Chapter 18 Discussions Flashcards
What is meant by the phrase “double taxation of corporate income?”
Corporate earnings are taxed when earned by a C Corp and then are taxed a second time when the earnings are distributed to the shareholders as a dividend. Hence, income received by a corporation is subject to a minimum of two separate income taxes before reaching an individual shareholder.
Why might a shareholder who is also an employee prefer receiving a dividend instead of compensation from a corporation?
Because although the dividend is subject to double taxation, both the corporate tax rate and the dividend rate can be substantially blow the single tax on compensation. For example, the corporate tax rate is 21% and the dividend is taxed at 0, 15, or 20%. Whereas compensation can be taxed at relatively higher ordinary tax rates (37%) plus the federal social security (FICA) taxes.
What are the three potential tax treatments of a cash distribution to a shareholder? Can the shareholder choose between these treatments?
- Dividend to the extent of earnings and profits.
- Tax-free return of capital to the extent of the shareholder’s tax basis in the stock
- Gain from sale of the stock (capital gain)
The tax law (301c) prescribes the tax treatment of the distribution, the shareholder cannot elect the treatment.
In general, what is the concept of earnings and profits (E&P) designed to represent?
The corporation’s ability to make distributions to its shareholders without eroding its invested capital. E&P is designed to reflect the corporation’s economic income, a broader concept than its taxable income.
How does the current earnings and profits account differ from the accumulated earnings and profits account?
Current E&P represent the corporation’s E&P of the current year before reduction by distributions made during the year. Accumulated E&P represent undistributed E&P from all the 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 This dual level of taxation was repealed in 1939, but the congressional distinction between current and accumulated E&P remained in the law.
Assume a calendar-year corporation has positive current E&P of $120 and a deficit in accumulated E&P of ($200). Under this circumstance, a cash distribution of $100 to the corporation’s sole shareholder at year-end will not be treated as a dividend because total E&P is negative. True or false? Explain.
False. The $100 distribution will be treated as a dividend because it does not exceed CURRENT E&P.
Assume a calendar-year corporation has a deficit in current E&P of ($120) and a positive beginning accumulated E&P of $120. Under this circumstance, a cash distribution of $120 to the corporation’s sole shareholder on June 30 will not be treated as a dividend because total E&P on December 31 is $0. True or false? Explain.
False. A portion of the distribution could be treated as a dividend based on accumulated E&P on June 30. This current year deficit is allocated ratably over the year, accumulated E&P on June 30 would be $60 [$120-(6/12x($120))]
List the four general categories of adjustments that a corporation makes to taxable income or net loss to compute current E&P. What is the rationale for making these adjustments?
A corporation adjusts its taxable income or loss by the following general items to compute current E&P:
1. Inclusion of income that is excluded from taxable income
2. Disallowance of certain expenses that are deducted in computing taxable income but do not require an economic outflow.
3. Deduction of certain expenses that are excluded from the computation of taxable income but do require an economic outflow.
4. Deferral of deductions or acceleration of income due to separate accounting methods required for E&P purposes.
Assuming adequate amounts of E&P, what is the formula for determining the amount of a noncash distribution of a shareholder must included in gross income?
The dividend amounts is the FMV of the property received less any liability assumed on the property.
What income tax issues must a corporation consider before it makes a noncash distribution to a shareholder?
A corporation must determine if the property’s FMV exceeds or is less than the property’s adjusted tax basis. To the extent the FMV exceeds the adjusted tax basis, the corporation recognizes gain on the distribution. Corporations can’t recognize the loss if the property’s FMV is less than the adjusted tax basis.
Assuming adequate E&P, will the shareholder’s tax basis in noncash property received equal the amount included in gross income as a dividend (assuming adequate E&P)? Under what circumstances will the amounts be different, if any?
The tax basis of the property will generally be its FNV. However, when the shareholder receives property subject to a liability, the amount of the dividend income is the property’s FMV less the liability assumed (301b). The shareholder’s tax basis in the property is not reduced by the liability assumed (301d).
A shareholder receives appreciated noncash property in a corporate distribution and assumes a liability attached to the property. How does this assumption affect the amount of gain the corporation recognizes? From the corporation’s prespective, does it matter if the liability assumed by the shareholder exceeds the property’s gross FMV?
In general, the shareholder’s assumption of a liability attached to appreciated property distributed as a dividend does not affect the gain recognized by the corporation. Gain recognized is the property’s FMV less the property’s adjusted tax basis. If the liability assumed by the shareholder exceeds the property’s FMV, the property is deemed to have a FMV equal to the liability assumed for purposes of determining the gain recognized by the corporation.
When a shareholder receives a noncash distribution of property that is encumbered by a liability (the shareholder assumes the liability on the distribution), how does the corporation determine the amount of the distribution?
The amount of the distribution is the FMV of the property received minus the amount of the liability the shareholder assumes on the distribution.
A corporation distributes depreciated noncash property (FMV-AB) to a shareholder. What impact does the distribution have on the corporation’s accumulated E&P?
The corporation reduces it’s accumulated E&P by the property’s adjusted tax basis after the basis is reduced by any liability assumed by the shareholder on the distribution.
How does the double taxation of corporate distributions affect whether an individual chooses to operate a business as a C corporation or a flow-through entity?
Although a single layer of tax in a flow-through entity appears better than double later of tax in a corporation, this is not always the case because the tax rates differ between the two types of entities. Income earned in a flow-through entity is only taxed once (37% max) whereas corporate earnings are taxed once earned (21%) and again when distributed to individual shareholders (20% max). Although both options appear to result in about 63% of income available after taxes, there are also other considerations.
1. Income from a flow-through entity and dividends may be subject to additional taxes (e.g. social security, net investment income tax, etc.)
2. Income is subject to tax when realized and recognized, but taxes on dividends can be delayed by postponing the distribution until the funds are needed. Deferral reduces the present value of the tax.
3. Income from a flow-through entity could qualify for a 20% deduction for qualified business income whereas corporate income is ineligible for this deduction.
