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35-Topic-7 Corporate Taxation Nonliquidating Distributions

35-Topic-7 Corporate Taxation Nonliquidating Distributions...

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Chapter 18 - Corporate Taxation: Nonliquidating Distributions Chapter 18 Corporate Taxation: Nonliquidating Distributions SOLUTIONS MANUAL Discussion questions 1. What is meant by the term double taxation of corporate income ? Answer: The term double taxation refers to the fact that under the U.S. system of taxation, corporate earnings are first taxed when earned by a C corporation and then are taxed a second time when the earnings are distributed to the shareholders as a dividend. 2. How does the issue of double taxation arise when a corporation decides between making a distribution to a shareholder employee as a dividend or compensation? Answer: A distribution characterized as a dividend is subject to double taxation, first at the corporate level and then a second time at the shareholder level, because a corporation cannot deduct it from taxable income. A distribution characterized as compensation is taxed only once, at the recipient level, because it is deducted by the corporation. 3. Why might a shareholder who is also an employee prefer receiving a dividend instead of compensation from a corporation? Answer: An individual might prefer a dividend to compensation because the dividend is eligible for a preferential tax rate (maximum tax rate of 15 percent), whereas compensation is taxed at the ordinary tax rates, which could be as high as 35 percent. 4. What are the three potential tax treatments of a cash distribution to a shareholder? Are these potential tax treatments elective by the shareholder? Answer: A cash distribution to a shareholder can be characterized as 1) dividend to the extent of earnings and profits, 2) tax-free return of capital to the extent of the shareholder’s tax basis in the stock, or 3) gain from sale of the stock (capital gain). The tax law (section 301(c)) prescribes the tax treatment of the distribution; it is not elective by the shareholder. 5. In general, what is the concept of earnings and profits designed to represent? 18-1
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Chapter 18 - Corporate Taxation: Nonliquidating Distributions Answer: Earnings and profits is intended to represent the corporation’s ability to pay distributions to its shareholders without eroding its invested capital. Earnings and profits is designed to reflect the corporation’s economic income, a broader concept than its taxable income. 6. How does current earnings and profits differ from accumulated earnings and profits ? Is there any congressional logic for keeping the two accounts separate? Answer: Current earnings and profits represents the corporation’s earnings and profits of the current year before reduction (“diminution”) by any distributions made during the year. Accumulated earnings and profits represents undistributed earnings and profits from all years prior to the current year. Congress created this distinction in 1936 when distributed current year earnings were taxed at the corporate level at a lower rate than undistributed earnings. This dual level of taxation was repealed in
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