Annual Edition/Instructor s Guide with Lecture Notes CHAPTER 4 CORPORATIONS: EARNINGS & PROFITS AND DIVIDEND DISTRIBUTIONS LECTURE NOTES

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1 Annual Edition/Instructor s Guide with Lecture Notes CHAPTER 4 CORPORATIONS: EARNINGS & PROFITS AND DIVIDEND DISTRIBUTIONS LECTURE NOTES SUMMARY OF CHANGES IN THE CHAPTER The following are notable changes in the chapter from the 2011 Edition. For major changes, see the Preface to the Instructor s Edition of the text. News Boxes Replaced Tax in the News titled Credit Crunch Triggers Record Dividend Cuts with a new article titled Higher Taxes on Dividends Don t Mean Lower Dividends. Updated Tax in the News titled The Case of the Disappearing Dividend Tax. Text Changes Revised Examples 10, 13, 15 and 16 to connect the topics more closely to The Big Picture feature at the beginning of the chapter. Shortened the discussion on the reduced tax rate on dividends for individuals and added discussion of the current uncertainty about the treatment of dividends beyond CORPORATE DISTRIBUTIONS OVERVIEW 1. Distributions by a corporation to its shareholders are presumed to be dividends unless the parties can prove otherwise. Section 316 makes such distributions dividend income to the shareholder to the extent of E & P of the distributing corporation (accumulated since 1913) or to the extent of E & P for the current year. 2. Distributions not taxed as dividends (because of insufficient E & P) are nontaxable to the extent of the shareholder s stock basis and will reduce that basis accordingly. Any excess of the distribution over the shareholder s basis usually is a capital gain. 5.2 EARNINGS AND PROFITS (E & P) E & P, though similar in concept to retained earnings, is computed differently. Retained earnings computation is based on financial accounting rules while E & P is determined using tax law. a. Stock dividends do not decrease E & P but they do decrease retained earnings.

2 b. E & P is reduced only by straight-line depreciation unless the corporation uses a depreciation method such as units of production or machine hours. c. E & P may be affected by gains and losses from property transactions only to the extent they are recognized for tax purposes (e.g., like-kind exchanges are not recognized for taxable income determination or for E & P purposes). 4. E & P is the factor that fixes the upper limit on the amount of dividend income a shareholder must recognize. It represents the corporation s economic ability to pay a dividend without impairing its capital. Computation of E & P 5. Additions to taxable income to compute E & P include the following. All tax-exempt income items such as municipal bond interest, excluded life insurance proceeds (in excess of cash surrender value). Dividends not taxed due to the dividends received deduction. Federal income tax refunds for taxes paid in prior years. Domestic production activity deduction (DPAD). 6. Subtractions from taxable income to compute E & P include the following. Nondeductible related party losses. Excess capital losses. Federal income taxes paid. Fines and penalties. Expenses incurred to produce tax-exempt income Key employee life insurance premiums in excess of the increases in the cash surrender value of the policy. 7. Timing adjustments shift a transaction s impact from the year it is included in taxable income to the year it has an economic effect on a corporation. These adjustments include the following. Excess capital losses. Excess charitable contributions. Net operating loss (NOL) carryovers. 8. Accounting method adjustments are the differences in accounting methods required for taxable income and E & P. These adjustments include the following. Depreciation and 179 expense adjustments. Installment sales. LIFO recapture. Adjustments for natural resource expenditures such as mining exploration and development costs, intangible drilling costs, and depletion. Circulation expenditures, trademarks, organizational expenditures amortization. Accounting for construction contracts must use percentage of completion. Summary of E & P Adjustments 9. Concept Summary 5.1 lists the adjustments that are made to a corporation s taxable income in arriving at E & P.

3 Chapter 5 Solutions to Research Problems Some of the more common E & P adjustments are the following. a. Cost Recovery. Alternative depreciation system (ADS) must be used for E & P. ADS uses straight-line depreciation over a recovery period equal to the Asset Depreciation Range (ADR) midpoint life. When accelerated depreciation is used for taxable income, an adjustment to E & P must be made. (1) No additional first year depreciation is allowed for E & P purposes. (2) When asset is later sold, increase or decrease to E & P is computed by using the adjusted basis of the asset for E & P purposes. Example 7 in the text demonstrates this concept. (3) Section 179 expenses must be deducted over five years. Thus, in the year 179 is elected, 80% is added back to arrive at E & P and in the following four years, 20% of the 179 expense is subtracted to determine E & P. (4) Rev. Proc , CB 674 sets the ADR midpoint lives for most assets. (5) Recovery period for cars and light-duty trucks is 5 years and 40 years for real property. Assets with no class life have 12 year recovery period. b. Only cost depletion, not percentage depletion may be used for E & P. Mining exploration and development costs are amortized over 60 months and intangible drilling costs are amortized over 120 months. Any unamortized balance is written off when the well becomes dry or the mineral property is abandoned. c. E & P is increased by the amount of any deferred gain in the year in which a corporation sells property on the installment basis. This is accomplished by treating all principal payments as having been received in the year of sale for purposes of computing E & P. d. Amounts amortized under 173 (circulation expenditures), 177 (trademark and trade name expenditures), and 248 (organizational expenditures) are to be capitalized for purposes of determining E & P. There is no amortization if the property does not have a reasonably determinable useful life. e. Construction period interest, taxes, and carrying charges are capitalized as a part of the asset to which they relate for purposes of computing E & P. f. Any increase in the LIFO recapture amount (excess of FIFO over LIFO inventory value) during the year is added to taxable income to determine current E & P. Decreases in the LIFO recapture amount are subtracted from taxable income. 11. Problem 27 in the text is an effective in-class exercise for teams of two or three students to complete after discussing the rules for computing E & P. Complete the problem and then discuss the solution. Current versus Accumulated E & P 12. Accumulated E & P is the total of all previous years current E & P (since February 28, 1913) as computed on the first day of each year, reduced by any distributions made from E & P.

4 13. It is important to distinguish between current and accumulated E & P because they are allocated to distributions differently. Allocating E & P to Distributions 14. When current and accumulated E & P are positive, corporate distributions are first made from current and then from accumulated. a. When distributions exceed current E & P, the allocations of current and accumulated are as follows. (1) Current E & P is allocated to distributions on a pro rata basis to each distribution (proportionately throughout the year). (2) Accumulated E & P is allocated to distributions in chronological order during the year, starting with the first distribution. b. Concept Summary 5.2 lists the steps in allocating E & P to distributions. 15. Allocations when either current or accumulated E & P has a deficit. a. If a deficit exists in accumulated and a positive balance exists in current, the two accounts are not netted. Instead, distributions are taxed as dividends to the extent of the positive balance in current E & P. b. If a deficit exists in current and a positive balance exists in accumulated, the two accounts are netted as of the date of the distribution. (1) Distributions are treated as dividends to the extent of a positive net balance. (2) Deficit in current E & P is allocated ratably throughout the year, unless the parties can show otherwise. 16. When current E & P is unknown at the shareholder s tax year-end (e.g., corporation uses a fiscal year and the shareholder uses a calendar year). a. Current E & P is assumed sufficient to cover all distributions made during the year. b. If current E & P is determined to be insufficient after the corporation s year-end, then the shareholder may file an amended return to claim a refund for taxes paid. ETHICS & EQUITY Is the Double Tax on Dividends Fair? (Page 5-10). Opinions are starkly divided on the fairness of double taxing dividends. The instructor can solicit student opinions to stimulate discussion. Be sure to ask for their rationale and supplement the discussion with the pro and con arguments provided below. Equity arguments for the double tax on dividends:

5 Chapter 5 Solutions to Research Problems 5-5 There is nothing about double taxation that ought to offend notions of fairness. Everyone in the United States is routinely taxed multiple times on the same income. For example, most employees pay social security tax, income tax and sales tax on every dollar that they spend. When it comes to fairness, the issue isn t how often taxes are paid but rather how much is paid. By this standard, eliminating the double tax on would violate most people s notion of fairness (especially those people who subscribe to the equity inherent in progressive tax rates). The Tax Policy Center at the Urban Institute has estimated that 42% of the benefits realized from complete repeal of the double tax on dividends would accrue to the richest 1% of taxpayers and 75% of the tax benefits would go to the richest 10%. The claim that dividends are double taxed is an exaggeration. More than half of corporate dividends go to tax-exempt entities (pension funds, retirement accounts, etc.) or to individuals that owe no income tax. In many cases, large dividend-paying corporations pay no income tax. Finally, corporate earnings are only subjected to the double tax when they are distributed, which may not occur for years, if ever. Taking into account time discounting, the present value of the tax in these cases is minuscule. And, any tax on dividends between corporations is mitigated or completely eliminated by the dividends received deduction. Equity arguments against the double tax on dividends: No dollar should be taxed twice, especially dollars created by taxpayer productivity. Arguing that salaries are taxed multiple times (social security, income tax, and sales tax) ignores the point that these taxes may also be unfair. Eliminating the double tax would spur capital investment and create jobs. To not provide these additional jobs to the taxpaying public is unfair. Most countries around the world do not tax dividends twice. The double tax system in the United States is unfair to domestic companies that must be competitive in the world marketplace. 5.3 DIVIDENDS 17. Tax treatment of dividends is determined in part by whether the shareholder is an individual, a corporation, or another type of taxpaying entity. a. Corporations receiving dividends are taxed at ordinary rates on amount remaining after subtracting the dividends received deduction. b. Through 2012, other taxpayers receive a reduced rate of tax on qualifying dividends, while non-qualifying dividends are taxed as ordinary income. Beyond 2012, current law taxes dividends as ordinary income, but the legislative outlook is unclear. Rational for Reduced Tax Rates on Dividends 18. Double taxation of dividends has been argued to distort the economy. a. Encourages investments noncorporate rather than corporate businesses.

6 b. Encourages corporations to finance operations with debt rather than new debt because interest is deductible. c. Encourages retention of earning to avoid double taxation. 19. Reasons for reducing the tax rate on dividends paid to individuals. a. Reduce the distortions do to the economy discussed in #18 above. b. Stimulate the economy. c. Make the U.S. more competitive in international markets. Double taxation of dividends is unusual the norm. Most countries have corporate integration. Qualified Dividends 20. From 2003 to 2010, qualified dividends are subject to a maximum 15% tax rate for most individual taxpayers. At the time this edition of the textbook was written, there is no assurance if the qualified dividend rules will be extended beyond If Congress does not act to extend the reduced tax rate on dividends, then they will be taxed as ordinary income beginning in a. Individuals in the 10% or 15% tax rate brackets are subject to a 0% tax rate on qualified dividends paid in 2008 to b. The special tax rates on qualified dividends also apply under the alternative minimum tax. c. Dividends taxed at 0% or 15% rates do not qualify as investment income for the investment interest expense limitation calculation. Taxpayers can, however, elect to treat dividends as investment income but the dividends will then be taxed as ordinary income. 21. To qualify for the special 0% or 15% tax rates, dividends must meet three requirements. a. Dividends must be paid by a qualifying corporation, which are the following. Domestic corporations. Foreign corporations whose stock is traded on U.S. markets Corporations located in countries that meet the following requirements. Have comprehensive income tax treaties with the U.S. Have information-sharing agreements with the U.S. Are approved by the Treasury. b. Dividends paid to shareholders who hold both long and short positions in the same stock do not qualify. c. Stock must be held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. Property Dividends

7 Chapter 5 Solutions to Research Problems Property dividends have the same impact as cash distributions for the shareholder. For the corporation there is the additional consideration of the sale of the property to the shareholder. 23. Shareholder effect. a. Shareholder dividend measured as the property s fair market value on the distribution date. This amount is reduced by any liabilities assumed by the shareholder due to the distribution. b. Shareholder s basis in distributed property is fair market value on distribution date. c. If property distributed is subject to a liability, the fair market value of the property is considered to be at least equal to the amount of the liability. 24. Corporation effect. a. Under 311(b), gain but not loss is recognized by the corporation on a property dividend distribution. Gain computed as if appreciated property was sold to the shareholder at its fair market value. b. If property distributed is subject to a liability, the fair market value of the property is considered to be at least equal to the amount of the liability. 25. Adjustments to E&P for property distributions. a. E & P is reduced by amount of money distributed and/or the greater of the fair market value or the adjusted basis of the property distributed less the amount of any liability on the property. b. E & P is increased by gain recognized on appreciated property distributed. This gain flows through the tax return. c. Distributions cannot generate or add to a deficit in E & P. Only corporate losses generate or add to a deficit in E & P. Constructive Dividends 26. Constructive dividends usually arise with closely-held corporation. They need not be formally declared or issued pro rata. Constructive dividends include the following. a. Personal use by a shareholder of corporate-owned property (e.g., company-owned automobiles, airplanes, yachts, hunting lodges). The measure of the dividend usually is the fair rental value of the property for the period of its personal use. b. Bargain sale of corporate property to the shareholders. The dividend is the difference between the amount paid for the property and its FMV. c. Bargain rental of corporate property to its shareholders. The dividend is the amount of the property s fair rental value that exceeds the rent actually paid. d. Payments for the benefit of shareholders. (1) Satisfaction by corporation of shareholder s personal obligation to third party. (2) Forgiveness of a shareholder debt to the corporation.

8 (3) Excessive rentals paid by a corporation for the use of shareholder property. e. Compensation to shareholder/employee that is unreasonable. (1) There are numerous factors that are considered in determining whether compensation is reasonable. See page 5-17 in text for a list. (2) Reasonable investor test is relatively new development in reasonable compensation. ETHICS & EQUITY Forgetting About the Past (page 5-25). Should the court find that Michael s salary is unreasonable in the current year, part of the $1 million (which assumes that Michael s work merits some amount of compensation) would be treated as a constructive dividend. This amount would not be deductible by Cormorant. The text provides a list of factors to be considering when making a determination regarding the reasonableness of salary payments. A summary of court cases addressing reasonable compensation issues is provided as an additional lecture resource in this instructor s guide. It is not necessary to view the prior year s IRS determination as binding for the new tax year. With questions of fact such as this case, every year stands on its own. It is appropriate for the tax advisor to accept the work. The tax advisor should start a file to document the value of Michael s contribution to the organization in an effort to substantiate the $1 million salary. Part of this documentation might include the fact that Cormorant s value has increased over the year since the previous deduction, the importance of Michael s contribution to the success of the company, salary policy for employees generally, Michael s unique qualifications for the job, and other factors that courts have relied on when making a determination regarding the reasonableness of salary. ADDITIONAL LECTURE RESOURCE Court cases concerning reasonable compensation in closely held corporations have received inconsistent treatment. When deciding these cases, the courts rely on two different types of tests. The 13 Federal circuits differ in the use of these tests based in part on earlier precedent in their respective jurisdictions. Multiple Factor Approach. The first type of test uses multiple factors to assess the reasonableness of compensation, such as the company s financial condition, its dividend history, and the size and complexity of its business. The approach also compares compensation to similarly situated employees of comparable companies and considers the employee s contribution to corporate profits and the relationship between compensation and level of stock holdings. This type of analysis originated in the 6th Circuit [Mayson Manufacturing Co. v. Comm., 49-2 USTC 9467, 38 AFTR 1028, 178 F.2d 115 (CA-6, 1949)] and is followed in the 10th Circuit [Eberl s Claim Service v. Comm., 87 AFTR2d , 249 F.3d 994 (CA-10, 2001)].

9 Chapter 5 Solutions to Research Problems 5-9 Independent Investor Approach. To examine reasonableness of compensation to the shareholderemployee, other courts are beginning to use a new approach, involving a hypothetical independent investor. The question asked by the judge is how much would an independent investor be willing to pay the employee, given the profits that are generated? The 7th Circuit Court is the principal advocate for this standard. Other courts (including the 2nd, 6th, and 9th Circuit Courts) have started to use a hybrid approach, considering both the multiple factors suggested in Mayson Manufacturing and the new independent investor test. In many of the cases adopting either a hybrid approach or the independent investor test, opinions have often been critical of the Tax Court s use of the multiple factor approach. A brief summary of a few of these cases follow. Alpha Medical, Inc. v. Comm., 99-1 USTC 50,461, 83 AFTR2d , 172 F.3d 942 (CA- 6, 1999). William Rogers, a pharmacist with a history of successful business ventures in the health care industry, started a medical consulting corporation with a $1,000 contribution to capital. After 4 years of success (largely attributable Rogers efforts), the corporation had taxable income of almost $7,000,000. The corporation paid compensation to Rogers of $4.4 million. During audit, the IRS determined that $4 million of the compensation paid was unreasonable. The Tax Court split the difference between the IRS and taxpayer, finding $2.3 million of Rogers pay to be reasonable. On appeal, however, the Sixth Court of Appeals ruled that all $4.4 million of the compensation paid to Rogers was reasonable. In its decision, the Court of Appeals said that, in light of Rogers record of accomplishment, risks he assumed, and amazing growth, reasonable shareholders would have gladly agreed to Rogers level of compensation. Leonard Pipeline Contractors v. Comm., 98-1 USTC 50,356, 81 AFTR2d , 142 F.3d 1133 (CA-9, 1998). In its decision, the Ninth Court of Appeals judge criticized the Tax Court s failure to explain how it arrived at its reasonable compensation figure (about halfway between amounts argued by the IRS and the taxpayer). The appellate court noted that the Tax Court simply enumerated the factors to be considered when determining reasonableness of compensation and then leapt to an intermediate figure between the IRS and taxpayer. Exacto Spring Corp. v. Comm., 84 AFTR2d , 196 F.3d 822 (CA-7, 1999). In this decision, the 7th Circuit Court was sharply critical of the Tax Court s use of the multiple factor approach in general, saying that it led to arbitrary results. The court suggested that the sole use of the independent investor approach is simpler and more purposive than the multiple factor approach. Under the test, the court argued, the higher the rate of return that an employee can generate through their own efforts, the higher the compensation they should be able to command. Menard, Inc., 88 TCM 229, TC Memo Menard, Inc. is a home improvement store that is closely held, with most of the stock owned by the CEO, Mr. Menard. In 1998, Mr. Menard received a $62,400 salary, $3 million in compensation from a profit sharing plan, and approximately $17 million as a bonus (set at 5% of net income before taxes). The corporation earned a higher return on investment than similar businesses in the industry. In its decision, the Tax Court agreed with the taxpayer that the independent investor test was satisfied. However, the court held that satisfaction of this test merely creates a rebuttable presumption that compensation is reasonable. The court relied on a statement in Reg (b)(3): It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. Since CEOs of publicly traded companies in the same line of business were paid considerably less for their services than Mr. Menard, the court found that only $7 million of his salary was reasonable. Vitamin Village, Inc. v. Comm., 94 TCM 278, TC Memo Mr. Reeves was the company s president, secretary, treasurer and sole shareholder of the corporation from 1979 through During that time frame, he performed all managerial duties. He

10 worked more than 80 hours per week managing research, development, production, sales, marketing, and advertising. He also supervised all Vitamin Village employees and made all hiring and firing decisions. Through 1993, the company either lost money or made modest amounts (up to $50,000) annually. Mr. Reeves was also compensated modestly during this period, earning between $0 and $47,000 each year. His compensation was set low so that profits could be used to expand the business. From 1993 to 1996, the company was very profitable and Mr. Reeve s compensation was increased substantially (between $182,000 and $2.2 million annually). In making a determination regarding the reasonableness of Mr. Reeve s compensation, the court applied both the independent investor test (finding a return on equity of between 25 and 95 percent for the years at issue) and a variety of other factors such as Mr. Reeve s role in the company, a comparison with salaries paid by similar corporations, the character and condition of the company. As a result of the analysis, the court found that almost the entire amount paid was reasonable. Note: a related case re: constructive dividends received by Mr. Reeves can be found in Daniel L. Reeves v. Comm., 94 TCM 287, TC Memo f. Advances by a corporation to a shareholder that are not bona fide loans. g. Imputed interest element on interest-free (or below-market) loans by a corporation to a shareholder. (1) Shareholder is deemed to make an interest payment to the corporation to the extent of the forgone interest. (2) Corporation is then deemed to make a dividend distribution to the shareholder for the same amount. (3) Although the shareholder may be permitted to deduct the deemed interest payment, the corporation has interest income. (4) No corresponding corporate interest deduction is allowed because imputed interest element is a constructive dividend. h. Interest and principal payments made by a corporation where debt owed to its shareholders is reclassified as equity (i.e., the corporation is thinly capitalized). i. See the Class Exercise on Constructive Dividends at the end of the Lecture Notes for this chapter. This can be as a take-home or classroom project. Stock Dividends and Stock Rights 27. Stock dividends are not taxable if they are pro rata distributions of stock, or stock rights, on common stock. Stock dividends are taxable under 305 in the following situations. If one shareholder can elect payment either in cash or in stock, all are taxable. Disproportionate distributions of stock dividends. Common stock distributions to some common shareholders and preferred stock to other common shareholders. A stock dividend of convertible preferred on common, if it is reasonable to expect that some shareholders will convert their preferred shares to common shares and that others will keep their preferred shares.

11 Chapter 5 Solutions to Research Problems 5-11 Distributions on preferred stock (except for changes in the conversion ratio of convertible preferred made to account for a stock dividend or stock split). Convertible preferred stock distributions that result in disproportionate distributions. Transactions increasing the proportionate interest of a shareholder even if they are not actually stock dividends. ADDITIONAL LECTURE RESOURCE The following examples illustrate the applicability of 305. A corporation has a dividend reinvestment plan that allows shareholders to choose either a stock dividend or a cash dividend. The stock dividend is of greater fair market value than the cash dividend. In addition, for those electing to take the stock dividend and thereby reinvest in the corporation, an optional plan to purchase additional common stock of the company at a price equal to 95% of the fair market value of the stock is available. Those choosing the stock dividend would have a taxable dividend under 305 to the extent of the fair market value of the stock received initially. In addition, for shareholders electing the optional plan, income will be recognized to the extent that the fair market value of the stock purchased at the 5% discount exceeds the purchase price of the stock (Rev. Rul , CB 130). A corporation has an annual redemption plan whereby shareholders can redeem 1% of their stock annually. While those who tender their stock for redemption have dividend income under 301 (because the provisions of 302 are not met), those who do not tender their stock also have dividend income under 305 because their proportionate share of E & P and assets of the corporation increases. While a distribution of property incident to an isolated redemption does not cause 305(b)(2) to apply (even though the redemption is treated as a 301 distribution), it does apply to an ongoing plan of annual stock redemptions (Rev. Rul , CB 81). Under 305(b)(1), a distribution to common shareholders of preferred stock, which is immediately redeemable is taxable as offering a choice of stock or cash (Rev. Rul , CB 95). A corporation has two classes of common, Class A and Class B. It makes a distribution of Class A stock to the current Class A shareholders, and a distribution of newly issued preferred stock to the Class B shareholders. Reg (b) hold that both distributions are taxable. A corporation, having one class of common stock, distributes to its common shareholders a new issue of convertible preferred having a six-month conversion period and a conversion price near the market value of the common stock. Reg (b) indicates that because early conversion by common shareholders is probable and this results in some common shareholders holding common stock while others hold preferred, the distribution of preferred is taxed under 305(b)(3). An interest payment to a convertible debenture holder will cause the distribution of a stock dividend to the common shareholders to be taxed under 305(b)(2). The holders of the convertible debentures are deemed to be shareholders; thus, some shareholders have received cash [Reg (b)(3)]. 28. If stock dividends are not taxable, there is no reduction in E & P. If they are taxable, the distribution is treated as any other property dividend.

12 29. If the stock dividend is not taxable, 307 applies and a basis allocation is necessary. If the stock dividend is taxable, the basis of the stock received is its fair market value. 30. For a recapitulation on the operation of 305, see Figure 5.1 appearing on next page 5-13 of this outline.