chap_15 - Chapter 15 Corporate Nonliquidating Distributions...

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Unformatted text preview: Chapter 15 Corporate Nonliquidating Distributions 2008 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com Chapter 15 Exhibits 1. Effect of Operations on Owners--Comparison Among Entities 2. Effect of Nonstock Distributions on Owners--Comparison Among Entities 3. Effect of Nonstock Distributions on Entities--Comparison Among Entities 4. Effect of Taxable Stock Distributions on Shareholders 5. Effect of Identical, Nontaxable Stock Distributions on Shareholders 6. Effect of Nonidentical, Nontaxable Stock Distributions on Shareholders 7. Effect of Stock Redemptions on Shareholders 8. Effect of Stock Redemptions on Corporations 9. Effect of Complete Liquidations on Shareholders 10. Effect of Complete Liquidations on Corporations Chapter 15, Exhibit Contents A CCH Federal Taxation Comprehensive Topics 2 of 59 Chapter 15 Exhibits 11. 12. 13. 14. 15. 16. 17. Nonstock Distributions--Effect on Shareholders Earnings and Profits of C Corporations Nonstock Distributions--Effect on Corporation Nonstock Distributions--Examples Stock Distributions Redemptions (Including Partial Liquidations)--Overview Redemptions (Including Partial Liquidations)--Tax Effect on Shareholders 18. Redemptions (Including Partial Liquidations)--Example on Shareholder Effect 19. Redemptions (Including Partial Liquidations)--Tax Effect on Corporations 20. Redemptions (Including Partial Liquidations)--Example on Corporate Effect Chapter 15, Exhibit Contents B CCH Federal Taxation Comprehensive Topics 3 of 59 Effect of Operations on Owners-- Comparison Among Entities Operating Item Undistributed income Current losses: General Limit Character conduit C Corps No tax to shareholder No deduction to shareholder N/A No S Corps Current tax Current deduction Outside basis at risk Yes (Code Sec. 1366(b)) Partnerships Current tax Current deduction Outside basis at risk Yes Chapter 15, Exhibit 1a CCH Federal Taxation Comprehensive Topics 4 of 59 Effect of Operations on Owners-- Comparison Among Entities Operating Item Owner's basis: General C Corps Constant (unaffected by corporate activity) None S Corps Adjusted annually Partnerships Adjusted annually Effect of entity debt None (neither basis nor AAA affected; only atrisk amount) Outside basis AND at-risk amount affected (Code Sec. 752) Chapter 15, Exhibit 1b CCH Federal Taxation Comprehensive Topics 5 of 59 Effect of Nonstock Distributions on Owners-- Comparison Among Entities C and S Corporations How is "amount distributed" to owners computed? FMV of all property received by shareholder Corporate debt assumed by shareholder Partnerships Cash + Debt relief [i.e., for purposes of determining gain, only cash + debt relief are subject to capital gains. Other property received by a partner is taxfree.] Chapter 15, Exhibit 2a CCH Federal Taxation Comprehensive Topics 6 of 59 Effect of Nonstock Distributions on Owners-- Comparison Among Entities C and S Corporations What is the owners' tax treatment for the "amount distributed?" 1. 2. 3. C Corps. Ord. up to curr. E&P; Ord. up to accum. E&P; Tax-free up to outside basis Cap gain on remainder. 1. S Corps. Tax-free up to the lesser of: AAA Bal. Stock Basis Ord. Up to accum. E&P from prior life as a C corp. (if any) Tax free up to any excess of stock basis over AAA balance Capital Gain on remainder Partnerships Cash + debt relief: 1. Tax-free up to outside basis; 2. Capital gain to a partner on the excess of cash or debt relief in excess of outside basis. (Loss is never recognized.) 3. Other property: Tax-free. 7 of 59 2. 4. 3. 4. Chapter 15, Exhibit 2b CCH Federal Taxation Comprehensive Topics Effect of Nonstock Distributions on Owners-- Comparison Among Entities C and S Corporations What is the basis of property distributed to an owner? Always FMV, even if an owner assumes corporate debt. Partnerships Same as the partnership's inside basis. [However, if a partner's outside basis is less than the partnership's inside basis in property distributed to a partner, then the partner's basis of property received is taken from his outside basis, not from the partnership's inside basis. This makes sense, given that a partner's outside basis must be reduced by the "amount" of distributions and that it cannot be negative.] 8 of 59 Chapter 15, Exhibit 2c CCH Federal Taxation Comprehensive Topics Effect of Nonstock Distributions on Entities-- Comparison Among Entities C and S Corporations Does an entity recognize gain or loss on the distribution of: i) Cash or its own bonds to owners? ii) Other property (other than its own stock)? No Gains: Yes (compute gain in the same way as if the property were sold) Losses: No (except in complete liquidation) Partnerships No No gain or loss, unless it is part of a disguised sale. In a disguised sale, the partnership's recognized gain or loss = (a) (b), where: (a) = FMV of property dist'd. (b) = AB of property dist'd. Chapter 15, Exhibit 3a CCH Federal Taxation Comprehensive Topics 9 of 59 Effect of Nonstock Distributions on Entities-- Comparison Among Entities C and S Corporations What is the character of the entity's gain or loss on distribution of property to owners? If owner owns 50%, then the character of the entity's gain is the same as the character of the property distributed. If owner owns > 50%, then the entity's gain is ordinary. Losses are not recognized. Partnerships The character of the partnership's gain or loss on a disguised sale is the same as the character of the property before it is distributed. Chapter 15, Exhibit 3b CCH Federal Taxation Comprehensive Topics 10 of 59 Effect of Taxable Stock Distributions on Shareholders Rules for Taxable Stock Dividends: 1. Upon receipt: Stock dividends are taxable as ordinary income at their fair market value (FMV). 2. Upon sale: Basis of taxable stock dividends = same amount as in (a) above; holding period begins on the day AFTER receipt (i.e., consistent with the general rule for holding period). Chapter 15, Exhibit 4a CCH Federal Taxation Comprehensive Topics 11 of 59 Effect of Taxable Stock Distributions on Shareholders Example on Taxable Stock Dividends Facts: 1. 1000 common stock (C/S) shares are purchased for $12,000 on March 31, 20x1. 2. On September 30, 20x1, a 20% taxable C/S dividend is received when the FMV is $20 per share. 3. On June 30, 20x2, the 200 new shares are sold for $30 per share Question: Determine the tax treatment for the receipt and sale of the stock dividends. Chapter 15, Exhibit 4b CCH Federal Taxation Comprehensive Topics 12 of 59 Effect of Taxable Stock Distributions on Shareholders Solution: March 31, 20x1 receipt: $4,000 taxable dividend income. $4,000 = $20/share x (1,000 old x 20%); June 30, 20x2 sale: $2,000 short-term capital gain. $2,000 = $6,000 sales proceeds - $4,000 basis of new shares. (The beginning holding period date is October 1, 20x1, the day AFTER receipt of the stock dividend. A June 30, 20x2 sale results in a short-term holding period.) Chapter 15, Exhibit 4c CCH Federal Taxation Comprehensive Topics 13 of 59 Effect of Identical, Nontaxable Stock Distributions on Shareholders Rules for Identical, Nontaxable Stock Dividends: 1. Upon receipt: Stock dividends are not taxable. 2. Upon sale: Allocate old basis over old and new shares using the following formula: Basis per share = old basis (# old shares + # new shares) (Holding period of original and new shares begins on day AFTER original acquisition.) Chapter 15, Exhibit 5a CCH Federal Taxation Comprehensive Topics 14 of 59 Effect of Identical, Nontaxable Stock Distributions on Shareholders Example on Identical, Nontaxable Stock Dividends Facts: 1. March 31, 20x1: 1000 common stock (C/S) shares are purchased for $12,000. 2. September 30, 20x1: a 20% nontaxable C/S dividend is issued. 3. June 30, 20x2: the 200 new shares are sold for $30 per share. Question: Determine the tax treatment for the receipt and sale of the stock dividends. Chapter 15, Exhibit 5b CCH Federal Taxation Comprehensive Topics 15 of 59 Effect of Identical, Nontaxable Stock Distributions on Shareholders Solution: March 31, 20x1 receipt: The stock dividends are not taxable. June 30, 20x2 sale: $4,000 long-term capital gain (6,000 2,000). $2,000 basis of new shares = $10/share x 200 new shares, where $10/share = [$12,000 (1,000 old shares + 200 new shares)]; (The beginning holding period date is 4/1/x1, the day AFTER receipt of the original stock. A 6/30/x2 sale results in a longterm holding period.) Chapter 15, Exhibit 5c CCH Federal Taxation Comprehensive Topics 16 of 59 Effect of Nonidentical, Nontaxable Stock Distributions on Shareholders Rules for Nonidentical, Nontaxable Stock Dividends: 1. Upon receipt: Stock dividends are not taxable. 2. Upon sale: Allocate the original common stock (C/S) basis between the number of original C/S shares and the number of new preferred stock shares (P/S) using relative fair market values as of the date of receipt. 3. The holding period of the original C/S does not change (i.e., it begins on the day AFTER original acquisition). The holding period of the new P/S shares is the same as the C/S. Chapter 15, Exhibit 6a CCH Federal Taxation Comprehensive Topics 17 of 59 Effect of Nonidentical, Nontaxable Stock Distributions on Shareholders Example on Nontaxable, Nonidentical Stock Dividends Facts: 1. March 31, 20x1: 1,000 C/S shares are purchased for $12,000. 2. September 30, 20x1: a 10% P/S dividend is issued when the fair market value of C/S and P/S shares is $16 and $80, respectively. 3. June 30, 20x2: the 1,000 C/S shares and 100 new P/S shares are sold for $20 per share and $100 per share, respectively. Question: Determine the tax treatment for the receipt and sale of the stock. Chapter 15, Exhibit 6b CCH Federal Taxation Comprehensive Topics 18 of 59 Effect of Nonidentical, Nontaxable Stock Distributions on Shareholders Solution: March 31, 20x1 receipt: The stock dividends are not taxable. June 30, 20x2 sale of common stock: $14,000 long-term capital gain 1. $14,000 capital gain: = (20,000 sales price 8,000 adjusted basis). 2. $8,000 AB = $12,000 x [(1,000 C/S shares x 16 per share] [16,000 + (100 P/S shares x 80 per P/S share)] 3. Long-term HP: The beginning holding period date is April 1, 20x1, the day AFTER receipt of the original stock. A June 30, 20x2 sale results in a long-term holding period. June 30, 20x2 sale of preferred stock: $6,000 long-term capital gain 1. $6,000 capital gain: = 10,000 sales price 4,000 adjusted basis). 2. $4,000 AB = 12,000 x [(100 P/S shares x 80 per share] [16,000 + 8,000] 3. Long-term HP: The beginning holding period date is April 1, 20x1, the same as the common stock. A June 30, 20x2 sale results in a long-term holding period. Chapter 15, Exhibit 6c CCH Federal Taxation Comprehensive Topics 19 of 59 Effect of Stock Redemptions on Shareholders Stock Redemptions What is the tax effect of redemptions on shareholders? If dividend treatment: Corporations Same as non-stock distributions, i.e., C Corps Ord. up to curr. E&P; Ord. up to accum. E&P; Tax-free up to outside basis Capital gain on remainder 1. 2. 3. 4. Chapter 15, Exhibit 7a CCH Federal Taxation Comprehensive Topics 20 of 59 Effect of Stock Redemptions on Shareholders Stock Redemptions What is the tax effect of redemptions on shareholders? If sales treatment: Corporations Capital gain/loss = (a) (b) (c): (a) = Fair market value of property received (b) = Corporate debt assumed (c) = Basis of stock given up Chapter 15, Exhibit 7b CCH Federal Taxation Comprehensive Topics 21 of 59 Effect of Stock Redemptions on Shareholders Stock Redemptions Owner's basis in unredeemed stock Corporations Reduce aggregate basis by (a) (b), where: (a) = # shares redeemed (b) = Total # shares owned before redemption Chapter 15, Exhibit 7c CCH Federal Taxation Comprehensive Topics 22 of 59 Effect of Stock Redemptions on Shareholders Stock Redemptions Owner's basis and holding period of property received Corporations 1. Same as non-stock distributions , i.e., always use fair market value, even if an owner assumes corporate debt. 2. The holding period begins on the date after receipt. Chapter 15, Exhibit 7d CCH Federal Taxation Comprehensive Topics 23 of 59 Effect of Stock Redemptions on Corporations Does a corporation recognize gain or loss on redemption? (a) If it distributes cash or its own bonds to owners? No (b) If it distributes other property to its owners? Gains: Yes, computed as if the property were sold; Losses: No. Chapter 15, Exhibit 8 CCH Federal Taxation Comprehensive Topics 24 of 59 Effect of Complete Liquidations on Shareholders Does an owner recognize gain or loss in a complete liquidation? 1. Parent owns less than 80% of subsidiary: Yes, gains and losses are recognized, using the same formula as for redemptions with sales treatment, i.e., capital gain/loss = (a) (b) (c): (a) = Fair market value of property received (b) = Corporate debt assumed (c) = Basis of stock given up No gain or loss 25 of 59 2. Parent owns 80% or more of subsidiary: Chapter 15, Exhibit 9 CCH Federal Taxation Comprehensive Topics Effect of Complete Liquidations on Corporations Does a corporation recognize gain or loss in a complete liquidation? 1. Parent owns less than 80% of subsidiary: 2. Parent owns 80% or more of subsidiary: Yes for gains AND losses, computed in the same way as if the property were sold No gain or loss Chapter 15, Exhibit 10 CCH Federal Taxation Comprehensive Topics 26 of 59 Nonstock Distributions--Effect on Shareholders What is the amount of distributions other than stock? The amount of distribution other than stock of the corporation is: (a) (b), where, (a) = The fair market value of all property received (other than the common stock of the distributing corporation) (b) = Liabilities of the distributing corporation, both recourse and nonrecourse, assumed by the shareholder Chapter 15, Exhibit 11a CCH Federal Taxation Comprehensive Topics 27 of 59 Nonstock Distributions--Effect on Shareholders Do shareholders of C corporations recognize income on nonstock distributions? Yes, then yes, then no, then yes. That is, when a corporation distributes property other than its own stock to shareholders, the tax treatment to shareholders moves in different directions, according to the following pecking order: Tier 1st 2nd 3rd 4th Distributions Other Than Stock, to the Extent of: Current earnings & profits Accumulated earning & profits Shareholder's basis in the stock Any balance remaining Tax Treatment to Shareholder Ordinary income based on fair market value Ordinary income based on fair market value Nontaxable return of capital Capital gain 28 of 59 Chapter 15, Exhibit 11b CCH Federal Taxation Comprehensive Topics Nonstock Distributions--Effect on Shareholders What is a shareholder's basis in the nonstock property distributed by the corporation? Basis = Fair market value of the asset. The assumption of a liability does not affect basis. Chapter 15, Exhibit 11c CCH Federal Taxation Comprehensive Topics 29 of 59 Earnings and Profits of C Corporations How are earnings and profits (E&P) determined? Earnings and profits are determined as follows: 1. 2. + +/ Income or loss per accounting books. Schedule M-1 or M-3 reconciling items. Recall that the schedule lists the differences, both permanent and temporary, between accounting and tax income. Corporation's gain recognized on distribution of appreciated property. Corporation's gain recognized on distribution of appreciated property. Fair market value of stock dividends that are taxable to shareholders. Earnings and profits CCH Federal Taxation Comprehensive Topics 30 of 59 3. 4. 5. + = Chapter 15, Exhibit 12 Nonstock Distributions--Effect on Corporation Does a corporation recognize a gain or loss on the distribution of cash or its own bonds? No. Chapter 15, Exhibit 13a CCH Federal Taxation Comprehensive Topics 31 of 59 Nonstock Distributions--Effect on Corporation Does a corporation recognize a gain or loss on the distribution of an asset? Yes for gains (unlike partnerships), no for losses (similar to partnerships). A corporation is considered to have sold the property to the shareholder at the larger of FMV of the asset or the debt associated with the asset. Gain is computed as follows: Gain = [greater of (a) or (b)], minus (c), where, (a) = FMV of property distributed (b) = corporation's debt relief (if any) (c) = corporations adjusted basis in the property distributed The character of the gain is based on the character of the assets distributed. However if the shareholder owns > 50% of the o/s stock, the corporation's gain is ordinary, regardless of the character of the assets. Chapter 15, Exhibit 13b CCH Federal Taxation Comprehensive Topics 32 of 59 Nonstock Distributions--Examples Nonstock Distributions where Mortgage > Fair Market Value of Property Facts: 1. X Corp. distributed land to Fred, a shareholder. The land had been held as investment by X for five years. At the time of the distribution, the land had a FMV of $60, a basis to X of $5, and was subject to a mortgage of $70. 2. X Corp.'s current and accumulated E&P was $2 and $18, respectively. Questions: 1 2 3 What is the amount and character of the recognized gain to X Corp. as a result of this distribution? If Fred the stockholder has a $20 basis in his X stock, what is the amount and character of his recognized gain? What is Fred's basis in the land? CCH Federal Taxation Comprehensive Topics 33 of 59 Chapter 15, Exhibit 14a Nonstock Distributions--Examples Nonstock Distributions where Mortgage < Fair Market Value of Property Facts: Same as Example 1, except the land was subject to a mortgage of $10, not $70. Questions: 1 2 3 What is the amount and character of the recognized gain to X Corp. as a result of this distribution? If Fred the stockholder has a $20 basis in his X stock, what is the amount and character of his recognized gain? What is Fred's basis in the land? Chapter 15, Exhibit 14b CCH Federal Taxation Comprehensive Topics 34 of 59 Nonstock Distributions--Examples Solutions to Examples 1 and 2 Example 1 (Mortgage > FMV): Question Answer 1 65 Computation (> of 60 FMV or 70 Mtg.) - (5 Basis) = 65 (Land FMV: $60) - (Land Mtg: $70) = (10) < 0 Always the FMV, regardless of mortgage. 1 Example 2 (Mortgage < FMV): Question Answer 55 Computation (> of 60 FMV or 10 Mtg.) - (5 Basis) = 55 Illustrated on next slide Always the FMV, regardless of mortgage. 2 0 2 50 3 60 3 60 Chapter 15, Exhibit 14c CCH Federal Taxation Comprehensive Topics 35 of 59 Nonstock Distributions--Examples Example 2, Question 2 Computation Amount of distribution = $50 [(Land FMV: 60) - (Mortgage on Land: 10) = 50] Tier 1. 2. 3. 4. Distributions to the Extent of: Current E&P Accumulated E&P Shareholder's basis in the stock Any balance remaining Total amount distributed 2 18 20 10 50 Tax Treatment to Shareholder Ordinary income based on FMV Ordinary income based on FMV Nontaxable return of capital Capital gain Chapter 15, Exhibit 14d CCH Federal Taxation Comprehensive Topics 36 of 59 Stock Distributions What types of stock distributions are taxable to shareholders? Stock dividends are usually tax-free to the shareholder unless any one of the following exceptions occurs under Code Sec. 305(b): 1. In lieu of cash. Shareholders could have opted for cash, but instead chose stock. 2. Disproportionate distributions. (e.g., some shareholders receive property, others receive stock.) 3. Common/preferred. (e.g., some shareholders receive C/S dividends, others receive P/S.) 4. Dividends "of" convertible preferred stock. 5. Dividends "of" preferred stock "on" preferred stock. Chapter 15, Exhibit 15a CCH Federal Taxation Comprehensive Topics 37 of 59 Stock Distributions Exceptions 1 - 4 (from previous slide) are taxable because they allow the proportionate ownership mix of the shareholders to change. (Economic benefit doctrine applies.) Exception 5 (from previous slide) is taxable because the recipients of preferred stock dividends get an increase in their priority claims (vis--vis common shareholders) against corporate net assets in event of liquidation. (Again, the economic benefit doctrine applies.) Chapter 15, Exhibit 15b CCH Federal Taxation Comprehensive Topics 38 of 59 Stock Distributions What is the tax effect of stock dividends on the corporation and its shareholders? It depends on whether stock dividends are taxable or nontaxable: Corporate Treatment Tax effect E&P Taxable Never a gain or loss on distribution Reduce E&P by market value Taxable Ordinary income based on market value at date of receipt Market value at date of receipt Nontaxable Never a gain or loss on distribution No effect on E&P Shareholder treatment Tax effect Nontaxable Not taxable until sold Basis in new stock Chapter 15, Exhibit 15c Allocate old basis over old and new shares 39 of 59 CCH Federal Taxation Comprehensive Topics Redemptions (Including Partial Liquidations)--Overview What is a stock redemption? Stock is redeemed when a corporation acquires its own stock from a shareholder in exchange for cash or other property. Redemptions occur for numerous reasons, including: 1. To allow current shareholders to retain complete control of the corporation when one of them wishes to terminate her interest in the corporation. 2. To allow a shareholder to terminate her interest in the corporation when it is difficult to find an outside buyer (i.e., the corporation stock is not publicly traded). 3. To allow the corporation to "invest in itself" when future stock appreciation is anticipated. 4. To build up treasury stock for later distribution to employees as a performance incentive. Chapter 15, Exhibit 16a CCH Federal Taxation Comprehensive Topics 40 of 59 Redemptions (Including Partial Liquidations)--Overview What is the tax effect of redemptions to the shareholder? The tax effect depends on whether the shareholder is required to treat the distribution as: 1. Dividend treatment. Receipt of nonstock distributions treatment (i.e., cash or other property), and stock dividends other than those qualifying for sales treatment (discussed below); or, 2. Sale treatment. Sale of stock to the corporation. Chapter 15, Exhibit 16b CCH Federal Taxation Comprehensive Topics 41 of 59 Redemptions (Including Partial Liquidations)--Overview A shareholder gets dividend treatment unless the redemptions cause one of the following 5 conditions to occur: 1. Terminate the shareholder's entire interest. 2. Are substantially disproportionate between shareholders. This condition exists if the shareholder: (i) gives up over 20% of his voting and nonvoting common stock; AND (ii) owns less than 50% of total corporate voting stock after the redemption. 3. Are NOT essentially equivalent to a dividend. Congress is vague on this condition. The courts have held that this condition exists if there is a "business contraction"--a corporation liquidating a "segment" of an existing business, such as a product line. Distribution of "excess" inventory or unwanted assets does not count (i.e., IS essentially equivalent to a dividend). 4. Are from a shareholder, other than a corporation, in partial liquidation. This condition occurs if the corporation was actively engaged in two or more businesses over the past five years and decided to shut one down and distribute its assets. (Note that "3" above referred to a "segment" of a business, while "4" refers to an entire business.) 5. Are received by an estate to the extent of death taxes and administrative expenses. If one of these 5 conditions occurs, then the shareholder gets sale treatment. Chapter 15, Exhibit 16c CCH Federal Taxation Comprehensive Topics 42 of 59 Redemptions (Including Partial Liquidations)-- Tax Effect on Shareholders Dividend vs. Sales Treatment Dividend Treatment Sale Treatment 1. Fair market value (FMV) of property Sale of stock: received less any liability assumed is FMV of property received ordinary income to the extent of current Liability assumed by E&P shareholder 2. Any balance in FMV liability is OI to Basis of stock given up the extent of accumulated E&P = Capital gain or loss 3. Any bal. is nontaxable recovery of capital to the extent of basis 4. Capital gain on any remaining balance Chapter 15, Exhibit 17a CCH Federal Taxation Comprehensive Topics 43 of 59 Redemptions (Including Partial Liquidations)-- Tax Effect on Shareholders Dividend vs. Sales Treatment Dividend Treatment Basis in any unredeemed stock: Aggregate basis in shareholder's stock remains unchanged. Sale Treatment Aggregate basis is reduced by (a) (b), where: (a) = # shares redeemed (b) = total # shares before redemption Chapter 15, Exhibit 17b CCH Federal Taxation Comprehensive Topics 44 of 59 Redemptions (Including Partial Liquidations)-- Tax Effect on Shareholders Dividend vs. Sales Treatment Dividend Treatment Basis in property received: Basis in property received is its FMV, without being reduced by any debt assumption Sale Treatment Same as dividend treatment Chapter 15, Exhibit 17c CCH Federal Taxation Comprehensive Topics 45 of 59 Redemptions (Including Partial Liquidations)-- Tax Effect on Shareholders Dividend vs. Sales Treatment Dividend Treatment Holding period of property received: HP of the property begins on the day after redemption Sale Treatment Same as dividend treatment Chapter 15, Exhibit 17d CCH Federal Taxation Comprehensive Topics 46 of 59 Redemptions (Including Partial Liquidations)-- Example on Shareholder Effect Facts: 1. In 20x1, X Corporation has current E&P of $1,000,000. 2. Emad owns 100 shares of X Corporation's 1,000 shares outstanding. His basis in the 100 shares is $100,000 and the shares had been held long-term. 3. On December 31, 20x1, X distributes land held for investment to Emad, and as part of the exchange, redeems 10 of Emad's 100 shares. 4. On the date of redemption, the land had a FMV of $50,000 and a basis to X of $15,000. Also, the land was subject to a $20,000 mortgage that Emad assumed. Questions: What are the tax consequences to Emad if the redemption is treated as a dividend? What if the redemption were treated as a sale? Chapter 15, Exhibit 18a CCH Federal Taxation Comprehensive Topics 47 of 59 Redemptions (Including Partial Liquidations)-- Example on Shareholder Effect Solution If Dividend Treatment Gain to shareholder $30,000 OI [$50,000 fair market value $20,000 debt assumed by shareholder is ordinary income to the extent of current E&P] If Sale Treatment $20,000 LTCG [$50,000 FMV] ($20,000, debt assumed by shareholder) (10% x 100,000, shareholder's basis of redeemed shares) $90,000 [$100,000 (10% x $100,000)] $50,000, same as div. treatment January 1, 20x2, the day after redemption 48 of 59 Basis in 90 remaining shares $100,000 (unchanged after redemption) Basis in property received Holding period beg. date: $50,000, its FMV ignoring debt assumption January 1, 20x2, the day after redemption Chapter 15, Exhibit 18b CCH Federal Taxation Comprehensive Topics Redemptions (Including Partial Liquidations)-- Tax Effect on Corporations What is the tax effect of redemptions to the corporation? Gain or loss recognition: Under Code Sec. 311, losses are NOT recognized. However, gains are recognized based on: [Greater of (a) or (b)], less (c), where, (a) = FMV of property transferred, (b) = Debt relief, and (c) = Adjusted basis of property transferred by the corporation to a shareholder to redeem her shares. This formula applies to both the Dividend Treatment Method and the Sales Treatment Method. Of course, if the corporation pays cash, and has no debt relief, it recognizes no gain, since [FMV AB of cash = 0]. Chapter 15, Exhibit 19a CCH Federal Taxation Comprehensive Topics 49 of 59 Redemptions (Including Partial Liquidations)-- Tax Effect on Corporations Character of gain The character of gain is based on the character of the property distributed (e.g., an inventory distribution creates OI if FMV > AB). Chapter 15, Exhibit 19b CCH Federal Taxation Comprehensive Topics 50 of 59 Redemptions (Including Partial Liquidations)-- Tax Effect on Corporations Redemption expenses incurred In general, the costs incurred by a corporation in the redemption of stock are NOT deductible. These costs, such as transfer fees and legal and accounting fees, must be capitalized but they are NOT amortizable. Generally, they are not deducted until complete liquidation. Chapter 15, Exhibit 19c CCH Federal Taxation Comprehensive Topics 51 of 59 Redemptions (Including Partial Liquidations)-- Tax Effect on Corporations Effect on E&P The effect on the corporation's E&P depends on shareholder treatment. Shareholders treat the redemption as either: 1. Dividend treatment: Receipt of a dividend (i.e., in the form of cash or other property by the shareholder); or 2. Sale treatment: Sale of shareholder's stock to the corporation.The effect on a corporation's E&P is explained in the following slide, and the tax effect to shareholders is discussed after the next section. Chapter 15, Exhibit 19d CCH Federal Taxation Comprehensive Topics 52 of 59 Redemptions (Including Partial Liquidations)-- Tax Effect on Corporations Corp. Effect (a) (b) E&P by: (c) E&P by: (d) = (a)+ (b)+(c) (e) E&P by: (f) Paid-inCapital: If Dividend Treatment to Shareholder Original E&P Corporate gain on property dist'n [Greater of FMV of property dist'd or debt relief; Less: Basis of property transferred] If Sale Treatment to Shareholder Original E&P Same as with dividend treatment. Corp. liabilities assumed by S/H = Adjusted E & P Greater of (i) or (ii), where (i) = FMV of prop. distributed to S/H (ii) = Debt relief N/A Same as with dividend treatment. = Adjusted E & P (e) = (d) x [# redeemed shares # shares outstanding before redemption] (cannot exceed the amount of the distribution) [(f) = Greater of (i) or (ii), minus (iii), where (i) = FMV of prop. distributed to S/H (ii) = Debt relief; (iii) = (e) above CCH Federal Taxation Comprehensive Topics 53 of 59 Chapter 15, Exhibit 19e Redemptions (Including Partial Liquidations)-- Example on Corporate Effect Facts (same as previous example but recapped below): 1. In 20x1, X Corporation has current E&P of $1,000,000. 2. Emad owns 100 shares of X Corporation's 1,000 shares outstanding. His basis in the 100 shares is $100,000 and the shares had been held long-term. 3. On December 31, 20x1, X distributes land held for investment to Emad, and as part of the exchange, redeems 10 of Emad's 100 shares. 4. On the date of redemption, the land had a FMV of $50,000 and a basis to X of $15,000. Also, the land was subject to a $20,000 mortgage that Emad assumed. Question: What are the tax consequences to X Corp. if the redemption is treated as a dividend? Chapter 15, Exhibit 20a CCH Federal Taxation Comprehensive Topics 54 of 59 Redemptions (Including Partial Liquidations)-- Example on Corporate Effect What if the redemption were treated as a sale? If Dividend Treatment Gain recognition: $35,000 LTCG on distribution of land [50,000 FMV 15,000 corporate basis in land] If Sale Treatment $35,000 LTCG on distribution of land [50,000 FMV 15,000 corporate basis in land] Chapter 15, Exhibit 20b CCH Federal Taxation Comprehensive Topics 55 of 59 Redemptions (Including Partial Liquidations)-- Example on Corporate Effect If Dividend Treatment E&P: Increase ( ) in E&P: Increase of E&P: Decrease ( ) in E&P: $1,000,000, unadjusted by $35,000 [corporate gain on distribution] by $20,000 [X Corp's. debt relief] The greater of (i) or (ii), where (i) = $50 FMV of property distributed to S/H (ii) = $20 debt relief $1,005,000 [$1,000,000 + $35,000 + $20,000 - $50,000] If Sale Treatment $1,000,000, unadjusted by $35,000 [corporate gain on distribution] by $20,000 [X Corp's. debt relief] by $10,550 [(10 shares 1,000 shares) x (1,000,000 + $35,000 + $20,000)] $1,044,450 [$1,000,000 + $35,000 + $20,000 $10,550] 56 of 59 E&P, adjusted: Chapter 15, Exhibit 20c CCH Federal Taxation Comprehensive Topics Redemptions (Including Partial Liquidations)-- Example on Corporate Effect If Dividend Treatment Paid-in-Capital N/A If Sale Treatment by $39,450, the greater of (i) or (ii), minus (iii), where, (i) = $50 FMV of prop. distributed to S/H (ii) = $20 debt relief (iii) = $10,550 reduction of E&P Chapter 15, Exhibit 20d CCH Federal Taxation Comprehensive Topics 57 of 59 Redemptions (Including Partial Liquidations)-- Example on Corporate Effect Corporation's Tax Accounting Entries Under Sales Treatment Method Accounts Land Corporate liabilities Retained earnings from gain on distribution of land ($50,000 $15,000) Retained earning from "debt relief income" Retained earnings from E & P adjustment [(10 shares 1,000 shares) x ($1,000,000 + $35,000 + $20,000)] Paid-in-Capital [$50,000 FMV $10,550 reduction of E&P] Total Debits and Credits Chapter 15, Exhibit 20e CCH Federal Taxation Comprehensive Topics Debit $20,000 Credit $15,000 35,000 20,000 10,550 39,450 $70,000 $70,000 58 of 59 Redemptions (Including Partial Liquidations)-- Example on Corporate Effect Non-corporate shareholders tend to prefer sales treatment because: 1. Gain is reduced by the basis of the stock redeemed; and Gain is subject to the favorable capital gains rate. Corporate shareholders tend to prefer dividend treatment because: 70% to 100% of the dividend income can be offset by the dividend-received deduction (DRD), which is available only to corporate shareholders. Chapter 15, Exhibit 20f CCH Federal Taxation Comprehensive Topics 59 of 59 ...
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This note was uploaded on 11/24/2010 for the course TXX 5762 taught by Professor Allen during the Spring '10 term at Nova Southeastern University.

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chap_15 - Chapter 15 Corporate Nonliquidating Distributions...

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