Topic 3 - Additional Tax Issues for C Corporations

Question 1

What are the three ways a C corporation can distribute some of the companies accumulated profits?

Answer 1

Dividend

Stock Redemption

Partial Liquidation

Question 2

When a shareholder receives a payment from a corporation, what are the two ways that payment can be characterized and what are the differences?

Answer 2

Return of Capital - not taxable; viewed as a reduction in the shareholder’s tax basis in the stock

Dividend Income - taxable; listed as dividend income in gross income

Question 3

What is Earnings & Profits?

Answer 3

A measure of a corporation’s economic earnings. Supposed to represent the economic income eligible for distribution to shareholders.

This helps classify the income being distributed to shareholders. The corporation cannot distribute dividends that are more than the E&P. If a corporation distributes more than the E&P, you must determine how much is dividends, how much is return of capital, and how much is a capital gain.

If they distribute more than the E&P, the remaining distribution is first treated as a repayment of capital. If this takes the tax basis to $0, any remaining amount of distribution is treated as a capital gain.

Question 4

How do you compute Earnings and Profits?

Answer 4

E&P includes both taxable and nontaxable income (municipal interest, tax-exempt life insurance proceeds, etc.)

The intent is to represent all of the corporation’s earnings.

Start with taxable income/loss then adjust:

1. Add Nontaxable Income
2. Add Deduction Expense (expenses that require no cash outlay cannot be used to reduce E&P. ex. Dividend received deductions, net capital loss carryovers from a different year, charitable contribution carryover from a different year)
3. Subtract Nondeductible Expenses that do reduce current E&P - these require a cash flow (ex. Federal income taxes paid or accrued, expenses incurred in earning tax-exempt income, meals expenses disallowed, nondeductible lobbying expenses and political contributions, penalties and fines, etc.)
4. Add or Subtract items requiring separate accounting methods for E&P purposes (ex. depreciation - tax rules allow double depreciation, E&P does not)

Question 5

How does a Corporation determine the amount distributed when noncash property is distributed to shareholders?

Answer 5

Money Received
+ FMV of other property received
- liabilities assumed by the shareholder on property received
= amount distributed

Question 6

Why is it often a bad idea for a corporation to pay noncash property out as a dividend?

Answer 6

Corporations recognize a taxable gain if the property distributed has a FMV higher than the corporations tax basis in the item but corporations do NOT recognize a taxable loss if the property distributed has an FMV less than the corporation tax basis.

Question 7

Why would a corporation declare a stock distribution rather than giving cash?

Answer 7

Might do this to increase the number of shares of stock outstanding (decreases the price of shares by increasing the number of shares outstanding

Or to minimize distributing the corporation’s cash to its stockholder (keeping cash while still making a good will gesture)

Question 8

What are the tax consequences for a shareholder receiving a pro rata stock distribution?

Answer 8

Nontaxable Stock Distribution - a shareholder does not recognize a gain because it does not increase the shareholders value in the stock owned

Question 9

What are the tax consequences for a shareholder receiving a non-pro rata stock distribution?

Answer 9

Taxable Stock Distribution - Non-pro rata stock distribution are usually included in the shareholder’s gross income as taxable dividend to the extent of distributing the corporation’s E&P.

This is because the recipient has received something of value.

Usually taxable as dividends.

Ex. if corporation give shareholders a choice between cash or stock distribution. If shareholder chooses stock, they have a taxable dividend equal to the FMV of the stock when it is received.

Question 10

What happens during the complete liquidation of a corporation?

Answer 10

A complete liquidation occurs when a corporation acquires all its stock from all its shareholders in exchange for all its net assets, after which the corporation ceases to do business.

File Form 966 - Intention to Liquidate

File form within 30 days after the board of directors resolve to liquidate the corporation

Question 11

What are the Tax Consequences to Shareholders in a complete liquidation?

Answer 11

All noncorporate shareholders receiving liquidating distributions have a fully taxable transaction.

Noncorporate shareholders treat property received as full payment in exchange for the stock transferred. They compute capital gain or loss by subtracting money and FMV of property received minus stock’s tax basis.

Corporate shareholders are also taxed unless the corporation owns 80% or more of the stock.

If it owns 80% or more, the corporation does not recognize gain or losses. This is mandatory. Tax basis in the property transferred carries over to the recipient.

Question 12

TRUE or FALSE?

S Corporations may hold stock in C corporations?

Answer 12

TRUE. Any dividends S Corps receive flow through to the shareholder.

Question 13

TRUE or FALSE?

S corporations are entitled to claim the dividends received deduction.

Answer 13

FALSE. C corps only

Question 14

How does an S corporation’s shareholder calculate their initial basis?

Answer 14

Initial basis in stock received is the tax basis of property transferred less any liability assumed by the corporation or the cost of purchasing the stock.

EX.
Shareholder 1 contributed $100,000 cash.

Shareholder 1’s initial basis = $100,000.

Shareholder 2 contributed $40,000 in cash and a piece of land with a FMV of $120,000 and an adjusted basis of $90,000. The land was encumbered by a $40,000 mortgage which the corporation assumed.

Shareholder 2’s initial basis = $40,000 + $90,000 - $40,000 = $90,000

(From the corporation’s perspective, they use the FMV of the land)

Question 15

What is an Annual Basis Adjustment and how is it calculated?

Answer 15

Every year, shareholders in S Corps and Partnerships must adjust their tax basis based on the income (loss) reflected in their schedule K.

To make the adjustment:
Increase basis for any contributions to the S corp during the year
Increase for shareholder’s share of ordinary business income and separately stated income/gain items (including tax-exempt)
Decrease for distributions
Decrease for shareholder’s share of nondeductible expenses (fines, penalties)
Decrease for shareholder’s share of ordinary business loss and separetly stated expense/loss items

Cannot decrease basis below $0

S Corp shareholders are not allowed to include any S corp debt in their stock basis (Partners are)

Question 16

TRUE or FALSE:

Self Employment income for S corporations are handled the same as Partnerships

Answer 16

FALSE
No self-employment income on S corporations

If you work for an S Corp, you are treated as an employee and will receive a salary.

Question 17

How are Distributions handled in an S Corp?

Answer 17

Shareholder’s distribution tax free up to extent of shareholder’s stock basis. The rest is treated as a capital gain.

(If the S Corp had previous accumulated E&P from a previous year as a C Corp, additional rules apply)

Question 18

What are the tax consequences to the liquidating corporation in a complete liquidation?

Answer 18

Typically liquidating corporation recognize all gains and certain losses on taxable distributions of property shareholders.

Liquidating corporations do not recognize loss if the property is distributed to a related party AND

1. the distribution is non-pro rata OR
2. the asset distributed is non qualifying property

Related party = a shareholder who owns more than 50% of the stock of the liquidating corporation

Disqualified property = property acquired within 5 years of the date of distribution in a tax deferred transaction or as nontaxable contribution to capital

Question 19

What are the tax consequences on nontaxable liquidating distributions?

Answer 19

Liquidating corporations do not recognize gain or loss on distribution of property to an 80% corporate shareholder.

Liquidation-related expenses are deductible by the liquidating corporation