ACRS (1,600) (6,400) Gain in taxable income $2,600 Amount realized $9,000 Adjusted basis: Cost $10, ADS (1,000) 2003 ADS (1,000) (8,000) E&P gain ($1,000) Negative adjustment to taxable income to compute E&P $ 1,600