Mastering Corporate Taxation: The Fun Way 🎊

Chapter 5 PowerPoint Lecture Corporations Earnings and Profits and Dividend Distributions

Estimated read time: 1:20

Summary

In this engaging lecture, Erinne M. Perry guides tax accountants through the intricacies of corporations, earnings, and profits, along with dividend distributions. Key topics include understanding the impact of earnings and profits (ENP) on tax treatment, computing a corporation's ENP, and determining taxable dividends. The lecture also delves into the complexities of property dividends, constructive dividends, and stock rights, offering insights on minimizing tax consequences through smart corporate distribution strategies. It's a comprehensive guide for those looking to master the art of corporate taxation, all delivered in a friendly, approachable manner.

Highlights

Erinne M. Perry sets the stage with a warm welcome and outlines expectations for mastering ENP! 🎓
The role of ENP in assessing a corporation's ability to pay dividends explained simply! 🧮
Three-tier approach to taxing corporate distributions offers an engaging financial puzzle! 🧩
Qualified dividends enjoy preferential tax rates - a boon for individual investors! 🙌
Complexities of property dividends and their effect on shareholder's bottom line are made clear! 🏢

Key Takeaways

Earnings and Profits (ENP) help determine tax treatment for corporate distributions! 💡
Three tiers of corporate distribution taxation: dividends, return of capital, and capital gains! 📊
Understanding qualified vs ordinary dividends can impact tax rates significantly! 📈
Property dividends can offer alternative distribution methods, but come with their own tax implications! 🏡
Constructive dividends are like secret dividends, often affecting closely held corporations! 🤫

Overview

Welcome to an enlightening journey into the world of corporate taxation with Erinne M. Perry! This session dives into Chapter 5 of Southwestern Federal Taxation, covering the essentials of corporations, earnings, and profits (ENP), and how they affect dividend distributions. Erinne skillfully breaks down the complex concepts of taxable dividends, property distributions, and constructive dividends, making them accessible and exciting.

The heart of the lecture focuses on understanding ENP, a measure akin to retained earnings, yet unique in its role in determining a corporation's dividend-paying capacity. Erinne walks through the mechanics of calculating ENP, touching on the nuances of current vs. accumulated ENP, tax implications of stock dividends, and the strategic maneuvering required to minimize tax burdens through smart corporate distributions.

Through practical examples and a dynamic teaching style, Erinne demystifies the intricate tax code regulations surrounding corporate earnings and profits. She addresses common challenges, such as constructive dividends and unreasonable compensations, and highlights the importance of thorough tax planning to avoid unnecessary penalties. It's a must-watch for anyone aiming to navigate the complexities of corporate tax with confidence and ease.

Chapters

00:00 - 03:00: Introduction and Overview In this chapter, Erinne M Perry provides an introduction and overview of Chapter 5 from the Southwestern Federal taxation textbook, focusing on corporations, partnerships, estates, and trusts. The chapter specifically addresses corporations with a focus on earnings, profits, and dividend distributions. By the end of the chapter, readers should be able to explain the role of earnings and profits in tax treatment for distributions and compute a corporation's earnings and profits (E&P).
03:00 - 11:00: Earnings and Profits: Definitions and Importance The chapter focuses on understanding the definition and significance of Earnings and Profits (E&P) in corporate finance. Erinne M Perry emphasizes the allocation of current and accumulated E&P to corporate distributions as a way to determine taxable dividends distributed within a year.
21:00 - 28:00: Tax Treatment of Dividends The chapter covers the tax treatment of dividends, focusing on identifying constructive dividends and calculating the resulting tax liabilities. It also discusses the tax implications of receiving stock dividends and stock rights, along with determining the shareholders' basis in these. Additionally, it offers strategies for structuring corporate distributions to minimize tax consequences for all parties involved.
28:00 - 34:00: Property Dividends In this chapter, the focus is on understanding how corporate formations impact the taxation and treatment of distributions. Specifically, it examines the tax implications of distributions made from corporate earnings and profits (E&P). These distributions are treated as dividends for shareholders, which has specific tax consequences depending on the company's earnings and profits. The chapter forms part of a larger discussion on corporate distributions and their tax treatments.
39:00 - 44:00: Constructive Dividends The chapter titled 'Constructive Dividends' discusses the taxation of dividends, highlighting that they are typically taxed as either ordinary income or dividend income, with a preferential tax rate. Corporate distributions are generally presumed to be dividends unless proven otherwise. The chapter further elaborates on the three tiers of taxation for corporate distributions, starting with its treatment as dividend distribution.
44:00 - 52:00: Unreasonable Compensation and Loans to Shareholders The chapter explains how certain distributions to shareholders can be taxed, either as ordinary income or dividend income, with dividends reported on form 1099-DIV.
52:00 - 59:00: Stock Dividends and Stock Rights This chapter discusses the tax treatment of stock dividends and stock rights. It explains that these can be considered a non-taxable return of capital based on the shareholder's basis. However, if distributions surpass these allocations and the shareholder's basis, they are treated as capital gains from the sale or exchange of stock. The section promises a practical example for better understanding.
59:00 - 65:00: Tax Planning for Corporate Distributions The chapter on 'Tax Planning for Corporate Distributions' begins with an explanation by Erinne M Perry about the notion of earnings and profits (E&P). It is highlighted that E&P is akin to the accounting concept of retained earnings as both measure a firm's accumulated capital. E&P encompasses all accumulated earnings and profits from the corporation's inception date along with the current year's earnings and profits. Moreover, it is mentioned that there will be a discussion on the differences in calculation methods for E&P later in the chapter.

Chapter 5 PowerPoint Lecture Corporations Earnings and Profits and Dividend Distributions Transcription

00:00 - 00:30 Erinne M Perry: Hi, there! Tax accountants. I hope all is well, and I pray that as you view on this video that you're in the best of health and spirit. This video will cover chapter 5 from Southwestern Federal taxation, corporations, partnerships, estates and trusts Erinne M Perry: and chapter 5 covers, corporations, earnings and profits and dividends distributions. Erinne M Perry: So by the end of this chapter you should be able to explain the role that earnings and profits play in determining the tax treatment of distributions, compute a corporation's earnings and profit, often referred to as enp.
00:30 - 01:00 Erinne M Perry: determine taxable dividends paid during the year by correctly allocating current and accumulated emp to corporate distributions Erinne M Perry: describe the tax treatment of dividends for individual shareholders, evaluate the tax impact of property dividends by computing the shareholders, dividend income basis and property received and the effect on the distributing corporation's emp and taxable income
01:00 - 01:30 Erinne M Perry: recognize situations when constructive dividends exist and compute the tax resulting from such dividends Erinne M Perry: determine the tax implications that arise from receipt of stock dividends and stock rights and the shareholders basis in the stock and stock rights received. And lastly, structure corporate distributions in a manner that minimizes tax consequences to the parties that are involved.
01:30 - 02:00 Erinne M Perry: So chapter 4, we examine the consequences of a corporate formation, and in chapter 5, and as we move on to Chapter 6, we'll also start to focus on the tax treatment of corporate distributions. So distributions from corporate earnings and profits again referred to as emp. Erinne M Perry: There's a specific ways in which it is treated, depending on the earnings and profits of the company. So whenever a distribution is made from the corporate earnings and profits. The shareholder is deemed to receive a dividend.
02:00 - 02:30 Erinne M Perry: and as it relates to dividends, it's either taxed as ordinary income or preferentially taxed as dividend income Erinne M Perry: generally corporate distributions are presumed to be paid out of emp and treated as dividends unless the parties can show otherwise. So there's 3 tiers in which corporate distributions are essentially going to be taxed. And we're going to learn a bit more about that. So first, st it'll be treated as a dividend distribution, as we see here.
02:30 - 03:00 Erinne M Perry: and, as mentioned, it's either taxed as ordinary income or preferentially taxed as dividend income and Erinne M Perry: the distribution that is going to be treated as dividends. It will be reported on form 1099, div Erinne M Perry: distributions that are not treated as dividends, and are treated as a non-taxable return of capital to the extent of the shareholders basis, and any distribution that exceeds the shareholders basis is treated as a gain from the sale or exchange or stock. So again, there's 3 tiers, the first, st the distribution is going to be treated as a dividend, second.
03:00 - 03:30 Erinne M Perry: it will be treated, treated as a non-taxable return of capital to the extent of that shareholders basis. And, lastly. Erinne M Perry: if the distribution exceeds the amount that's allocated as dividends and exceeds the shareholders basis, it's treated as a gain a capital gain for the sale or exchange or stock. Right now, this is just terminology, but we'll get to look at a practical example of how this would be applied.
03:30 - 04:00 Erinne M Perry: So the notion of earnings and profits. It's kind of similar to the accounting concept of retained earnings both. They essentially measure a firm's accumulated capital, so earnings and profits, it includes both the accumulated earnings and profits of the corporation since its inception date. In addition to the current year's earnings and profits. But there's a difference in how the figures are calculated which we'll see a little later, as it relates to earnings and profits. There's no
04:00 - 04:30 Erinne M Perry: there's no definition in the tax code. But, as mentioned again, it's similar to retain earnings for financial reporting, but it's often not the same. Erinne M Perry: So emp represents the upper limits on the amount of dividend income recognized on corporate distributions
04:30 - 05:00 Erinne M Perry: and simply stated emp is a measure of dividend paying capacity of a corporation. So it measures their economic income. So as a result, whenever the corporation makes a distribution to shareholder the earnings and profits the Emp, it represents the Max amount of dividend income that shareholders must recognize. So Erinne M Perry: as a result the effect of a specific transaction on earnings and profits, it can be determined by assessing whether the transaction increases the corporation's ability to pay the dividend? Or does it decrease the corporation's ability to pay a dividend?
05:00 - 05:30 Erinne M Perry: The code regulations, rulings, and court cases. They provide a series of adjustments to taxable income that result in the measure of the corporation's dividend, paying capacity. So for both the cash basis and accrual basis corporations. They use the same approach when they have to determine
05:30 - 06:00 Erinne M Perry: taxable or determine rather earnings and profits. So again, the calculation, it'll generally begin with taxable income. Then you add, or you minus certain adjustments. Erinne M Perry: So there's some additions to taxable income. So to determine the current emp all excluded income items, they're added back to taxable income. So this includes tax exempt interest, life insurance proceeds, federal income tax, recent funds and dividends received deductions. And if we think about it logically
06:00 - 06:30 Erinne M Perry: for tax purposes. These amounts are not recognized as income. Erinne M Perry: But there's cash that's being received. There's money that's being received by the corporation interest, right? The money that they're receiving for tax exempt interest. Life insurance proceeds. That's money that's coming in Federal income tax refunds. That's money that's coming in the dividends received deduction that helps to ease the burden Erinne M Perry: of potentially there being triple taxation. But in all reality it's still money that's coming in. And again, earnings and profits that measures a corporation's dividend paying capacity. Hence, why these excluded income items are added back to taxable income.
06:30 - 07:00 Erinne M Perry: as it relates to the subtractions when calculating current, Emp. There's certain non-deductible expenses that are subtracted from taxable income. These negative adjustments. They include any non-deductible portion of meals, any entertainment expenses, related party losses, any expenses that are incurred
07:00 - 07:30 Erinne M Perry: to produce tax exempt income, Federal income taxes paid, any key employee, life insurance premiums, net of any increases in the cash surrender value, any non-deductible fines, penalties, and lobbying expenses. So again, the same logic, right for tax purposes. These expenses are not recognized.
07:30 - 08:00 Erinne M Perry: but in all reality cash is still being paid out, we paid money for meals. We paid money for the entertainment expenses. We absorbed the loss. We paid the Federal income taxes alright. Erinne M Perry: So once you keep in your mind that earnings and profits is a measure of the dividend paying capacity, it makes more sense in regard to which items need to be added back, and which items items need to be subtracted.
08:00 - 08:30 Erinne M Perry: So some earnings and profits, adjustments, they shift the effect of transaction from year of inclusion in, or deduction from taxable income to the year of the economic effect. So this is starting to deal with timing adjustments. You know, there's some Erinne M Perry: deductions or items that would be included in income Erinne M Perry: comp in comparison to financial purposes for tax purposes. When it is going to be included or deducted, there might be a timing difference. So in such case.
08:30 - 09:00 Erinne M Perry: charitable contributions, net operating losses, and capital losses. These all require these types of adjustments. Erinne M Perry: Next, we have gains and losses from property transactions so gains and losses from property transactions, they'll generally affect the termination of earnings and profits, but only to the extent that they are going to be recognized for tax purposes. So we know we have what's called realized gains, and we have what's called recognized gains, realized gain deals with the appreciation
09:00 - 09:30 Erinne M Perry: of property. A realized loss deals with the depreciation of property, recognize, gain, or loss that is ultimately, when it is going to be recorded for tax purposes. So that is when it makes a difference. So as a result, as we see here gains or losses that are deferred under the like kind, exchange provisions and gains that are deferred under the involuntary conversion provision. They don't affect earnings and profits
09:30 - 10:00 Erinne M Perry: until they're actually recognized and simply stated with recognized. That means a transaction took place. There was a sale of some sort. There was an exchange of some sort that you know, triggers, a taxable event. Erinne M Perry: and there's some other adjustments that need to be accounted for so accounting methods for earnings and profits. They're generally more conservative than for taxable income.
10:00 - 10:30 Erinne M Perry: So reason being. Erinne M Perry: or example, rather installment method is not permitted. Erinne M Perry: In addition, alternative depreciation systems must be used. Also, there's a it prohibits any additional 1st year depreciation. This also factors in a section 1, 79 expense that needs to be deducted over 5 years, 20%
10:30 - 11:00 Erinne M Perry: per year. So depending on, you know, the bigger the company, obviously the more complex computing earnings and profits can be. Erinne M Perry: So this just ties into some other adjustments, and, as mentioned again, accounting methods for the earnings and profits more conservative than for taxable income, because, again, earnings and profits, it measures the dividend paying capacity of a corporation. So they're factoring in all of these different things and the impact that it has on the corporation's ability to pay
11:00 - 11:30 Erinne M Perry: dividends. And these are just some, you know, extra adjustments. So cost depletion has to be used rather than percentage depletion. Percentage of completion must be used. There's no completed contract method for long-term contracts. Amortization of organizational expenses are not allowed. An adjustment is required for changes in life or recapture amount. Any intangible drilling costs must be amortized over a period of 60 months.
11:30 - 12:00 Erinne M Perry: Mine exploration and development costs must be amortized over a period of 120 months. So, as we see, there's some variation between the accounting method for financial purposes, tax purposes versus how you know it's being calculated for earnings and profits. Erinne M Perry: So this
12:00 - 12:30 Erinne M Perry: summary basically provides emp adjustments. A look at. Erinne M Perry: is it going to be added to emp? Or is it going to be subtracted? So, as we know our Erinne M Perry: income that are that is excluded for tax purposes that is going to be added back, because again it increases the cash that the company has. Yes, for tax purposes it's not recognized as income, but the reality is. Erinne M Perry: money is coming into the corporation vice versa, certain expenses, even though for tax purposes they are not deductible. It's still an expense. It's still money that's being paid out. And then again, there are some adjustments for some more complex situations.
12:30 - 13:00 Erinne M Perry: So one of the important things as we deal with Erinne M Perry: earnings and profits Erinne M Perry: is accumulated versus current E and P. So for our accumulated E and P. It's a total of all previous years, current E and P. Since February 28, th 1913.
13:00 - 13:30 Erinne M Perry: Obviously, there's Erinne M Perry: you know, some different laws before then. So as of 1913, it is reduced by the distributions made from emp in previous years. It is of the utmost importance to make sure that there's a distinction between the current earnings and profits and the accumulated earnings and profits, because the taxability of corporate distributions depends on how these 2 accounts are allocated to each distribution made through the year. So
13:30 - 14:00 Erinne M Perry: there's a bit of a complex set of rules that govern the allocation process, and we'll start to go through it. Erinne M Perry: So when it comes to allocating emp to distributions. So when there's a positive balance that exists in both the current and the accumulated emp accounts. It's fairly easy to know, you know, how to allocate, so in such case, corporate distributions, they're always deemed to be made 1st from the current earnings and profits, and then from accumulated emp.
14:00 - 14:30 Erinne M Perry: If there's only one distribution during the year, and the distribution is less than the total earnings and profits, both current and accumulated together, then the entire distribution is going to be classified as a dividend. Whenever there's multiple distributions, the total, and if the total distributions exceed Erinne M Perry: the amount of current emp, then it's necessary to allocate the current and accumulated earnings and profits to each distribution that's made during the year. First, st the current earnings and profits is prorated
14:30 - 15:00 Erinne M Perry: among the distributions, and there's a specific formula. So as we see here, we allocate the current emp pro rata, using the dollar amounts to each distribution, and we apply the accumulated Erinne M Perry: earnings and profits in chronological order.
15:00 - 15:30 Erinne M Perry: When the tax years of the corporation and its shareholders. Not the same, obviously, that adds a bit of nuance, a bit of complexity. Erinne M Perry: so it may be impossible to determine the amount of current emp on a timely basis, and allocation rules presume that current emp is sufficient to cover every distribution made during the year until the parties can show otherwise. Erinne M Perry: Now there's another scenario, if the current earnings and profit is positive, but the accumulated earnings and profits has a deficit, so in such case current, emp positive accumulated emp is, there's a deficit. At the time of distribution the current and accumulated emp are not netted. What happens in such cases that dividends are
15:30 - 16:00 Erinne M Perry: distributed to the extent of the current emp, and if the distribution exceeds the current, emp, the excess 1st reduces the stock basis to 0, and then from there generates a taxable gain.
16:00 - 16:30 Erinne M Perry: Let's say the accumulated emp is positive, and the current emp. There's a deficit. Erinne M Perry: In such case the current in the accumulated emp we net them. So I want you to keep that in mind when the current emp is positive and the accumulated emp has a deficit. They are not netted. However, when the current emp has a deficit and accumulated emp has a positive balance, the current in the accumulated
16:30 - 17:00 Erinne M Perry: E and P are netted. Erinne M Perry: Any loss in the current emp. It's deemed to have accrued ratably through the year, unless the corporation can show otherwise. And if, when we net the amount. Erinne M Perry: if it's positive. The distribution is a dividend to the extent of the balance, and if the distribution exceeds the net emp, then the excess 1st reduces the stock basis and then generates a taxable gain. Because again, as we mentioned the distributions from a corporation, there's 3 tiers. 1st is treated as a dividend.
17:00 - 17:30 Erinne M Perry: then it is treated as a reduction of stock basis, which is a non taxable return of capital, and then, lastly, any excess generates a taxable gain. Next, if the net amount is negative. When we net the current and accumulated emp, then the distribution is treated as a return of capital, 1st reducing the stock basis to 0,
17:30 - 18:00 Erinne M Perry: and then generates a taxable gain. Erinne M Perry: So here we have an example. Erinne M Perry: It shows there's a $20,000 cash distribution made at year end in each of the independent situations. So we see in this example. Erinne M Perry: there's an accumulated emp at the beginning of the year of a positive 100,000.
18:00 - 18:30 Erinne M Perry: There's a positive current emp of $50,000, Erinne M Perry: and the dividend that was distributed Erinne M Perry: is $20,000. Erinne M Perry: So in such case the entire amount is going to be treated as a dividend, we have a sufficient amount in our current emp as well as our accumulated emp. Erinne M Perry: In the second scenario we see that there's a positive current emp, and there is a deficit in our accumulated emp. So, as mentioned, whenever there's
18:30 - 19:00 Erinne M Perry: positive current emp and a deficit in our accumulated emp, the current and accumulated earnings and profits is not netting, so the distributions are dividends to the extent of the current emp, and if the distribution exceeds the current, emp, the excess reduces the stock basis to 0 and generates a taxable gain. So we see in this case
19:00 - 19:30 Erinne M Perry: the dividend is paid is 20,000, and the current emp is 50,000, so we have a sufficient amount of current earnings and profits. Therefore this $20,000 dividend. The entire amount would be treated as a dividend Erinne M Perry: in Scenario 3. Erinne M Perry: We see that there is a deficit in our current E and P. Erinne M Perry: And there is a positive accumulated emp, so, as mentioned.
19:30 - 20:00 Erinne M Perry: When the current and accumulated emp is netted, any loss in current emp is deemed to accrue rapidly throughout the year, unless the corporation can show otherwise. So when we net the 2, when we net the positive 15,000 for accumulated emp and we net the $10,000 deficit for current emp. Erinne M Perry: because the net amount is positive. The distribution is a dividend to the extent of the balance, and in this case it's $5,000.
20:00 - 20:30 Erinne M Perry: So therefore, the maximum amount of the $20,000. Cash distribution Erinne M Perry: is $5,000. The maximum amount that be treated as a dividend is 5,000, because again we netted the positive accumulated emp and the deficit in the current emp that gave us a positive 5,000. So that is the maximum amount that can be treated as a dividend Erinne M Perry: in the amount that let's say, it was the reverse, and the positive accumulated emp was 10,000, and the negative deficit for current emp was 15,000 when we net the 2 that would give us a negative 5,000. So in such case
20:30 - 21:00 Erinne M Perry: none of the dividend would be treated as none of the distribution rather would be treated as a dividend. Erinne M Perry: $0 would be treated as a dividend. From there Erinne M Perry: the distribution will be treated as a return of capital, reducing the stock basis to 0 and then generating a taxable gain. So again, that is why it is extremely important to distinguish between current emp and accumulated emp at the time of distribution.
21:00 - 21:30 Erinne M Perry: This brings us to unit 3 dividends. Erinne M Perry: so as it relates to dividends. Erinne M Perry: we know that this is one of the challenges of the corporate structure of a business. So distributions by a corporation from its emp are treated as a dividends. But, as we just learned, it ultimately depends on the
21:30 - 22:00 Erinne M Perry: earnings and profits, both current and accumulated. So the tax treatment of dividends it varies, depending on whether the shareholder receiving them is a corporation, or if it's an individual, all corporations, they treat dividends as ordinary income. Erinne M Perry: and thus they are permitted to claim the dividends received deduction. Erinne M Perry: and for individuals. Whenever qualified dividend income is received, it's taxed at reduced rate. So it's very important to distinguish for individuals. If it is ordinary dividends or qualified dividends.
22:00 - 22:30 Erinne M Perry: So there's some challenges, as mentioned with dividends being issued. So the double tax on corporate income has always been controversial right? That's 1 of the biggest nuances corporations. They pay taxes on their taxable income, and then they distribute
22:30 - 23:00 Erinne M Perry: dividends, or or they make distributions to the shareholders in the form of dividends and the amount that is treated as a dividend. The shareholder has to include it on their tax return, and then they also pay taxes on it. Erinne M Perry: So taxing dividends twice it creates some undesirable economic distortions, including the incentive to invest in non-corporate rather than corporate entities. Because, again. Erinne M Perry: why would you want to pay taxes twice the incentive for corporations to finance operations with debt rather than with equity, because the interest payments are deductible. So this increases the vulnerability of corporations in economic downturns because of higher leverage
23:00 - 23:30 Erinne M Perry: and incentives for corporations to retain earnings in structured distribution of profits to avoid the double tax. So again. Erinne M Perry: these are some of the challenges.
23:30 - 24:00 Erinne M Perry: Dividend payments are not deductible, but in here, where it says debt, this is Erinne M Perry: essentially where the corporation issues bonds, they borrow money in order to finance operations when they pay interest for the bonds. Those payments are deductible, but with equity, the stock, unfortunately, the payment of dividends not considered deductible right? So that's the challenge. That's something for those who have a corporate structure. That's something they have to consider, and the incentive for corporations to retain earnings and structured distribution. So
24:00 - 24:30 Erinne M Perry: there might be some things that you know corporations will do in order to avoid having to recognize it as a dividend, which we'll learn a little later. Erinne M Perry: So because of these challenges, these differing opinions, the taxation of dividends in the United States. Obviously it has varied through the year. So there's a reduced tax rate on qualified dividends for individuals, and this kind of helps to
24:30 - 25:00 Erinne M Perry: make it a little easier. The elimination of tax on dividends and the treatment of dividends as ordinary income. So for most individual taxpayers qualified dividends, they are treated similar to long-term gains to either taxed at 0%, 15% or 20%. Erinne M Perry: So qualified dividends are subject to a 15% tax rate. High income taxpayers are subject to a 20% tax rate and a 0% tax rate applies to lower income taxpayers. So corporations treat dividends as ordinary income and are permitted a dividends received deduction.
25:00 - 25:30 Erinne M Perry: So for most individuals dividends that meet certain requirements called qualified dividends, and if you look at a form 1099 d. Iv. Erinne M Perry: You will see that box. One shows the ordinary dividends, and then box 2 will show the qualified dividends so that way again, it factors in what the individual
25:30 - 26:00 Erinne M Perry: or how rather it will be taxed for the individual Erinne M Perry: all right. Erinne M Perry: and to qualify for lower rates the dividends must be. They have to be paid by a domestic or certain qualifying corporations.
26:00 - 26:30 Erinne M Perry: and obviously there are certain rules that must be met in order for it to be considered a a qualified foreign corporation. Erinne M Perry: The qualified foreign corporation includes those that are traded on the Us. Stock Exchange, or any corporation located in a country that has a comprehensive Erinne M Perry: income tax treaty with the Us. Has an information sharing agreement with the us, and is approved by treasury. That's the 1st requirement paid by domestic or certain qualified foreign corporation.
26:30 - 27:00 Erinne M Perry: 2 paid on stock that is held for more than 60 days during the 121 day period, beginning 60 days before the ex-dividend date. Erinne M Perry: and dividends paid to shareholders who hold both long and short positions in the stock
27:00 - 27:30 Erinne M Perry: do not qualify. So again, there's some specific requirements as it relates to the qualifying dividends Erinne M Perry: and qualified dividends are not considered investment income when determining the investment interest, expense, deduction. Erinne M Perry: So there's an election that's available to treat qualified dividends as ordinary income taxed at regular rates. Thus you would be able to include them in investment interest income. So obviously, there's a benefit to qualified dividends.
27:30 - 28:00 Erinne M Perry: It's taxed at a lower rate. But when you consider the interest. Erinne M Perry: deduction. Erinne M Perry: the interest, expense, deduction, rather than you know, there's some nuance there. So for certain taxpayers, it might be better to forfeit the dividends being treated as qualified income because they get the benefit of claiming the interest, expense, deduction, so
28:00 - 28:30 Erinne M Perry: different strokes for different folks. Thus, taxpayers that are subject to an investment, interest, expense, limitation. Again, they have to compare the benefit of low tax on the qualifying dividends versus the increased amount of deductible investment interest, expense. Erinne M Perry: Next, we have property dividends all right. Maybe they're not issuing cash. Maybe there's a form of a property. So, although most corporate distributions, they're generally cash a corporation, they may distribute a property dividend for various reasons. So, for example, maybe a shareholder might want a particular property that's held by the corporation. So similarly, a corporation that has low cash reserves, they might still want to distribute a dividend to its shareholders.
28:30 - 29:00 Erinne M Perry: Property distributions. They have the same impact as cash distributions, except Erinne M Perry: for the effects related to any difference between the basis of the property distributed and the fair market value of the property that has been distributed. So in most situations distributed, property is appreciated. What that simply means is that the basis of the property
29:00 - 29:30 Erinne M Perry: or the fair market value of the property rather exceeds the basis. So, for example. Erinne M Perry: there is a property the corporation owns. They paid $100,000 for it, and now the property is worth $150,000. The property has appreciated in value versus, let's say the
29:30 - 30:00 Erinne M Perry: corporation paid $100,000 for the property, and now it's worth $80,000. That would be an example of depreciated property. The value of the property has decreased below the basis. So again, in most situations the distributed property is appreciated. So it's sale Erinne M Perry: would result in a gain to the corporation. So in such case, distributions of property where the basis differs from the fair market value, there's several things that need to be considered, so the amount distributed equals the fair market value of the property.
30:00 - 30:30 Erinne M Perry: and it'll be taxable as a dividend to the extent of earnings and profits. Because, again. Erinne M Perry: there's questions that the shareholders need to consider as it relates to taxes. So the shareholder needs to consider what's the amount of the distribution. What is the basis of the property in the shareholders hand? The corporation, on the other hand, needs to think, okay, is this a gain or loss that need to be recognized as a result of the distribution. And what is the effect of the distribution on earnings and profits? So
30:30 - 31:00 Erinne M Perry: whenever the corporation distributes property Erinne M Perry: rather than cash to a shareholder. Again, the amount distributed is measured by the fair market value of the property on the date of distribution so much like the cash distribution. The portion of the property distribution Erinne M Perry: is a dividend with the to the extent of earnings and profits.
31:00 - 31:30 Erinne M Perry: Any excess is going to be treated as a return of capital to the extent of basis in the stock, and any remaining amount is treated as capital gain. Erinne M Perry: Next, we need to consider all right. Are there any liabilities assumed by the shareholder? And in such case, if liabilities have been assumed by the shareholder, then the basis, it's going to be reduced. Rather the amount of the distribution, and then the basis of the property that's distributed would be equivalent to the fair market value. So obviously
31:30 - 32:00 Erinne M Perry: there's a lot of nuance when it relates to property dividends. So Erinne M Perry: if they distribute depreciated property, it's not wise from a tax perspective, but again, appreciated property would make the most sense. But there are some things that the shareholder needs to consider. Was there a liability? Because Erinne M Perry: if the shareholder assumes the liability of the corporation. Then, in such case the amount of the distribution is reduced by the liability, but not below 0. So there's a lot to consider. This is an opportunity for tax planning, because obviously, if a corporation makes a distribution without fully considering the tax implications, not just to the corporation, but the shareholder as well
32:00 - 32:30 Erinne M Perry: it can. It can cause a lot of challenges. Erinne M Perry: So the effect on a corporation, all distributions of appreciated property generate a gain to the distribution distributing corporation. Because, again.
32:30 - 33:00 Erinne M Perry: let's say, the corporation did not issue or distribute the property to a shareholder. But it was a normal sale. It would be a gain if they sold appreciated property. So in such case. Erinne M Perry: if a corporation distributes game property, it's treated again as if it had sold the property to the shareholder for its fair market value. However, the distributing corporation would not recognize a loss on the distributions of property, so
33:00 - 33:30 Erinne M Perry: the corporation recognizes the gain, but not the loss. In the event. If the distributed property is subject to a liability in excess of basis, or the shareholder assumes a liability, there's a special rule that applies so for purposes of determining gain on a distribution, the fair market value of the property is treated as being at least the amount of the liability.
33:30 - 34:00 Erinne M Perry: And now we have to consider what impact would a property dividend have on the corporation's earnings and profits? So corporate distributions reduce earnings and profits by the amount of money distributed, or by the greater of the fair market value. Erinne M Perry: or the adjusted basis of the property that has been distributed less the amount of any liability on the property, and in the event that there's a gain, earnings and profits is increased by the gain recognized on the appreciated property that's distributed as a property dividend. So again.
34:00 - 34:30 Erinne M Perry: it increases emp for excess of fair market value over basis of property. So when a gain is recognized, but it reduces earnings and profits by fair market value of property distributed or basis, if greater. Erinne M Perry: less the liabilities on a property. So again, any distributions of cash or property, it cannot generate or add to a deficit in emp deficits and earnings and profits only arises through corporate losses, so something important to keep in mind.
34:30 - 35:00 Erinne M Perry: So here we have a property distribution. Example Erinne M Perry: says, property is distributed. Corporations basis is 20,000 in each of the following situations. It says, assume Erinne M Perry: current and accumulated emp are both a hundred $1,000 in each case.
35:00 - 35:30 Erinne M Perry: So here we see there's a fair market value of distributed property in scenario one. It's 60,000 scenario, 2, 10,000 and scenario 3, Erinne M Perry: 40,000. Erinne M Perry: So in scenario one, we see that the fair market value of the distributed property again was 60,000. There's no liability on the property. So the gain that's going to be recognized is 40,000. How do we know Erinne M Perry: we factor in the basis and the corporation's basis in a property was 20,000. It appreciated in value to 60,000. So there's a difference of 40,000, the earnings and profits that's increased by the gain is 40,000,
35:30 - 36:00 Erinne M Perry: and the earnings and profits would decrease Erinne M Perry: for the distributed property, because again, the fair market value is 60,000, there is a sufficient amount in current accumulated emp so, therefore. Erinne M Perry: the corporate distribution is reduced, or the corporate distribution. In this case the $60,000 reduces the earnings and profits by the greater of the fair market value or the adjusted basis of the property, and in such case the greater of the 2 the basis is 20,000,
36:00 - 36:30 Erinne M Perry: the fair market value is 60,000. So, therefore, the earnings and profits is decreased by the greater of the 2. Erinne M Perry: Next, we consider scenario 2. Where the fair market value of the distributed property is $10,000,
36:30 - 37:00 Erinne M Perry: so there's no liability on the property. Erinne M Perry: There's no gain. Erinne M Perry: Obviously the basis is 20,000. We sold it for 10,000. So that's a loss. And, as mentioned, the corporation only recognizes gains. They do not recognize losses. So therefore. Erinne M Perry: there's no loss recognized. There's no increase to earnings and profits because there was no gain. The decrease, however, again, the distribution reduces earnings and profits by the amount of money distributed, or the greater of fair market value, or the adjusted basis of property
37:00 - 37:30 Erinne M Perry: less liability. In this case Erinne M Perry: the basis is greater than the fair market value. So, therefore, we claim the greater of the 2, which is 20,000. Erinne M Perry: Scenario. 3. Erinne M Perry: The fair market value of the distributed property is 40,000. There's a liability on a property of 15,000. So now we need to determine the gain or the loss recognized.
37:30 - 38:00 Erinne M Perry: So Erinne M Perry: we see that the corporation's basis is 20,000, Erinne M Perry: and the fair market value of the distributed property is 40, Erinne M Perry: and then liability again is 15. So the gain and loss recognized Erinne M Perry: again. Basis of 20 Erinne M Perry: fair market value of 40. The gain or loss recognizes 20,000. Erinne M Perry: The earnings and profits is increased by the gain of 20,000. Now, as it relates to the earnings and profits decrease.
38:00 - 38:30 Erinne M Perry: the distribution Erinne M Perry: is always Erinne M Perry: reduced by the amount of the money distributed, or the greater of the fair market value or the adjusted basis of the property, and we see in this case Erinne M Perry: the fair market value is 40,000. The corporation's basis is 20,000. So we start off with the $40,000 fair market value. But again Erinne M Perry: it is reduced by the liability on the property, so 40,000,
38:30 - 39:00 Erinne M Perry: minus the $15,000 liability on a property. The earnings and profits is decreased by 25,000. The difference between the fair market value Erinne M Perry: and the liability on a property, and that is how we calculate the 25,000. Erinne M Perry: Next, we move on to what is called constructive dividends. So an economic benefit
39:00 - 39:30 Erinne M Perry: provided by our corporation to a shareholder can be treated as a dividend for Federal income tax purposes, even though it's not formally declared or identified as a dividend Erinne M Perry: so constructive dividends they don't need to be issued pro rata all shareholders, or satisfy the legal requirements of a dividend. So for tax purposes Erinne M Perry: constructive distributions are treated the same as actual distributions. So essentially as a result, the corporation that provides these constructive dividends. They're not allowed a deduction and corporate shareholders can use the dividends received deduction and non-corporate shareholders. They receive preferential treatments.
39:30 - 40:00 Erinne M Perry: The constructive dividends Erinne M Perry: or constructive distribution rather. Erinne M Perry: is taxable as a dividend to the extent of the current and accumulated emp anything in excess treated as a return of capital, then as a taxable gain.
40:00 - 40:30 Erinne M Perry: So this usually arises with closely held corporations. So this is because the dealings between the parties there's a structure, and they may not well be well documented. So the constructive dividend is often intended to convert a non-deductible dividend into some type of corporate deduction. Because, again, that's why, as we saw in the previous Erinne M Perry: slides that some corporations, they would much rather take on debt, so they can deduct the interest payment versus having equity, because payments of dividends are not considered deductible. So this is kind of like a tax avoidance kind of strategy
40:30 - 41:00 Erinne M Perry: so alternatively to shareholders, they may be seeking benefits for themselves while avoiding the recognition of income. So, although some constructive dividends are disguised dividends. Not all deliberate attempts to avoid dividends may be inadvertent, so it's very important to keep these in mind again, some of the benefits corporate shareholders they're entitled to the dividends received deduction and other shareholders. They receive preferential tax rates.
41:00 - 41:30 Erinne M Perry: so some examples of constructive dividends. Erinne M Perry: shareholders. They use corporate property at a reduced cost or no cost. So, for example, a company car to a non-employee shareholder, the bargain sale of property to a shareholder, for example, sale of a thousand dollars for property that's worth 10,000
41:30 - 42:00 Erinne M Perry: bargain rental of corporate property Erinne M Perry: payments on behalf of shareholders. So, for example, a corporation makes payments to satisfy obligation of shareholders, any unreasonable compensation, for example, a salary payment to a shareholder employee Erinne M Perry: any below market interest rate, loans to shareholders, or any high rate interest loans from shareholder to a corporation. So again, these are some of the most common types of constructive dividends.
42:00 - 42:30 Erinne M Perry: Next, we have unreasonable compensation. This is something that needs to be considered. So if there's a salary payment to a shareholder employee that's determined to be unreasonable compensation, it's going to be treated or well not might assuming. Erinne M Perry: obviously it is reviewed and determined by the Irs, that it is unreasonable compensation in such cases, treated as a constructive dividend. As a result it is not deductible by the corporation, so whether the compensation is reasonable or not, it ultimately depends on the facts and the circumstances. So, in order to determine the reasonableness of salary payments. There's some
42:30 - 43:00 Erinne M Perry: factors that have been used by courts. This includes the employees, qualifications, the comparison of their salary with dividends that have been made in the past any comparable salaries for similar positions in the same industry. The nature and the scope of the employees work, in addition to the size and the complexity
43:00 - 43:30 Erinne M Perry: of the business, and there might be. There are some other considerations. The comparison of salaries paid with the gross income, the net income, the taxpayers, salary policy toward all of the employees within the corporation for small corporations that have a limited number of officers. The amount of compensation Erinne M Perry: that has been paid to the employee in question in previous years. And whether a shareholder is, are they acting in the best interest of the corporation? All right? Would they have agreed to that level of compensation that they are receiving. So
43:30 - 44:00 Erinne M Perry: this is known. This last Erinne M Perry: point is known as the reasonable investor test, and it's been used in different ways by different courts. So in some cases the 7th Circuit Court of the Appeals, they rely solely on the reasonable investor test in determining reasonableness right? Because the shareholder, if they were acting in the best interest of the corporation, and they had to pay someone else what they considered a compensation that they are receiving, would they consider it reasonable
44:00 - 44:30 Erinne M Perry: right? On the other hand, the 10th Circuit Court of the Appeals, they ignore this factor, so other Federal circuits. They've used this approach that considers all of the factors in the list. And obviously this is like a challenging area of tax law. So the taxpayers, the Irs. And of course, they apply these factors we just discussed in different ways to help support conclusions, and sometimes, obviously, they differ.
44:30 - 45:00 Erinne M Perry: So one of the key things is for taxpayers, corporations. They have to keep good records, and they have to be prepared to defend the amount of compensation that is being paid, because, if not, they run the risk of it being treated as unreasonable compensation. Erinne M Perry: Therefore it would be treated as a constructive dividend, and it would not be deductible by the corporation.
45:00 - 45:30 Erinne M Perry: Next, we have loans to shareholders, so any advances to shareholders that are not bona fide loans. These are usually reclassified as constructive dividends so much like the reasonableness of compensation, whether in advance qualifies as a bona fide loan, it really all. Again, it depends on the facts. It depends on the circumstances. Erinne M Perry: So some factors that are considered in determining whether an advance to a shareholder is bona fide? Is, does the advance? Is it on an open account, or is it evidenced by a written instrument? Is there a note? Is there an interest rate? Does the shareholder, or did the shareholder furnish collateral or some other type of security for the advance, just like
45:30 - 46:00 Erinne M Perry: you know, in in the real world. Right? If you take out a loan. Erinne M Perry: there's generally some type of collateral. If you have a mortgage, a note on a home, if you don't pay, they'll take the home a car. You don't pay the car note. They'll take the car. So is there some type of collateral that the shareholder has provided for the advance? How long has the advance been outstanding? Were any repayments made? What is the shareholders ability to repay the advance?
46:00 - 46:30 Erinne M Perry: What is the shareholders use of the funds? Is it the payment of routine bills versus non-recurring, extraordinary expenses. What's the regularity of the advances? Does this happen very often in the business? It's just a 1 time thing. And what is the dividend paying history of the corporation. So
46:30 - 47:00 Erinne M Perry: even when a corporation makes a bona fide loan to shareholders, a constructive dividend may be triggered if it's interest free, because in reality, where are you getting an interest-free loan in this day and age? So in such case the constructive dividend will be equal to the amount of the foregone interest in the loan, and this would ultimately dependent
47:00 - 47:30 Erinne M Perry: on the interest paid by the Federal Government on new borrowings. That's compounded semi-annually. So there's a lot of nuance that goes into determine how much would be treated as a constructive dividend. Erinne M Perry: Next, we have stock dividends. So we've covered cash dividends. We've covered property dividends. Now we'll start to look at stock dividends. Erinne M Perry: So in general, stock dividends are excluded from income on the theory that ownership interest of the shareholder. It's unchanged as a result of the distribution. So when a stock dividend is declared, the shareholder ends up with additional shares of stock, but they retain the same total stock basis. So as a result, the shareholders basis is basically reallocated across both the original shares
47:30 - 48:00 Erinne M Perry: as well as the new shares. So in total, the basis stays the same. You owned a thousand dollars worth of shares. Erinne M Perry: You still own a thousand dollars. What does change is the per share basis.
48:00 - 48:30 Erinne M Perry: So again, it's excluded from income. If the pro rata distribution of stock or stock rights paid on common stock. So there's 5 exceptions to non-taxable treatment. And this deals with various disproportionate distribution situations, because, again. Erinne M Perry: just like cash distributions and property distributions, or Erinne M Perry: can be taken advantage of Erinne M Perry: as it relates to the impact the effect on earnings and profits. If it's non-taxable earnings and profits is not reduced, and if it's taxable, then it's treated as any other taxable property distribution.
48:30 - 49:00 Erinne M Perry: the basis of stock received, if it's non-taxable. If the shares received are identical to the shares that were previously owned, the basis equals the cost of the old shares divided by the total number of shares. If the shares received are not identical, you need to allocate the basis of the old stock Erinne M Perry: between the old and the new shares based on a relative fair market value, and the holding period includes the holding period of formally held stock. If it's taxable.
49:00 - 49:30 Erinne M Perry: the basis of the new shares received is equal to the fair market value, and the holding period starts on the date of receipt. So that's our stock dividends. Next, we have what's called stock rights. So the rules for determining the taxability of stock rights is identical to those for determining a tax Erinne M Perry: taxability of stock dividends. If the rights are taxable, then a recipient has income equal to the fair market value of rights, and then from there the fair market value becomes the shareholders
49:30 - 50:00 Erinne M Perry: basis in the rights, and if the rights are exercised in the holding period for the new stock begins on date of of rights, and this is ultimately, whether it's taxable or non-taxable. Erinne M Perry: the basis will be equivalent to the fair market value of the stock rights. If it's exercised again, the holding period begins on the date that the rights are exercised, and the basis of new stock will be equal to the basis of rights plus any other consideration that is given.
50:00 - 50:30 Erinne M Perry: and if the stock rights are non-taxable, so if the value of rights received are less than 15% of the value of old stock, then the basis in rights is 0. There is an election available which allows allocation of some basis of formally held stock rights. And if the value of rights is 15% or more
50:30 - 51:00 Erinne M Perry: of the value of old stock, and the rights are exercised or sold. It must allocate some of the basis in the formally held stock. Right? So obviously, there are some nuance to determining how the stock rights are going to be treated dependent on. If it is taxable versus if it is non-taxable, and, as we see in this case, if it is non-taxable, if the values of the rights are less versus, if the value of the rights are more, the treatment is different.
51:00 - 51:30 Erinne M Perry: So there's some very key things to keep in mind, as it relates to tax planning, because again, it would be not wise for a corporation to make distributions and not consider the tax implications to the corporation as well as to the shareholder. So there's some key things that are especially important when planning for corporate distribution. So they need to maintain ongoing records of earnings and profits, because, as we learned.
51:30 - 52:00 Erinne M Perry: it ultimately determines our accumulated and current emp determines the extent to which the distribution is going to be treated as dividends, so maintaining an ongoing records of earnings and profits. This ensures that the return of capital is not taxed as a dividend. Erinne M Perry: There's no statue of limitation on earnings and profits, so the Irs, at any time they can decide to redetermine and accurate records minimize this possibility
52:00 - 52:30 Erinne M Perry: need to adjust the timing of the distribution to optimize the tax treatment. So if there's an accumulated emp deficit in a current emp loss. They make the distribution at the end of the tax year to achieve a return on capital. Erinne M Perry: If current Emp is likely Erinne M Perry: it would make the most sense to make the distribution at the beginning of next year to defer taxation.
52:30 - 53:00 Erinne M Perry: as it relates to retirement. Plans reduced tax rates are not available when stock is held in retirement. Erinne M Perry: Accounts! Erinne M Perry: Distributions from these plans are taxed at ordinary rates. So again, something to keep in mind. Erinne M Perry: internal individual alternative minimum tax. So the lower rates on dividends and long term capital gains. It applies under both the regular income tax as well as the alternative minimum tax. So
53:00 - 53:30 Erinne M Perry: this increases the exposure of many individuals to the alternative minimum tax, particularly those that have significant income from dividends or long-term capital gains. So as a result. Erinne M Perry: individuals who have to pay the alternative minimum tax, they have to consider modifying their investment strategies, because, again. Erinne M Perry: if they appropriately manage the mix of ordinary income dividend income and capital gain income, they can minimize the alternative minimum tax often referred to as Amt.
53:30 - 54:00 Erinne M Perry: Next, with closely held corporations closely held. Corporations have considerable discretion regarding their dividend policies, but in the past the double tax result provided strong motivation to avoid payment of any dividends, because, again as a corporation. You don't want to pay the corporate tax, and then the shareholders again have to pay taxes on the dividends. So as a result.
54:00 - 54:30 Erinne M Perry: there was compensations, loans, lease, agreements, because the salaries, interest, and rent are considered deductible. But Erinne M Perry: however, under current law shareholders, they might prefer dividends, because salaries, interest and rent are taxed at ordinary rates, whereas dividends received Erinne M Perry: for preferential treatment. So as a result. Erinne M Perry: they ultimately have to ask themselves, you know, and as a tax accountant, or you are, as you are helping your client
54:30 - 55:00 Erinne M Perry: to determine how to distribute it. Should the corporation or the shareholder benefit, or how will their they benefit, and ultimately that will help you decide on which strategy would be best. Erinne M Perry: Next, we have avoiding constructive dividends. So in order to avoid constructive dividends, tax planning Erinne M Perry: obviously, can be very effective. To avoid constructive dividend situations and the shareholders, they should try their best to structure the dealings with the corporation on an arm's length basis. So, for example, reasonable rent should be paid for the use of corporate property, and a fair price should be paid to a shareholder for its purchase.
55:00 - 55:30 Erinne M Perry: The party should support the amount involved with appraisal data or market information, something that's obtained from reliable sources near the time of the transaction, as it relates to loans, the party should provide an adequate rate of interest. There should be a written evidence of the debt, and should also establish a realistic payment schedule.
55:30 - 56:00 Erinne M Perry: and then just using a mix of techniques to bail out corporate earnings such as shareholder loans to corporation salaries, to shareholder employees, rent property to corporation, pay some dividends. And again overdoing any one of these techniques. Erinne M Perry: you basically are telling Uncle Sam, hey, come, check this out. And if they do, and you do not have anything to substantiate the amounts. Unfortunately it would be treated as a constructive dividend. So this brings us to the end of Chapter 5 corporations, earnings and profits and dividend distributions. So now that this lesson has ended, you should have learned how to explain the role that earnings and profits play in determining the tax treatment of distributions.
56:00 - 56:30 Erinne M Perry: compute a corporation's earnings and profits, determine taxable dividends paid during the year by correctly allocating current and accumulated emp to corporate distributions.
56:30 - 57:00 Erinne M Perry: describe the tax treatment of dividends for individual shareholders, evaluate the tax impact of property distributions by computing the shareholders dividend income basis in the property received, and the effect Erinne M Perry: of the distribution Erinne M Perry: on the distributing corporation Erinne M Perry: recognize situations when constructive dividends exist and compute the tax resulting from such dividends Erinne M Perry: determine the tax implications arising from receipt of stock dividends and stock rights
57:00 - 57:30 Erinne M Perry: and the shareholders basis in the stock right and stock rights received. And lastly, structure corporate distributions in a manner that minimizes the tax consequences to the parties involved. Erinne M Perry: as it relates to proper tax planning.