TAXATION OF PROPERTY DISTRIBUTIONS

LO 7-1
The characterization of a distribution from a C corporation to a shareholder has important tax
consequences to both the shareholders and the corporation. If the tax law characterizes the
distribution as a dividend rather than compensation, the corporation may not deduct the
amount paid in computing its taxable income. In addition, the shareholder must include the
dividend received in gross income. The nondeductibility of the distribution by the corporation,
coupled with the taxation of the distribution to the shareholder, creates double taxation of the
corporation’s income, first at the corporate level and then at the shareholder level. The double
taxation of distributed corporate income has been a fundamental principle of the U.S. income
tax since 1913.
Historically, tax planning focused on eliminating or mitigating one level of taxation on C
corporation earnings. For example, if the distribution can instead be characterized as salary,
bonus, interest, or rent, the corporation can deduct the amount paid in computing its taxable
income, thereby avoiding the corporate income tax on this incremental payment. It is also
important to recall that the corporate tax rate (21 percent) is significantly lower than the
maximum individual tax rate (37 percent). However, the individual marginal tax rate on
dividends is generally below the top individual tax rate. Hence, it is conceivable that some
taxpayers may save taxes by choosing to have a business entity taxed as a C corporation.
In other words, depending on the timing and form of distributions of profits, subjecting a
business to double taxation may be preferable to operating the business as a flow-through
entity and subjecting the income to a single tax at a higher individual rate.
DETERMINING THE DIVIDEND AMOUNT FROM EARNINGS AND PROFITS
LO 7-2
Overview When a corporation distributes property to shareholders in their capacity as
shareholders, the distributions are characterized as dividend income, return of capital, and/or
capital gain. The portion characterized as dividend income is included in gross income. In
contrast, a return of capital is not considered income, but rather a reduction in the
shareholder’s tax basis in the stock. If the nondividend portion of the distribution exceeds the
tax basis of the stock, then the excess distribution (above basis) is taxed as a capital gain
from the sale of the shares.
Corporate distributions of “property” usually take the form of cash, but distributions can also
consist of other tangible or intangible property. Special rules apply when a corporation
distributes its own stock to its shareholders.

Dividends Defined
A dividend is any distribution of property made by a corporation to its shareholders from
earnings and profits (E&P). Congress created E&P to be a measure of the corporation’s
economic earnings available for distribution to its shareholders. Hence, earnings and profits
is similar in concept to financial accounting retained earnings. Corporations keep two
separate E&P accounts. One is called current earnings and profits that is comparable to the
economic income earned in the current period. The other account represents the
undistributed earnings and profits accumulated in all prior years and is called accumulated
earnings and profits.

Each year corporations compute their current E&P by making specific adjustments to taxable
income (discussed below). When both current and accumulated E&P are positive,
distributions can be treated as dividends up to the available amount of E&P (current plus
accumulated). Any E&P that is not distributed to shareholders becomes the amount of
accumulated E&P at the beginning of the next taxable year. Distributions reduce E&P but
cannot produce (or increase) a deficit (a negative balance) in E&P. In other words, a
corporation cannot distribute E&P if there is a deficit in E&P, and only losses can create a
deficit in E&P. A corporation that makes a distribution in excess of its available E&P (i.e., a
return of capital and/or capital gain to shareholders) must report the distribution on Form 5452
and include a calculation of its E&P balance to support the tax treatment.

Example 7-1
Jim owns 75 percent of the Spartan Cycle and Repair (SCR) stock, while Ginny owns the
remaining 25 percent. Jim has a tax basis in his SCR stock of $24,000. Ginny’s tax basis in
her SCR stock is $10,000.
What if: Assume SCR has current earnings and profits (E&P) of $30,000 and no accumulated
earnings and profits. At year-end, SCR makes a $64,000 distribution—a $48,000 distribution
to Jim and a $16,000 distribution to Ginny.
What is the tax treatment of the distribution to Jim and Ginny?
Answer: Only $30,000 of the $64,000 distribution is treated as a dividend. The distribution is
first deemed to be paid from current E&P to each shareholder in proportion to their ownership
interest on the date of the distribution: $22,500 to Jim ($30,000 × 75%) and $7,500 to Ginny
($30,000 × 25%). The $34,000 distribution in excess of current E&P ($64,000 − $30,000) is
then deemed to be paid from accumulated E&P in proportion to ownership interests.
However, because there is no accumulated E&P, the distribution in excess of E&P is first
treated as a return of capital and then capital gain once basis is exhausted. Jim treats the
$48,000 distribution for tax purposes as follows: $22,500 is treated as a dividend. $24,000 is
a nontaxable reduction in his stock tax basis (return of capital). $1,500 is treated as gain from
the deemed sale of his stock (capital gain). Note that a return of capital cannot reduce a
shareholder’s stock basis below zero. Amounts paid in excess of stock basis result in gain
recognition. Ginny treats the $16,000 distribution for tax purposes as follows: $7,500 is
treated as a dividend. $8,500 from E&P is a nontaxable reduction in her stock tax basis (return
of capital). Ginny has no capital gain because the distribution did not exceed the tax basis of
her SCR stock. What is Jim’s tax basis in his SCR stock after the distribution? What is Ginny’s
tax basis in her SCR stock after the distribution?
Answer: Jim has a zero basis in the SCR stock, while Ginny has a remaining tax basis of
$1,500 ($10,000 − $8,500) in the SCR stock.

TAXES IN THE REAL WORLD

Keeping Track of Tax Basis Is Important
When a corporation makes a distribution that is treated as a return of capital (i.e., a
distribution in excess of E&P), it is incumbent on each shareholder to establish their basis for
the stock in determining the extent to which the distribution is a nontaxable return of capital
or a capital gain. The burden of proving the basis of the stock is on the shareholder, as a
taxpayer, Mr. Visconti, ultimately discovered. To avoid income taxes on a corporate
distribution, a shareholder must establish that the distribution is in respect to the corporation’s
stock, there is an absence of earnings and profits, and the stock basis is in excess of the
distribution. The government charged Mr. Visconti with tax evasion for failing to pay capital
gains taxes on a corporate distribution in excess of earnings and profits. At trial, focus was
on whether the taxpayer could prove that the distributions did not exceed the stock basis.
Visconti argued the stock had a basis of $13.13 million. Checks were presented showing that
Visconti paid $4.9 million to purchase the stock. Visconti also argued that the value of
property contributed to the corporation increased the tax basis to $8.25 million. However,
Visconti provided no evidence of the property's value or basis aside from his own estimate.
In contrast, the government’s evidence consisted of testimony of a CPA who testified that the
property Visconti transferred to the corporation was only valued at $6.25 million. The
government also presented bank records and a statement that Visconti submitted in divorce
proceedings. These documents showed that the corporation had previously distributed
$12.25 million to Visconti. Hence, the government argued that Visconti had a zero basis in
his stock. At trial, the district court ruled that Visconti’s statements were insufficient to support
the $8.25 million valuation or rebut the government’s evidence. Hence, the court precluded
Visconti's return-of-capital defense. On appeal, the Ninth Circuit Court held that the trial court
did not abuse its discretion in finding that Visconti failed to establish a factual basis for a
return-of-capital defense. When a shareholder is unable to establish his basis for the stock,
the IRS will treat the shareholder as having a zero basis in the stock. Hence, it pays for
shareholders to be prepared and keep records of corporate contributions and distributions.
Source: United States v. Visconti, 122 AFTR2d 2018-5976 (9th Cir. 2018.)

Computing Earnings and Profits

The concept of earnings and profits has been part of the tax laws since 1916. Although
Congress has never provided a precise definition, E&P is supposed to represent the
economic income eligible for distribution to shareholders. Consistent with this rationale, E&P
includes both taxable and nontaxable income, indicating that Congress intended E&P to
represent a corporation’s economic income. As a result, shareholders may be taxed on
distributions of income even if the income was not taxable to the corporation.
A corporation begins the computation of current E&P with taxable income or loss. It then
makes adjustments required by the Internal Revenue Code or the accompanying regulations
and IRS rulings. These adjustments fall into four broad categories:
1. Certain nontaxable income is included in E&P.
2. Certain deductions do not reduce E&P.
3. Certain nondeductible expenses reduce E&P.
4. The timing of certain items of income and deduction is modified for E&P calculations
because separate accounting methods are required for E&P purposes.

THE KEY FACTS

Adjustments to Taxable Income (Loss) to Compute Current E&P
A corporation makes the following adjustments to taxable income to compute current E&P:
. Include certain income that is excluded from taxable income.
. Disallow certain expenses that are deducted in computing taxable income.
. Deduct certain expenses that are not deductible in computing taxable income.
Defer deductions or accelerate income due to separate accounting methods required
for E&P purposes.

Nontaxable Income Included in Current E&P

Tax-exempt income represents economic income that can be distributed to shareholders.

Thus, tax-exempt income is included in current E&P. Common examples of tax-exempt
income included in current E&P are tax-exempt municipal interest and tax-exempt life
insurance proceeds.
Example 7-2
SCR reported $5,000 of tax-exempt interest from its investment in City of East Lansing
municipal bonds. What effect does the tax-exempt interest income have on current earnings
and profits, if any?
Answer: The tax-exempt interest income is included in current earnings and profits thereby
increasing current E&P by $5,000 because it reflects economic income.

Deductible Expenses That Do Not Reduce Current E&P

Deductions that require no cash outlay by the corporation or are carryovers from another tax
year do not represent current economic outflows and cannot be used to reduce current E&P.
Examples include the dividends-received deduction, net capital loss carryovers from a
different tax year, net operating loss carryovers from a different tax year, and charitable
contribution carryovers from a prior tax year.

Nondeductible Expenses That Reduce Current E&P

A corporation reduces its current E&P for certain expenditures that are not deductible in
computing its taxable income but require a cash outflow. Examples of such expenses include:
. Federal income taxes paid or accrued (depending on the corporation’s method of
accounting).
. Expenses incurred in earning tax-exempt income (such income is included in E&P).
. Current-year charitable contributions in excess of the taxable income percentage
limitation (there is no percentage limitation for E&P purposes).
. Premiums on life insurance contracts in excess of the increase in the policy’s cash
surrender value.
. Current-year net capital loss (there is no limit on capital losses for E&P purposes).
Nondeductible meal expenses.
. Nondeductible entertainment expenses.
. Nondeductible lobbying expenses and political contributions.
. Nondeductible penalties and fines.
. Disallowed business interest expense.

Items Requiring Separate Accounting Methods for E&P Purposes

A corporation must generally use the same accounting methods for computing both E&P and
taxable income. For example, a gain or loss deferred for income tax purposes under the like-
kind exchange rules (§1031) or the involuntary conversion rules is also deferred for
calculating E&P. A corporation using the accrual method for income tax purposes generally
must use the accrual method for E&P purposes. However, there are important differences
between the accounting methods used to compute taxable income and current E&P. Hence,
the adjustments to taxable income reflect differences in both the recognition and the timing
of certain items of income and expense. The list of adjustments in deriving current E&P from
taxable income is somewhat lengthy; some adjustments are positive and others are negative.
Some types of income deferred from current-year taxable income must be included in the
computation of current E&P in the year in which the transaction occurs. For example, a
corporation that defers gains under the installment method for income tax purposes must still
include the deferred gain in current E&P. This difference reverses in future years when the
installment payments are received, thereby triggering recognition of the deferred gain. In
these years, the gain increases taxable income but is not included in current E&P.

Certain expenses currently deducted in the computation of taxable income are deferred in
computing E&P.6 For example, organizational expenditures, which can be deducted currently
or amortized for income tax purposes, must be capitalized for E&P purposes. Depreciation
must be computed using the prescribed E&P method. For property acquired after 1986, the
alternative depreciation system (ADS) must be used. This system requires that assets be
depreciated using the asset depreciation range.7 Also, bonus depreciation is not allowed for
E&P purposes. This generally results in more accelerated depreciation for taxable income
purposes than for E&P purposes. Further, amounts expensed under §179 (first-year
expensing) must be amortized over five years for E&P purposes.
For any given year, adjustments in this category may increase or decrease current E&P
because these adjustments are timing differences that reverse over time.

Example 7-3
This year, SCR reported taxable income of $10,000 and paid federal income tax of $2,100.
SCR reported the following items of income and expense:
. $50,000 of depreciation, including bonus depreciation. $700 dividends-received
deduction. $3,000 net operating loss carryover.
. $5,000 of tax-exempt interest.
. $6,000 of entertainment expense.
. $4,000 net capital loss from the current year.
For E&P purposes, depreciation computed under the alternative depreciation system is
$30,000.
What is SCR’s current E&P?
Answer: $26,600, computed as follows:
Table Summary: Table summarizes computation for current E&P.
What if: Assume the original facts except that SCR also reported a $50,000 net capital loss
for the current year (rather than a $4,000 loss). What is SCR’s current E&P under these
circumstances?
Answer: Current E&P would be a negative $19,400 ($26,600 + $4,000 − $50,000). E&P can
be negative, but E&P cannot be driven below zero by distributions.

Exhibit 7-1
provides a summary of common adjustments to taxable income to compute current E&P. The
IRC does not impose a statute of limitations on the computation of E&P. Hence, many
corporations (public and private) may mistakenly fail to compute E&P until after years of
operations. This delay makes the computation difficult because the annual adjustments
necessary to derive the current E&P from taxable income may not have been well
documented and because it is necessary to derive the current E&P for each year to calculate
accumulated E&P.

EXHIBIT 7-1 Template for Computing Current Earnings and Profits

Taxable Income (Net Operating Loss)

Add: Exclusions from Taxable Income
. Tax-exempt bond interest income.
. Life insurance proceeds. \
 . Federal tax refunds (if a cash-method taxpayer).
. Increase in cash surrender value of corporate-owned life insurance policy.
Add: Deductions Allowed for Tax Purposes but Not for E&P
. Dividends-received deduction.
. NOL deduction.
. Net capital loss carryforwards.
. Contribution carryforwards.
. Organizational expenditures.
Subtract: Deductions Allowed for E&P Purposes but Not for Tax Purposes
. Federal income taxes paid or accrued.
. Expenses of earning tax-exempt income. Current-year charitable contributions in
excess of the taxable income limitation.
. Nondeductible premiums on life insurance policies.
. Current-year net capital loss. Penalties and fines.
. Nondeductible portion of meal expense. Entertainment expenses.
. Disallowed lobbying expenses, dues, and political contributions.
. Decrease in cash surrender value of corporate-owned life insurance policy.
. Disallowed business interest expense.
Add or Subtract: Timing Differences Due to Separate Accounting Methods for Taxable
Income and E&P
. Installment method. Add deferred gain under installment method in year of sale and
subtract recognized gain in subsequent years.
. Depreciation. Compare taxable income depreciation to E&P depreciation (other than
§179 expense) under regular tax rules to E&P depreciation (bonus depreciation is not
allowed). Add back difference if taxable income depreciation exceeds E&P depreciation.
Subtract difference if E&P depreciation exceeds taxable income depreciation for the year.
. §179 expense. Immediately deductible for taxable income purposes. Deductible over
five years for E&P purposes. Add back in year of §179 expense but subtract in subsequent
years.
. Inventory. If LIFO is used for tax purposes, FIFO must be used for E&P calculations.
. Gain or loss on sale of depreciable assets. Subtract greater taxable gain (lesser
taxable loss) due to lower asset basis for taxable income purposes than for E&P purposes.
This is a reversal of the depreciation deduction adjustment.
. Long-term contracts. Percentage completion method is required for E&P. Compare
the income recognized under both methods. Add back if more income is recognized under
the completed contract method; subtract if more income is recognized under the percentage
completion method.
. Depletion. Must use the cost depletion method for E&P purposes. If using percentage
depletion for taxable income, add back the difference if percentage depletion exceeds cost
depletion for the year. Otherwise, subtract the excess of cost depletion over percentage
depletion for the year.
Equals: Current Earnings and Profits
Ordering of E&P Distributions

Corporations must refer to both current and accumulated E&P accounts in determining the
amount of distributions that are deemed to be dividends. Distributions are designated as
dividends in the following order:
1. Distributions are dividends up to the balance of current E&P.
2. Distributions in excess of current E&P are dividends up to the balance in
accumulated E&P.
Under these ordering rules, whether a distribution is characterized as a dividend depends on
whether the balances in these two accounts are positive or negative. As a result, there are
only four possible scenarios:
1. Positive current E&P, positive accumulated E&P.
2. Positive current E&P, negative accumulated E&P.
3. Negative current E&P, positive accumulated E&P.
4. Negative current E&P, negative accumulated E&P.

Positive Current E&P and Positive Accumulated E&P

Corporate distributions are deemed to be paid out of current E&P first. If distributions exceed
current E&P, the amount distributed from current E&P is allocated pro rata to all the
distributions made during the year. The amount of distributions in excess of current E&P
come from accumulated E&P and distributions are allocated to the accumulated E&P in the
chronological order in which the distributions were [Link] ordering of distributions is
particularly important when distributions exceed current E&P and either the identity of the
shareholders receiving the distributions changes or a shareholder’s percentage ownership
changes during the year. Because current E&P is calculated at year-end, it can be difficult to
determine the dividend status of a distribution at the time of the distribution.

Example 7-4
What if: Assume SCR reported current E&P of $40,000 and the balance in accumulated E&P
was $16,000. On December 31, SCR distributed $48,000 to Jim and $16,000 to Ginny. What
amount of dividend income do Jim and Ginny report, and what is accumulated E&P for SCR
at the beginning of next year?
Answer: Jim and Ginny report $42,000 and $14,000 of dividend income, respectively. The
distribution is first deemed to be paid from current E&P to each shareholder in proportion to
their ownership interest on the date of the distribution: $30,000 to Jim ($40,000 × 75%) and
$10,000 to Ginny ($40,000 × 25%). The $24,000 distribution in excess of current E&P
($64,000 − $40,000) is then deemed to be paid from accumulated E&P ($16,000) in
proportion to ownership interests ($12,000 to Jim and $4,000 to Ginny). The remaining
distribution of $8,000 ($64,000 total minus $40,000 current E&P and $16,000 accumulated
E&P) is a return of capital. Hence, Jim will reduce his stock basis by $6,000 and Ginny will
reduce her stock basis by $2,000.
SCR has a zero balance in accumulated E&P at the beginning of the next year because all
current and accumulated E&P was distributed during the current year.
What if: Assume that SCR’s current E&P is $40,000 and its accumulated E&P is $15,000.
Also, assume that Jim is the sole shareholder of SCR and that he received a $45,000
distribution on June 1. Assume that after the June distribution Jim sold all his SCR shares to
Ginny for $12,000. Ginny received a $15,000 distribution on December 31. What are the
amount and the character of each distribution?
Answer: Jim has a $45,000 dividend, and Ginny has a $10,000 dividend with a $5,000 return
of capital. The $40,000 of current E&P is allocated between the two distributions in proportion
to total distributions. Hence, $30,000 ($40,000 × $45,000/$60,000) is allocated to the first
distribution and $10,000 ($40,000 × $15,000/$60,000) is allocated to the second distribution.
After current E&P is exhausted, accumulated E&P is then allocated in chronological order.
Thus, because Jim’s distribution took place before Ginny’s distribution, Jim’s distribution
($15,000) is allocated to accumulated E&P, leaving $0 in remaining accumulated E&P to be
allocated to Ginny’s distribution. Because Ginny is allocated only $10,000 of E&P, the excess
distribution of $5,000 ($15,000 − $10,000) is treated as a nontaxable reduction of her basis
in the SCR stock. Ginny’s basis is reduced to $2,000 ($12,000 − $10,000). Refer to Exhibit
7-2 to see how this fact pattern would be presented on a Form 5452.
Positive Current E&P and Negative Accumulated E&P
In this scenario, distributions deemed paid out of current E&P are taxable as dividends.
Because accumulated E&P has a negative balance, distributions in excess of current E&P
will be treated as a return of capital. If the nondividend distribution exceeds the stock basis,
the excess is then treated as a capital gain.

Example 7-5
What if: Assume SCR reported current E&P of $60,000, but the balance in accumulated E&P
is negative $20,000. On December 31, SCR distributed $48,000 to Jim and $16,000 to Ginny.
Jim has a tax basis in his SCR stock of $24,000. Ginny’s tax basis in her SCR stock is
$10,000. What amount of income will Jim and Ginny report?

Answer: Jim and Ginny will report $45,000 and $15,000 of dividend income, respectively.
The distribution is first deemed to be paid from current E&P ($45,000 to Jim and $15,000 to
Ginny). No additional amount is treated as a dividend because current E&P has been
exhausted and SCR has negative accumulated E&P.

What tax basis will Jim and Ginny have in their SCR stock after the distribution?
Answer: The distribution in excess of current E&P ($3,000 to Jim, $1,000 to Ginny) would
be treated as a return of capital. Neither will recognize any gain because they both have
sufficient tax basis in their SCR stock. Jim’s tax basis in his SCR stock after the distribution
would be $21,000 ($24,000 − $3,000), and Ginny’s tax basis in her SCR stock after the
distribution would be $9,000 ($10,000 − $1,000).

What is SCR’s balance in accumulated E&P at the end of the year/beginning of next year.?
Answer: SCR has a $20,000 deficit (negative) balance in accumulated E&P at the end of the
current year/beginning of the next year.

Negative Current E&P and Positive Accumulated E&P

When current E&P is negative, the tax status of a distribution is determined by the available
accumulated E&P on the date of the distribution. The available accumulated E&P is computed
by allocating the negative current E&P up to the distribution date (but not including the
distribution date) and then subtracting the allocated amount from accumulated E&P. The
deficit in current earnings and profits can be prorated throughout the year using months or
days, or the allocation can be made by closing the books and specifically identifying when
the current earnings and profits was incurred. Distributions in excess of available E&P in this
scenario are treated as return of capital, and any nondividend distribution in excess of stock
basis is treated as a capital gain.

Example 7-6
What if: Assume SCR reported current E&P deficit (negative) of $20,000. However, the
balance in accumulated E&P at the beginning of the year was $60,000. On July 1, SCR
distributed $48,000 to Jim and $16,000 to Ginny. Jim has a tax basis in his SCR stock of
$24,000. Ginny’s tax basis in her SCR stock is $10,000. What amount of dividend income do
Jim and Ginny report?
Answer: Jim and Ginny report $37,500 and $12,500 of dividend income, respectively.
Because current E&P is negative, SCR must determine its available E&P on the distribution
date. SCR prorates the full-year negative current E&P to June 30 [6 months/12 months ×
($20,000) = ($10,000)]. The negative current E&P of $10,000 is subtracted from the balance
in accumulated E&P on the date prior to the distribution ($60,000) to compute the available
accumulated E&P as of the end of the day June 30 ($50,000). Because their distributions
were made at the same time, Jim is allocated 75 percent of the total E&P (75% × $50,000 =
$37,500) and Ginny is allocated the remaining 25 percent (25% × $50,000 = $12,500).

What tax basis do Jim and Ginny have in their SCR stock after the distribution?
Answer: $13,500 for Jim and $6,500 for Ginny. The amount in excess of available E&P
($10,500 to Jim, $3,500 to Ginny) is treated as a return of capital. Jim reduces the basis in
his SCR stock to $13,500 ($24,000 − $10,500). Ginny reduces the basis in her SCR stock to
$6,500 ($10,000 − $3,500).

What is SCR’s balance in accumulated E&P at the end of the year?

Answer: Negative $10,000. Note that the distribution in excess of available E&P does not
reduce E&P because it would generate a deficit in E&P. Only a loss can produce a deficit in
E&P, as follows:

Negative Current E&P and Negative Accumulated E&P

When current E&P and accumulated E&P are both negative, none of the distribution is treated
as a dividend. Distributions will be return of capital to extent of stock basis. Any distribution
in excess of stock basis is treated as a capital gain.

Example 7-7
What if: Assume SCR reported current E&P of negative $50,000. The balance in
accumulated E&P at the beginning of the year was negative $60,000. Jim has a tax basis in
his SCR stock of $24,000. Ginny’s tax basis in her SCR stock is $10,000. On December 31
of this year, SCR distributed $48,000 to Jim and $16,000 to Ginny. What amount of dividend
income do Jim and Ginny report this year?

Answer: Neither Jim nor Ginny recognizes any dividend income from this distribution.
Because current E&P and accumulated E&P are negative, the entire distribution would be
treated as a return of capital/capital gain. Will Jim or Ginny recognize any capital gain as a
result of the distribution, and what is the tax basis in the SCR stock for Jim and Ginny at year-
end? Answer: Jim has a capital gain of $24,000, the amount by which the distribution exceeds
the tax basis in his SCR stock ($48,000 − $24,000). Ginny has a capital gain of $6,000, the
amount by which the distribution exceeds the tax basis in her SCR stock ($16,000 − $10,000).
Both Jim and Ginny have a zero basis in their SCR stock at year-end.
What is SCR’s balance in accumulated E&P at the end of the year?
Answer: A deficit (negative) balance of $110,000, the sum of the accumulated E&P deficit of
$60,000 plus the negative current E&P of $50,000. Exhibit 7-3 summarizes the rules for
determining whether a distribution represents dividend income. When both balances are
positive, the distribution is treated as a dividend to the extent of current E&P at year-end and
then to the extent of the balance of accumulated E&P. A distribution in excess of current and
accumulated E&P is treated as a return of capital/capital gain. When current E&P is negative
and accumulated E&P is positive, distributions are dividend income to the extent of
accumulated E&P after netting against the deficit in current E&P (up to the date of the
distribution). The distribution reduces accumulated E&P but not below zero. When
accumulated E&P is negative and current E&P is positive, distributions are dividend income
to the extent of current E&P. Finally, when both balances are negative, the distribution is
treated as a return of capital/capital gain and the deficits in E&P are unaffected.

EXHIBIT 7-3 Summary of E&P Status and Taxability of Cash Distributions

THE KEY FACTS
Dividend Distributions
The amount of a distribution equals:
. Cash distributed.
. Increased by fair market value of noncash property distributed.
. Reduced by any liabilities assumed by the shareholder on property received.
. The amount distributed is a dividend to the extent of available E&P (see Exhibit 7-3).

Distributions of Noncash Property to Shareholders

On occasion, a shareholder will receive a distribution of property other than cash. The
dividend sourcing rules, described in Exhibit 7-3, apply to both cash and noncash
distributions. However, noncash distributions can be more complex for two reasons. First,
any liability attached to the property affects the amount distributed, and second, any
difference between the value and the tax basis of the property affects the calculation of E&P.
In addition, noncash distributions can have income tax consequences to the distributing
corporation. To begin, when noncash property is received, the shareholder determines the
amount distributed as follows:

Money received
+ Fair market value of other property received
- Liabilities assumed by the shareholder on property received
Amount distributed
Example 7-8
What if: Assume that rather than distributing $16,000 of cash to Ginny, SCR distributes
$15,000 in cash and a Fuji custom touring bike that has a fair market value of $1,000.
Suppose that SCR has current E&P of $100,000 (including the impact of the distribution on
current E&P) and no accumulated E&P. What amount of dividend income will Ginny report
this year?
Answer: $16,000. Ginny would include the $15,000 plus the $1,000 fair market value of the
bicycle in her gross income as a dividend.

As a general rule, a shareholder’s tax basis in noncash property received as a dividend

equals the property’s fair market value.11 Although liabilities affect the amount of the
distribution, liabilities do not affect the new basis of the distributed property. In other words,
the basis of the property received consists of the taxable distribution plus the liabilities
assumed by the shareholder. The fair market value is determined as of the date of the
distribution.

Example 7-9
What is Ginny’s tax basis in the bicycle she received as a dividend in the previous example?
Answer: $1,000. Ginny has a tax basis in the bicycle of $1,000, the bicycle’s fair market
value.
Example 7-10
What if: Assume that, instead of distributing $48,000 in cash to Jim, SCR distributes a parcel
of land that SCR previously purchased for $60,000. The land has a fair market value of
$60,000 and a mortgage of $12,000 attached to it. Jim assumes the mortgage on the land.
Suppose that SCR has current E&P of $100,000 and no accumulated E&P. How much
dividend income does Jim recognize on the distribution?

Answer: $48,000. Jim recognizes dividend income in an amount equal to the land’s fair
market value of $60,000, less the mortgage he assumes on the land in the amount of
$12,000.

What is Jim’s tax basis in the land he receives?

Answer: $60,000. Jim receives a tax basis equal to the land’s fair market value. Jim has a
$60,000 basis in the land because he recognized $48,000 of income and assumed $12,000
of debt.

Effect of Noncash Property Distributions on Taxable Income

When a corporation distributes noncash property to shareholders, the corporation recognizes
a taxable gain on the distribution to the extent that the fair market value of the property
distributed exceeds the corporation’s adjusted tax basis in the property.12 In contrast, if the
fair market value of the property distributed is less than the corporation’s adjusted tax basis
in the property, the corporation does not recognize a deductible loss for computing taxable
income.

Example 7-11
What if: Assume SCR has an adjusted tax basis of $650 in the Fuji custom touring bike (for
both income tax and E&P purposes) that it distributes to Ginny (see the facts in Example 7-
8). How much taxable gain, if any, does SCR recognize when it distributes the bicycle to
Ginny? Recall the FMV of the bicycle is $1,000.
Answer: $350. SCR recognizes a taxable gain of $350 on the distribution of the bicycle to
Ginny ($1,000 − $650). Because the bike is considered inventory, SCR would characterize
the gain as ordinary income. SCR would pay a corporate-level tax of $73.50 on the
distribution (21% × $350). Current E&P for SCR is increased by the $350 gain and reduced
by the $73.50 tax liability.

What if: Assume SCR has an adjusted tax basis of $1,200 in the Fuji custom touring bike
that it distributes to Ginny. The bicycle’s fair market value has declined to $1,000 because it
is an outdated model. How much loss, if any, does SCR recognize when it distributes the
bicycle to Ginny?
Answer: $0. SCR is not permitted to recognize a loss on the distribution of the bicycle to
Ginny.
What if: Suppose SCR sells the bicycle to Ginny for $1,000. How much loss, if any, can SCR
recognize if it sells the bicycle to Ginny?
Answer: $200. SCR is permitted to recognize a loss on the sale of property to a shareholder
provided it does not run afoul of the related-person loss rules found in §267. To be a related
person, Ginny must own more than 50 percent of SCR, which she does not in this scenario.

Liabilities
The amount of any liability assumed by the shareholder can also affect the recognized gain.
When a liability assumed by the shareholder is greater than the distributed property’s fair
market value, the property’s fair market value is deemed to be the amount of the liability
assumed by the shareholder.13 If the liability assumed is less than the property’s fair market
value, the gain recognized on the distribution is still the excess of the property’s fair market
value over its tax basis (i.e., the liability is ignored by the distributing corporation).

Example 7-12
What if: Assume Jim receives a parcel of land previously purchased by SCR for possible
expansion. The land has a fair market value of $60,000 and a remaining mortgage of $12,000
attached to it. SCR has a tax basis in the land of $20,000, and Jim assumes the mortgage
on the land. How much gain, if any, does SCR recognize when it distributes the land to Jim?
Answer: $40,000 ($60,000 − $20,000). Because the mortgage assumed by Jim is less than
the land’s fair market value, SCR recognizes gain in an amount equal to the excess of the
land’s fair market value over its tax basis.

What if: Assume the mortgage assumed by Jim is $75,000 instead of $12,000. The land has
a fair market value of $60,000, and SCR has a tax basis in the land of $20,000. Jim will
assume the mortgage on the land. How much gain, if any, does SCR recognize when it
distributes the land to Jim?
Answer: $55,000 ($75,000 − $20,000). Because the mortgage assumed by Jim exceeds the
land’s fair market value, SCR treats the land’s fair market value as $75,000 and recognizes
gain in an amount equal to the excess of the mortgage assumed over its tax basis. Because
the mortgage exceeds the value of the property, Jim is treated as receiving a distribution of
$0 and will take a basis in the land of $75,000.

Effect of Noncash Property Distributions on E&P

As we discuss below, noncash property distributions to shareholders can affect a
corporation’s current E&P and accumulated E&P.

THE KEY FACTS

Effect of Distributions on E&P
E&P is reduced by distributions as follows:
. Cash distributed.
 . E&P adjusted tax basis of noncash depreciated property (fair market value less than
or equal to its E&P adjusted tax basis).
. Fair market value of noncash appreciated property.
. Noncash property distributions are reduced by any liabilities assumed by the
shareholder on property received.
. E&P reductions for distributions cannot cause E&P to drop below zero.

Current E&P.
Noncash property distributions can affect current E&P in two ways. First, current E&P is
reduced by the income taxes paid (or payable) on the taxable gain (fair market value of
property distributed in excess of the property’s adjusted tax basis). Second, current E&P is
increased to the extent the fair market value of the property distributed exceeds the E&P
basis of the property. For most types of property, the corporation’s E&P basis is the same as
the corporation’s taxable income basis, so the taxable gain on the distribution is equal to the
current E&P gain on the distribution. However for certain types of property (e.g., inventory
and depreciable assets), a corporation’s income tax basis for the property is different from
the E&P basis of the property (e.g., inventory may have a LIFO basis for taxable income
purposes but must have a FIFO basis for E&P purposes and the adjusted basis of certain
depreciable assets may differ for taxable income and E&P purposes because the
accumulated depreciation for income tax is different from accumulated depreciation for E&P
purposes). In these situations, the taxable gain will be different from the current E&P gain.
When a corporation distributes property with a fair market value that is lower than the E&P
basis of the property, the corporation does not deduct the loss in determining current E&P.

Accumulated E&P.
To reflect the fact that a distribution reduces a corporation’s economic resources to pay
dividends in future years, a corporation reduces its accumulated E&P at the end of the current
year. The amount of the reduction depends on whether the distributed property was
appreciated or depreciated for E&P purposes. When a corporation distributes appreciated
property (fair market value in excess of E&P adjusted tax basis), the distribution reduces
accumulated E&P at year-end by the fair market value of the property distributed. However,
when a corporation distributes depreciated property (E&P adjusted tax basis in excess of fair
market value of the property), the distribution reduces accumulated E&P at the end of the
year by the E&P adjusted tax basis of the property. When the distributed property is subject
to a liability, the amount of the liability assumed by the shareholder(s) increases accumulated
E&P essentially netting the liability against the distribution of the property. Recall, however,
distributions cannot cause accumulated E&P to drop below zero and cannot increase a
negative balance in E&P.
Example 7-13
What if: Assume the same facts as in Example 7-12. SCR distributed land to Jim that has a
fair market value of $60,000 and a remaining mortgage of $12,000 attached to it. SCR has
an income tax and E&P adjusted tax basis in the land of $20,000. Jim has assumed the
mortgage on the land. SCR has current E&P of $100,000, which includes the net gain of
$31,600 from distribution of the land ($40,000 gain less a related tax liability of $8,400) and
accumulated E&P at the beginning of the year of $500,000. What is SCR’s balance in
accumulated E&P at the end of this year (i.e., the beginning of next year) as a result of the
distribution of the land to Jim?
Answer: $552,000, computed as follows

What if: Assume SCR has current E&P of $40,000, which includes the net gain of $31,600
from the land distribution ($40,000 gain less a related tax liability of $8,400) and accumulated
E&P of $500,000. What is SCR’s beginning balance in accumulated E&P at the end of this
year (i.e., the beginning of next year) as a result of the distribution of the land to Jim?
Answer: $492,000, computed as follows:

What if: Assume the land distributed to Jim has a tax and E&P basis to SCR of $75,000
instead of $20,000. SCR has current E&P of $100,000 ($15,000 loss on the distribution is not
allowed in computing current E&P). SCR has accumulated E&P at the beginning of the year
of $500,000. What is SCR’s beginning balance in accumulated E&P at the beginning of next
year after taking the distribution of the land into account?
Answer: $537,000, computed as follows
TAXES IN THE REAL WORLD Tax
Planning for Distributions Visteon Corporation is a global technology company that designs,
engineers, and manufactures innovative cockpit electronics and connected car solutions for
the world’s major vehicle manufacturers. During 2008 and 2009, weakened economic
conditions triggered a global economic recession that severely impacted the automotive
sector. Visteon filed voluntary petitions for reorganization relief in 2009, but the company has
been profitable since it emerged from bankruptcy in 2010. Visteon had two technology-
focused core businesses: vehicle cockpit electronics and thermal energy management. The
company’s vehicle cockpit electronics product line includes audio systems, infotainment
systems, driver information systems, and electronic control modules. In order to focus its
operations on automotive cockpit electronics, Visteon sold a subsidiary at a pretax gain of
approximately $2.3 billion. The sale was completed on June 9, 2015, and Visteon’s net cash
proceeds from the sale were approximately $2.7 billion. Visteon then announced a plan to
return $2.5 billion−$2.75 billion of cash to its shareholders through a series of actions
including a special distribution. Ultimately, Visteon actually distributed approximately $1.75
billion on January 22, 2016. Is there a tax reason why Visteon might have delayed the
distribution from 2015 until 2016? One possibility is that Visteon had a large deficit in its
accumulated E&P at the beginning of 2015 from prior losses. However, the gain on the sale
of the subsidiary created significant 2015 current E&P. Recall that distributions are dividends
to the extent of current E&P even when there is a deficit in accumulated E&P. If true, then
Visteon’s special distribution in 2015 would have been characterized entirely as a dividend
to its shareholders. However, by waiting until 2016 to make the distribution, it is possible that
a significant portion of the distribution was treated as a nontaxable return of capital to
shareholders instead of a taxable dividend. This is because Visteon’s available E&P
(beginning-of-year accumulated E&P plus current E&P) was significantly less than the
distribution amount. Sources: Visteon Corporation 2014 and 2015 Forms 10-K and annual
reports.
STOCK DISTRIBUTIONS
LO 7-3
Rather than distribute cash to its shareholders, a corporation may instead distribute additional
shares of its own stock (or rights to acquire additional shares) to shareholders. A publicly held
corporation is likely to distribute additional shares of stock to promote shareholder goodwill
(it allows the corporation to retain cash and still provide shareholders with tangible evidence
of their interest in corporate earnings) or to reduce the market price of its outstanding shares
(the stock distribution reduces the price of shares by increasing their number, making the
stock more accessible to a wider range of shareholders). For example, a 5 percent stock
distribution will increase the number of shares outstanding by 5 percent. Hence, a
shareholder holding 100 shares will own 105 shares after a 5 percent stock distribution.
Corporations may also declare a stock split, in which the number of shares outstanding is
increased by the ratio of the split. For example, a 2-for-1 stock split would double the number
of shares outstanding. Hence, a shareholder holding 100 shares will own 200 shares after a
2-for-1 stock split. Stock splits are sometimes used by public corporations to keep stock
prices accessible to a diverse group of investors.

Tax Consequences to Shareholders Receiving a Stock Distribution

Nontaxable Stock Distributions
In theory, stock splits and pro rata stock distributions do not provide shareholders with any
increase in value. This is because these distributions do not change a shareholder’s interest
in the corporation except that the shareholder now owns more pieces of paper (shares of
stock). As a result, these distributions are generally not included in the shareholders’ gross
income.15
In a nontaxable stock distribution, each shareholder allocates a portion of their tax basis from
the stock on which the distribution was issued to the newly issued stock based on the relative
fair market value (FMV) of the stock.16 In the case of a simple distribution of common stock
or a stock split where the stock distributed is identical to the stock from which the distribution
is made (same class and same fair market value), the new per-share tax basis is the original
tax basis divided by the total number of shares held (including the new shares).
For example, assume a shareholder owns 100 shares of Acme Corporation stock, for which
they paid $3,000. Acme declares a 100 percent stock distribution and sends the shareholder
an additional 100 shares of stock. The shareholder will now own 200 shares of stock with the
same tax basis of $3,000. The basis of each share of stock decreases from its original $30
per share ($3,000/100) to $15 per share ($3,000/200). The holding period of the new stock
includes the holding period for which the shareholder held the old stock.17

Example 7-14
Jim has a tax basis in his SCR stock of $24,000. Ginny’s tax basis in her SCR stock is
$10,000. Jim owns 75 of the 100 shares of outstanding SCR stock, while Ginny owns the
remaining 25 shares.
What if: Assume that SCR declares a 100 percent stock distribution. As a result, Jim will own
150 shares of SCR stock and Ginny will own the remaining 50 shares. Is the stock distribution
taxable to Jim and Ginny? Answer: No. The stock distribution to Jim and Ginny is nontaxable
because it is made pro rata to the shareholders (that is, the distribution did not change their
proportional ownership of SCR).

What is the tax basis of each share of SCR stock now held by Jim and Ginny?
Answer: Jim’s original tax basis of $24,000 is divided among 150 shares. Hence, each one
of Jim’s shares has a basis of $160. Ginny’s original tax basis of $10,000 is divided among
50 shares. Hence, each one of Ginny’s shares has a basis of $200.

THE KEY FACTS

Tax Consequences of Stock Distributions
. Pro rata stock distributions generally are nontaxable.
. Shareholders allocate basis from the pre-distribution shares of stock to the recently
acquired shares of stock based on relative fair market value.
. Non–pro rata (disproportionate) stock distributions are treated as a property
distribution that is taxed as a dividend up to the corporation’s E&P.

Taxable Stock Distributions

Non–pro rata (i.e., disproportionate) stock distributions generally are treated as a property
distribution and characterized as dividends to the extent of the distributing corporation’s
E&P.18 This makes sense because the recipient has now received something of value: an
increase in the shareholder’s claim on the corporation’s income and assets. For example, a
corporation may give its shareholders the choice between a cash or a stock distribution. In
this case, shareholders who elect to receive stock in lieu of money will be treated as having
received a property distribution equal to the fair market value of the stock received, and the
shareholder will have a tax basis in the new stock equal to its fair market value.

Example 7-15
What if: Assume that SCR declares a 10 percent stock distribution but offers Jim and Ginny
the choice between more stock or $100 per share in cash. Is the distribution taxable to Jim if
he elects to receive 15 shares of stock worth $1,600? If Jim has received a taxable
distribution, what is the character of the income?
Answer: Yes, Jim is taxed on $1,600, the fair value of the stock, because the distribution has
the potential to change the proportionate ownership interests in SCR. If Jim elected the cash,
he would be taxed on the cash distribution of $1,500. If Jim elected the stock, the distribution
would be a property distribution treated as a dividend to the extent of SCR’s earnings and
profits.
STOCK REDEMPTIONS
LO 7-4
(Chapter Opener Continued) In the original storyline, Jim and Ginny raised some of the initial
capital they needed to start SCR by borrowing $50,000 from Jim’s father, Walt. An alternate
strategy would have been to issue 25 additional shares of SCR stock to Walt in return for
$50,000. This change in facts would reduce Jim’s ownership percentage in SCR to 60 percent
(75 shares/125 shares). Ginny’s ownership percentage would decrease to 20 percent (25
shares/125 shares). Walt would own the remaining 20 percent. We will assume this change
in facts to continue the storyline.
Walt does not participate in the management of the company. In fact, he was hoping to cash
out of SCR when it became profitable and use the money to put a down payment on a
condominium in a retirement community near Orlando, Florida. With the SCR stock valued at
$5,000 per share ($125,000 in total), Walt saw an opportunity to realize his retirement dream.
Jim and Ginny saw it as a chance to own all SCR’s stock, eliminating a potential source of
discord should Jim’s father disapprove of the way they are managing the company.
By the end of this year, SCR will have sufficient cash to buy back some or all of Walt’s shares
of SCR stock. Jim and Ginny were wondering about the potential tax consequences to SCR
and Walt under various redemption plans. In particular, Jim and Ginny wanted to know
whether there was a tax difference between (1) buying back 5 of Walt’s shares this year and
the remaining 20 shares equally over the next four years (at 5 shares per year) and (2) buying
back all 25 shares this year using an installment note that would pay Walt 20 percent of the
purchase price in each of the next five years plus interest.
Page 7-18
Publicly held corporations buy back (redeem) their stock from existing shareholders for many
and varied reasons. For example, a corporation may have excess cash and limited
investment opportunities, or management may feel the stock is undervalued. Management
may see a large redemption as a way to get shareholders or stock analysts to reconsider
their valuation of the company or as a way to selectively buy out dissenting shareholders who
have become disruptive. Reducing the number of outstanding shares also increases earnings
per share (by reducing the number of shares in the denominator of the calculation) and
potentially increases the stock’s market price.19

Privately held corporations often use stock redemptions for other reasons, such as to shift
ownership control from older to younger family members who do not have the resources to
purchase shares directly or to buy out dissatisfied, disinterested, or deceased shareholders.
In addition, redemptions of an ex-spouse’s stock can provide liquidity in a divorce agreement
and eliminate the individual from management or ownership in the company. Finally,
redemptions can provide cash to satisfy estate taxes imposed on the estate of a deceased
shareholder of the company.

The Form of a Stock Redemption

A stock redemption is an acquisition by a corporation of its stock from a shareholder in
exchange for property. It is irrelevant whether the stock acquired by the corporation is
cancelled, retired, or held as treasury stock.20 The term property in this context has the same
meaning as it does for distributions (i.e., cash and noncash property).

Stock redemptions take the form of an exchange in which the shareholders give up stock in
the corporation for property, usually cash. If the form of the transaction is respected,
shareholders compute gain or loss (capital gain or loss if the stock is held as an investment)
by comparing the amount realized (money and the fair market value of other property
received) with their tax basis in the stock exchanged.
Without any tax law restrictions, a sole shareholder of a corporation could circumvent the
dividend rules by structuring distributions to have the form of an exchange (i.e., a stock
redemption). For example, rather than have the corporation make a $100,000 dividend
distribution, the shareholder could have the corporation buy back $100,000 of stock from the
shareholder. If the shareholder had a tax basis of $60,000 in the stock redeemed, the amount
of income reported on the shareholder’s tax return would decrease from $100,000 (dividend)
to $40,000 (capital gain). At present, both amounts would be taxed at the same preferential
tax rate (20 percent is the highest capital gains tax rate), assuming the shareholder held the
stock for more than a year. In contrast to a dividend, a capital gain can be offset with capital
losses. Similar to a dividend, however, the sole shareholder would continue to own 100
percent of the corporation before and after the stock redemption.
Form is not always respected in a redemption, however. The tax law may determine (or the
IRS may argue) that the transaction is, in substance, a distribution of earnings, the tax
consequences of which should be determined under the dividend rules we discussed above.
The IRC provides both objective/mechanical tests (so-called bright-line tests) and
subjective/judgmental tests to distinguish when a redemption should be treated as an
exchange or a potential dividend.21 The result is an intricate set of rules that the corporation
and its shareholders must navigate carefully to ensure that the shareholders receive the tax
treatment they desire. This is especially true in closely held family corporations, where the
majority of stock is held by people related to each other through birth or marriage.

Page 7-19
While individual shareholders prefer sale treatment, corporate shareholders generally have
more incentive for dividend treatment. Dividends from domestic corporations are eligible for
the dividends-received deduction (DRD) (usually 50 or 65 percent), whereas a capital gain is
not eligible for the DRD. A corporation might prefer exchange treatment if the redemption
results in a loss, if the corporation has capital loss carryovers, or if its stock tax basis as a
percentage of the redemption price exceeds the DRD ratio.

Redemptions That Reduce a Shareholder’s Ownership Interest

The IRC allows a shareholder to treat a redemption as an exchange if the transaction meets
one of three change-in-ownership tests: the substantially disproportionate test, the complete
termination test, or the not essentially equivalent to a dividend test.22 These ownership tests
consider the effect of each redemption from the shareholder’s perspective.
Redemptions That Are Substantially Disproportionate
The IRC states in §302(b)(2) that a redemption will be treated as an exchange if the
redemption is “substantially disproportionate with respect to the shareholder.” A shareholder
meets this requirement by satisfying the three objective (“bright-line”) stock ownership tests:
1. Immediately after the exchange, the shareholder owns less than 50 percent of the total
combined voting power of all classes of stock entitled to vote.
2. The shareholder’s percentage ownership of voting stock after the redemption is less
than 80 percent of their percentage ownership before the redemption.
3. The shareholder’s percentage ownership of the aggregate fair market value of the
corporation’s common stock (voting and nonvoting) after the redemption is less than 80
percent of their percentage ownership before the redemption.23
For example, suppose a shareholder owns 60 percent of a corporation’s stock prior to a
redemption. To satisfy the 80 percent test, this shareholder must own less than 48 percent
of the outstanding stock after a redemption (60% × 80% = 48%). Note that in this instance
the redemption would also satisfy the 50 percent test (48 percent is less than 50 percent).
Note also, that a redemption reduces that number of shares outstanding, and this must be
taken into account in calculating the ownership tests. In contrast, suppose the same
shareholder owns 70 percent before a redemption. In this case, a redemption that satisfies
the 80 percent reduction test (70% × 80% = 56%) will not satisfy the 50 percent test.
The determination as to whether a shareholder meets both the 50 percent and 80 percent
tests is made on a shareholder-by-shareholder basis. If multiple shareholders have shares
redeemed, some shareholders can satisfy the test while others do not. If a shareholder owns
multiple classes of common stock (voting and nonvoting), the less-than-80-percent of fair
market value test is applied to the shareholder’s aggregate ownership of the common stock
rather than on a class-by-class basis.

Example 7-16
What if: Assume Walt is not related to either Jim or Ginny. This year, SCR redeemed five
shares of Walt's stock in exchange for $25,000. Walt has a tax basis in the five shares of
SCR stock of $10,000 ($2,000 per share). What is the tax treatment of the stock redemption
to Walt under §302(b)(2)? Page 7-20
Answer: $25,000 dividend to the extent of SCR’s E&P. Prior to the redemption, Walt owned
20 percent of SCR (25/125 shares). After the redemption, his ownership percentage in SCR
dropped to 16.67 percent (20/120 shares). This redemption does not satisfy the substantially
disproportionate test. After the redemption, Walt owns less than 50 percent of SCR stock, but
his ownership percentage after the redemption (16.67 percent) does not fall below 80 percent
of his ownership percentage prior to the redemption (80% × 20% = 16%). Walt will not be
able to treat the redemption as an exchange under this change-in-ownership test. Unless he
can satisfy one of the other change-in-ownership tests, Walt will have a $25,000 dividend,
assuming SCR has sufficient E&P, rather than a $15,000 capital gain ($25,000 − $10,000).

How many shares of stock would SCR have to redeem from Walt to guarantee exchange
treatment under the substantially disproportionate test?
Answer: For Walt to meet the 80 percent test, SCR must redeem six shares of stock. The
computation is made as follows:
25 − X < 16% where X is the number of shares to be redeemed
125 − X
Using some algebra, we can compute x to be 5.95, rounded up to six shares.24 If SCR
redeems six shares from Walt, his ownership percentage after the redemption will be 15.97
percent (19/119 shares), which now meets the 80 percent test. The redemption of this one
additional share transforms the transaction from a $30,000 dividend (6 shares × $5,000) to
an $18,000 capital gain ($30,000 − $12,000).

In determining whether the 50 percent and 80 percent tests are met, an individual shareholder
must take into account the constructive ownership or stock attribution rules found in §318.
Under certain circumstances, the stock attribution rules require that stock owned by other
persons (individuals and entities) that are related to the redeeming shareholder are
considered to be constructively owned (we also refer to this as indirect ownership) by the
redeeming shareholder for purposes of determining whether the shareholder has met the
change-in-stock-ownership tests. The purpose of the attribution rules is to prevent
shareholders from dispersing stock ownership to either family members who have similar
economic interests or entities controlled by the shareholder to avoid having a stock
redemption characterized as a dividend.

Family attribution.
Individuals are treated as owning the shares of stock owned by their spouse, children,
grandchildren, and parents. Stock owned constructively through the family attribution rule
cannot be reattributed to another family member through the family attribution rule.

Example 7-17
Return to the amended storyline in which Walt is Jim’s father and, in exchange for contributing
$50,000, he received 25 shares of SCR stock and 20 percent ownership of the company.
This year, SCR redeems 6 shares of stock from Walt in exchange for $30,000. Walt has a
tax basis in the 6 shares of stock redeemed of $12,000 ($2,000 per share).
What is the tax treatment of the stock redemption to Walt under §302(b)(2)?
Answer: $30,000 dividend to the extent of SCR’s E&P.
Prior to the redemption, Walt owned 20 percent of SCR (25/125 shares) directly. Under the
family attribution rules, Walt is treated as constructively owning the shares of SCR stock
owned by Jim (75 shares). In applying the substantially disproportionate change-in-stock-
ownership tests, Walt is treated as owning 100 shares of SCR stock (25 + 75), or 80 percent
of the SCR stock (100/125 shares). After the redemption, Walt's ownership percentage in
SCR drops to 79 percent (94/119 shares). This redemption does not satisfy the substantially
disproportionate test because Walt is deemed to own more than 50 percent of the SCR stock
after the redemption. As a result, Walt will have a $30,000 dividend, assuming SCR has
sufficient E&P, rather than an $18,000 capital gain ($30,000 − $12,000).
Page 7-21 \
An interesting question relates to what happens to the tax basis of stock redeemed that is not
used in determining the shareholder’s tax consequences. This occurs in a redemption treated
as a dividend, where the tax basis of the stock redeemed is not subtracted from the amount
received from the corporation. Under the current rules, the tax basis of the stock redeemed
is added to the tax basis of any shares still held by the shareholder.

Example 7-18
In the preceding example, SCR redeemed six shares of stock from Walt for $30,000, and the
transaction was treated as a dividend because of the application of the family attribution rules.
Walt had a tax basis in the 6 shares of stock redeemed of $12,000 ($2,000 per share), but
this tax basis was not used in determining their taxable income from the transaction.
What is Walt’s tax basis in the remaining 19 shares of SCR stock?
Answer: $50,000. Walt adds the unused $12,000 tax basis in the 6 shares redeemed to the
tax basis of the remaining 19 shares. The tax basis in these remaining shares increases to
$50,000, the original tax basis of the 25 shares.

If the shareholder no longer holds any shares, the tax basis transfers to the stock held by
those persons who caused the shareholder to have dividend treatment under the attribution
rules.25

Attribution from entities to owners or beneficiaries.

Owners or beneficiaries of entities can be deemed to own shares of stock owned by the entity
itself. Under these rules, partners are deemed to own a pro rata share of their partnership’s
stock holdings (i.e., a partner who has a 10 percent interest in a partnership is deemed to
own 10 percent of any stock owned by the partnership). Beneficiaries are deemed to own a
pro rata share of the stock owned by the trust or estate of which they are a beneficiary.
Shareholders are deemed to own a pro rata share of their corporation’s stock holdings, but
only if they own at least 50 percent of the value of the corporation’s stock. Other attribution
rules, such as family attribution, apply in determining if this 50 percent test is met.

Example 7-19
What if: Assume that Walt is not Jim’s father, and besides the 25 shares of SCR that he
owns directly, he is a 40 percent partner in a partnership that also owns 25 shares in SCR.
The other 60 percent of the partnership is owned by his neighbors, Fred and Ethel, who are
unrelated to Walt. How many shares of SCR is Walt treated as owning directly and indirectly
through the partnership? .
Answer: 35 shares. Walt owns 25 shares directly and another 10 shares indirectly. Walt is
treated as indirectly owning a pro rata share of SCR stock owned by the partnership; in this
example, 40 percent times 25 shares is 10 shares.
What if: Assume now that Walt is a 40 percent shareholder in Acme Corporation, which owns
25 shares in SCR. The other 60 percent of Acme shares is owned by his neighbors, Fred and
Ethel, who are unrelated to Walt. How many shares of SCR is Walt treated as owning
indirectly through Acme Corporation?
Answer: 0 shares. None of the shares owned by Acme Corporation are attributed to Walt
under the constructive ownership rules because Walt does not own at least 50 percent of the
stock of Acme Corporation. Stock owned by a corporation (Acme in this example) is attributed
to a shareholder only if the shareholder owns at least 50 percent of the corporation’s stock.
In this case, Walt owns only 40 percent of Acme, and, therefore, SCR shares owned by Acme
are not attributed to Walt.

What if: Assume now that Walt is a 60 percent shareholder in Acme Corporation, which owns
25 shares in SCR. The other 40 percent of Acme shares is owned by his neighbors, Fred and
Ethel, who are unrelated to Walt. How many shares of SCR is Walt treated as owning
indirectly through Acme Corporation? .
Answer: 15 shares. Walt is treated as indirectly owning a pro rata share of SCR stock owned
by Acme; in this example, 60 percent times 25 shares. A portion of Acme’s stock in SCR is
attributed to Walt because Walt owns at least 50 percent of the stock of Acme Corporation.

Page 7-22
Attribution from owners or beneficiaries to entities.
Entities can be deemed to own other stock owned by their owners or beneficiaries. Under
these rules, a partnership is deemed to own 100 percent of the shares owned by its partners.
A trust or estate is deemed to own 100 percent of the shares owned by its beneficiaries. A
corporation is deemed to own 100 percent of the shares owned by a shareholder who owns
at least 50 percent of the value of the corporation’s stock (direct plus indirect (constructive)
ownership). Stock that is deemed owned by an entity cannot be reattributed to the other
owners in the entity under the entity-to-owner rules previously discussed (this is known as
sideways attribution).

Example 7-20
What if: Assume that Walt owns 25 shares of SCR and he is a 40 percent partner in a
partnership. The other 60 percent of the partnership is owned by Walt’s neighbors, Fred and
Ethel, who are unrelated to Walt. How many shares of SCR is the partnership treated as
owning indirectly through Walt?
Answer: 25 shares. Stock in a corporation (SCR) is attributed from an owner in an entity
(Walt) to the entity (the partnership) in full. Under the owner-to-entity attribution rule, all of
Walt’s 25 shares would be attributed to the partnership as long as Walt had any ownership
interest in the partnership.

What if: Assume the same facts as in the previous what-if example except that the
partnership is now Acme Corporation. How many shares of SCR is Acme treated as owning
indirectly through Walt?
Answer: 0 shares. Because the entity (Acme) is a corporation, the owner in the entity (Walt)
must own at least 50 percent of the stock of the entity (Acme) in order for there to be any
attribution from the owner (Walt) to the entity (Acme).

What if: Assume the same facts as in the previous what-if example except that Walt owns
60 percent of Acme Corporation. How many shares of SCR is Acme Corporation treated as
owning indirectly through Walt? Answer: 25 shares. Because the entity (Acme) is
a corporation and the owner (Walt) owns at least 50 percent of the entity (Acme), all of Walt’s
25 shares in SCR are attributed to Acme Corporation.

Option attribution.
A person having an option to purchase stock is deemed to indirectly own the stock that the
option entitles the person to purchase.

Complete Redemption of the Stock Owned by a Shareholder

A redemption will be treated as an exchange if it is in “complete redemption of all of the stock
of the corporation owned by the shareholder.”26 This test seems redundant with the
substantially disproportionate test discussed above; after all, a complete redemption
seemingly satisfies the 50 percent and 80 percent tests. The difference is in the application
of the family attribution rules discussed above.
The stock attribution rules also apply to a complete redemption. This presents a potential
problem in family-owned corporations in which the only (or majority) shareholders are
parents, children, and grandchildren. Parents who have all their stock redeemed will be will
not be able to qualify for sale or exchange treatment if their children or grandchildren continue
to own the remaining stock in the corporation because of the operation of the family attribution
rules. To provide family members with relief in these situations, shareholders can waive
(ignore) the family attribution rules in a complete redemption of their stock.27 As usual, there
are some strings attached.

Page 7-23
The first requirement is that the shareholder has no interest in the corporation immediately
after the exchange as a “shareholder, employee, director, officer or consultant.”28 These
relations to the corporation are referred to as prohibited interests. The second requirement is
that the shareholder does not acquire a prohibited interest within 10 years after the
redemption, unless by inheritance (this is known as the 10-year look-forward rule). Finally,
the shareholder must agree to notify the IRS district director within 30 days if a prohibited
interest is acquired within 10 years after the redemption. The shareholder can still be a
creditor of the corporation (e.g., the parents can receive a corporate note in return for their
stock if the corporation does not have the cash on hand to finance the redemption).
Example 7-21
Return to the amended storyline in which Walt is Jim’s father and he owns 25 shares of SCR
stock. Assume SCR redeemed all 25 of his shares this year for $125,000, and for the year
SCR has current E&P of $500,000. Walt’s tax basis in the SCR shares is $50,000 (25 ×
$2,000). Under the family attribution rules, Walt would still be treated as indirectly owning 75
percent of the SCR stock (Jim would own 75 of the remaining 100 shares in SCR). The
$125,000 payment would be treated as a taxable dividend to the extent of SCR's E&P.
What happens to the unused $50,000 tax basis in the SCR stock redeemed?
Answer: The tax basis transfers to Jim’s stock, giving Jim a tax basis in his SCR stock of
$74,000 ($24,000 + $50,000).

How can Walt change the tax treatment of the complete redemption?
Answer: Because Walt has redeemed all his shares, he can waive the family attribution rules,
provided he files an agreement with the IRS and does not retain a prohibited interest in SCR
(e.g., as an employee or consultant). By waiving the family attribution rules, Walt will be
treated as not owning any SCR stock and, thus, will be able to treat the redemption as an
exchange and report a capital gain of $75,000 ($125,000 − $50,000).

Redemptions That Are Not Essentially Equivalent to a Dividend

A redemption will also be treated as an exchange if it is “not essentially equivalent to a
dividend.”29 This is a subjective determination that turns on the facts and circumstances of
each case. To satisfy this requirement, there must be a “meaningful” reduction in the
shareholder’s ownership interest in the corporation as a result of the redemption.30 Neither
the IRS nor the courts provide any mechanical tests to make this determination. The courts
generally look at the substance of the transaction to determine if the redemption is a sale or
a disguised dividend. As a result of the potential for litigation, shareholder reliance on this
test is typically a last resort.

Although the courts have held that a shareholder’s interest can include the right to vote and
exercise control, participate in current and accumulated earnings, or share in net assets on
liquidation, the IRS generally looks at the change in voting power as the key factor. The
shareholder’s voting power must decrease and be below 50 percent as a result of the
exchange before this test can be considered.31 As before, the stock attribution rules apply
to these types of redemptions. Shareholders generally turn to this test to provide exchange
treatment for redemptions when they cannot meet any of the other tests discussed previously.

Page 7-24

TAXES IN THE REAL WORLD

Form Sometimes Prevails over Substance
Jon Dickinson was a shareholder and CFO for Geosyntec Consultants, Inc. (GCI), a privately
held corporation. With authorization from the GCI board of directors, Dickinson donated
appreciated long-term GCI shares to a qualified charity, Fidelity Investments Charitable Gift
fund (Gift Fund). GCI immediately redeemed the donated shares for cash (i.e., the Gift Fund
sold stock back to the corporation for cash). Because the Gift Fund is a tax-exempt charity,
it recognized no gain on the redemption. Dickinson, in turn, claimed a charitable contribution
deduction for the fair market value of the donated stock. The IRS argued that the transaction
should be recast as though GCI redeemed Dickinson’s stock for cash and then Dickinson
donated the cash to the charity. In this scenario, Dickinson would be taxed on the appreciation
in the donated stock.
At trial, Dickinson presented contemporaneous evidence that he relinquished all ownership
rights in the shares at the time of the donation. GCI’s letters to the Gift Fund confirmed the
ownership transfer, and the Gift Fund’s letters to Dickinson explained that the charity had
“exclusive legal control” over the donated shares. The Tax Court held that where control is
relinquished, the form of the transaction (donation then redemption) takes precedence over
the substance of the transaction (redemption then donation). In this case, the tax
consequences follow from the form of the transaction regardless of whether the donation was
closely followed by a redemption or whether there was a preexisting “understanding” that the
stock would be redeemed. Thus, Dickinson was able to claim a donation for the appreciated
stock and was not taxed on the redemption.
Source: Jon Dickinson, et ux. v. Comm’r, TC Memo 2020-128.

Example 7-22
What if: Assume Walt is not related to Jim or Ginny. This year, SCR redeemed five shares
of his stock in exchange for $25,000. Walt has a tax basis in the five shares of SCR stock of
$10,000 ($2,000 per share). Assume that SCR has sufficient E&P to cover any distribution.
What is the tax treatment of the stock redemption to Walt under the not essentially equivalent
to a dividend test?
Answer: $15,000 capital gain.

Prior to the redemption, Walt owned 20 percent of SCR (25/125 shares). After the
redemption, his ownership percentage in SCR drops to 16.67 percent (20/120 shares). This
redemption does not satisfy the substantially disproportionate test, which would treat the
redemption as an exchange. Walt can argue that the redemption should be treated as an
exchange because it was not essentially equivalent to a dividend. Walt’s ownership
percentage decreased (20 percent to 16.67 percent) and is below 50 percent after the
redemption. However, the result Walt seeks (exchange treatment) is not guaranteed. For
peace of mind, he might prefer having SCR redeem one additional share and have the
certainty that the redemption will be treated as an exchange under §302(b)(2).

Example 7-23
What if: Assume Walt is Jim’s father, and SCR redeemed five shares of his stock in exchange
for $25,000. Walt has a tax basis in the five shares of SCR stock of $10,000 ($2,000 per
share), and SCR has sufficient E&P to cover any distribution. What is the tax treatment of the
stock redemption to Walt under the not essentially equivalent to a dividend test?
Answer: $25,000 dividend to the extent of SCR’s E&P.
Prior to the redemption, Walt is treated as owning 80 percent of SCR (25 shares directly and
75 shares through Jim). After the redemption, his ownership percentage in SCR drops to 79
percent (95/120 shares). This redemption does not satisfy the not essentially equivalent to a
dividend test because Walt is treated as owning more than 50 percent of the SCR stock.

Page 7-25
Tax Consequences to the Distributing Corporation
The corporation distributing property to shareholders in a redemption generally recognizes
gain on the distribution of appreciated property but is not permitted to recognize loss on the
distribution of property with a fair market value less than its tax basis.32
If the redemption is treated as a distribution, the corporation reduces its accumulated E&P at
the end of the year by the cash distributed and the greater of the fair market value or the
adjusted tax basis of other property distributed.33 If the redemption is treated as an
exchange, the corporation reduces E&P at the date of distribution by the percentage of stock
redeemed (i.e., if 60 percent of the stock is redeemed, E&P available at the time of the
distribution is reduced by 60 percent), not to exceed the fair market value of the property
distributed.34 When dividend distributions and redemption distributions are made in the same
taxable year, the dividend distributions are allocated to E&P first and then the redemptions
reduce the remaining E&P on a per share basis.35
The distributing corporation cannot deduct expenses incurred in a stock redemption.36 The
corporation can, however, deduct interest on debt incurred to finance a redemption.

Example 7-24
What if: Assume SCR redeemed all of the 25 shares owned by Walt in exchange for
$125,000. The stock redeemed represents 20 percent of the total stock outstanding. Walt
has a tax basis in his SCR shares of $50,000. Further assume that Walt treated the
redemption as an exchange because he waived the family attribution rules and filed an
agreement with the IRS.37 As a result, Walt recognized a capital gain of $75,000 ($125,000
− $50,000). The redemption took place on December 31, on which date SCR had
accumulated E&P at the end of the year (including current E&P for year) of $500,000. SCR
did not make any distributions during the year.
By what amount does SCR reduce its E&P as a result of this redemption?
Answer: $100,000. SCR reduces E&P by the lesser of (1) $100,000 (20% × $500,000) or (2)
$125,000, the amount paid to Walt in the redemption.

What if: Assume E&P was $1,000,000 at the end of the year. By what amount does SCR
reduce its available E&P as a result of this redemption?
Answer: $125,000. SCR reduces E&P by the lesser of (1) $200,000 (20% × $1,000,000) or
(2) $125,000, the amount paid to Walt in the redemption.

THE KEY FACTS

- Stock Redemptions Treated as Exchanges
. A stock redemption is treated as an exchange if it meets one of the following three
tests: Substantially disproportionate with respect to the shareholders.
. In complete termination of the shareholder’s interest.
 . Not essentially equivalent to a dividend.
- The following attribution rules are used to determine if one of the three tests is met:
. Family attribution.
. Entity-to-owner attribution (pro rata).
. Owner-to-entity attribution (100 percent).
. Options.
- A corporation reduces its E&P as a result of a stock redemption as follows:
. If the distribution is treated as an exchange, E&P is reduced by the lesser of (1) the
amount distributed or (2) the percentage of stock redeemed times accumulated E&P at
the redemption date.
. If the distribution is treated as a distribution, E&P is reduced using the dividend rules.
PARTIAL LIQUIDATIONS
LO 7-5
Corporations sometimes contract their operations either by distributing the stock of a
subsidiary to their shareholders or by selling the business. In the case of a sale, the
corporation may distribute the proceeds from the sale to its shareholders in partial
liquidation of the corporation. The distribution may require the shareholders to tender
shares of stock back to the corporation or may be pro rata to all the shareholders without an
actual exchange of stock.
Page 7-26
The tax treatment of a distribution received in a partial liquidation depends on the type of
entity receiving the distribution.38 All noncorporate shareholders (partnerships, LLCs,
individuals, etc.) receive exchange treatment. This entitles the individual to sale or exchange
treatment with respect to the gain or loss recognized on the actual or deemed exchange. If
the shareholder is not required to tender stock to the corporation in return for the property
received, the shareholder computes gain or loss recognized on the exchange by calculating
the tax basis of the shares that would have been transferred to the corporation had the
transaction been a stock redemption.

THE KEY FACTS

Tax Consequences to Shareholders in a Partial Liquidation of a Corporation
. Noncorporate shareholders receive exchange treatment.
. Corporate shareholders determine their tax consequences using the change-in-stock-
ownership rules that apply to stock redemptions.

All corporate shareholders are subject to the change-in-stock-ownership rules that apply to
stock redemptions. This usually results in dividend treatment because partial liquidations
almost always involve pro rata distributions. Corporate shareholders generally prefer dividend
treatment because of the availability of the dividends-received deduction, although the benefit
of the dividends-received deduction is mitigated because a partial liquidating distribution to a
corporate shareholder is treated as an extraordinary dividend under §1059 which requires
corporations to reduce their stock basis by the amount of the dividends received deduction.

For a distribution to be in partial liquidation of the corporation, it must be either “not essentially
equivalent to a dividend” (as determined at the corporate level) or the result of the termination
of a “qualified trade or business.”39 The technical requirements to meet these requirements
are beyond the scope of this text.

TAXES IN THE REAL WORLD

A Partial Liquidation in Dutch Auction Tender Offer
XBiotech is a Canadian biotech company that trades on NASDAQ (XBIT). In December 2019,
the company sold a subsidiary, True Human antibody Bermekimab, to Janssen Biotech, Inc.
(Janssen), a subsidiary of Johnson & Johnson. Upon closing, XBiotech received $750 million,
with the possibility that the company could also receive up to $600 million subject to other
conditions. The company announced plans to use the sale proceeds for a new research
program and to return remaining funds to shareholders. In January 2020, the company
announced that it planned to use $420 million to repurchase shares in a Dutch auction tender
offer. In a Dutch auction tender offer, the company sets a price range for the offering, in this
case $30–$33. Shareholders interested in tendering their shares offer a price where they are
willing to sell. At expiration, the company adds up the shares tendered, starting at the
minimum price, until they reach the number of shares they are seeking, in this case 33%. The
highest price of that group is the price the company will pay for all shares tendered at or
below that price. According to the company, Canadian shareholders will treat the offer as a
taxable dividend. However, U.S. shareholders who participate in the tender will be entitled to
treat the offer as a redemption under §302. Specifically, the company indicated in the tender
offer that it intends for the sale to be treated as a partial liquidation under §302(e). As a partial
liquidation, noncorporate shareholders would be entitled to treat the redemption as a sale
regardless of whether it qualifies as substantially disproportionate. Of course, the company
suggests that shareholders should consult with tax advisers because treatment as a partial
liquidation depends on the facts and circumstances, and the IRS may disagree with this
position. Source: Schedule TO (pages 39–40), filed with the SEC by XBiotech Inc. on January
14, 2020.