Sample Answers to Question 2
Corporate Tax
Spring 2015

Exam No. 1608

To determine the tax consequences of many of the transactions described in the problem, it will be necessary to determine Distco's current E&P in the year of the distribution. The E&P computation starts with the corporation's taxable income. Then it adds back in certain exclusions (e.g. tax exempt bond interest) and certain deductions (e.g. dividends received from other corporations). Then it deducts certain items that are normally not deductible, e.g. federal corporate income tax. Certain timing adjustments must also be made, whereby you adjust the E&P by adding or subtracting timing adjustments made to the taxable income (e.g. depreciation periods, LIFO inventory calculations). Here Disco's gross income is 1,000,000 with 800,000 worth of deductions. Thus, it's taxable income is 200,000. Some deductions and exclusions will be added back to that number, and some items will be subtracted. The problem does not provide enough information to determine the exact current E&P, but it is likely that there is more than 100K of current E&P. Any gain that the corporation recognizes under 311(b) on account of distributions will also be added to this number.

Payment for services

Disco will probably be able to deduct any salary it pays to R and S for their services to the corporation from it's taxable income as a business expense. Any amount that R and S receive in exchange for their services will be treated as ordinary income. However, if the compensation they receive in exchange for their services is determined to be unreasonable, the excessive portion of those payments may be treated as dividend (no deduction for the corp, capital gain for the SHs).

If any payments that Disco makes to S for her work developing strategic plans is characterized as a start up expenditure, some portion of it (5K max) may be deductible as a start up expenditure.

July 15 distributions

IRC 301 governs the SH's consequences of a distribution of property made by a corporation with respect to its stock, like the July 1, 2015 distribution (cash and inventory are both property for 301 purposes. 317(a).

The amount of a distribution under 301(b) is the amount of cash distributed plus the FMV (determined on the date of distribution) of any property received, reduced by any liabilities assumed by the SHs. So, in the case of both SHs (R and S), the amount of the distribution is $60K (60K cash to R, 60K FMV to S).

The next step is to determine how much of that amount is a dividend defined by 616. A distribution is a dividend to the extent that is made out of the E&P for the current year or, if the current E&P are insufficient, out of the accumulated E&P. Here Disco has a 150,000 deficit in E&P. Thus, the July 1 distribution will be treated as dividends to each SH only to the extent of this years E&P.

Distribution to Ruby

Cash distributions are dividends to the extent that they are made out of current or accumulated E&P. To determine whether a SH has a dividend out of current E&P, it is necessary to wait until the end of the taxable year and look at the full year's current E&P. In this case, it appears as though there will be enough current E&P to cover the entire distribution to Ruby. As a result, the entire distribution will probably be a dividend, taxable at capital gains rates. If there is not enough E&P to cover the cash distribution, the portion of the distribution that is treated as coming from the current E&P is determined using the following formula: (amount of the distribution) x (current E&P/total current distributions). The remainder of the distribution would be treated first as a return of R's basis in the stock, and then as income from the sale or exchange of the stock, probably a capital gain in R's case where it appears that she holds the stock as a capital asset. (R's basis is more than enough to cover the distribution). If the distribution is treated as a return of basis, the SHs' (both R&S) stock basis going forward will be reduced to that extent.

Distribution to Sam

When a corp distributes property to its SH, the amount of the distribution is the FMV of the distributed property on the date of the distribution reduced by any liabilities to which the property is subject. 301(b). Here, the amount of the Distco's distribution to Sam is 60K, the FMV of the inventory. The portion of the distribution that is dividend is determined under the same rules as described above. Thus, the distribution is a dividend to the extent of Disco's current E&P. It's important to note here, that on a distribution of appreciated property, the distributing corp increases its current E&P by the gain recognized under 311(b) (discussed below), reduced by the corporate tax paid on the gain. 312(b)(1). So here, Disco's transfer of inventory to Sam increases the current year's E&P by nearly 20K. As a result, (and as described above) it's likely that there was enough current E&P to cover the distributions to both S and R. So like Ruby, the distribution to same is probably a dividend taxable at capital gains rates. The same analysis as above applies if the current E&P is insufficient to cover the distributions: dividend to the extent of E&P, then treated as a tax free return of Sam's basis.

Consequences to Distco.

Normally a corporation's E&P is reduced to the extent of distributions made to SH's, however a distribution may not result in a deficit in accumulated E&P. So to the extent that Distco's rolls any current E&P into the next year, it will be reduced by the amount of the distributions to R and S.

Under 311(b), Distco will recognize a gain on the non-liquidating distribution of appreciated inventory to Sam. As mentioned above, that distribution also increases the corp's current E&P by the amount of the distribution less corporate taxes paid on any gain. (Once you have appreciated property inside a corporation, the lobster trap is in full effect and you can't get it out without paying corporate tax on the gain. Thus, Disco will recognize $20K (60 realized - 40 basis) gain as a result of the distribution, and because the property is inventory, the character of the gain will be ordinary.

Bonuses

The bonuses that Disco pays to its regular employees will be deductible to the corporation as a business expense.

The 35K bonuses that R&S receive will probably be treated party as a bonus based on their services performed and part as a distribution, with effects similar to those described above. This determination will be based on whether the bonuses are determined to be unreasonable compensation. It seems as though at least part of the distribution will be treated as unreasonable based on its proportion to the bonuses for other employees, so it's likely that at least part of it will be treated as a constructive distribution to the extent that it is excessive. The analysis of that distribution will be similar to that described above.

Exam No. 1682

Distco is not an S Corp because Sam is a non-resident alien. Thus, they are a C Corp.

July 1 Distributions

Per IRC 301(a), a distribution of property made by a corporation to a shareholder on its stock could be a dividend. Property is defined in IRC 317(a), and includes money, securities, and any other property, except it does not include stock of the distributing corporation. IRC 301(c), there is a three part pecking order of what a distribution to a shareholder could be treated as for the shareholder's purpose. If it is a dividend, it is treated as gross income, and taxed as a capital gain. If it is not a dividend, it applies against and reduces the shareholder's basis, and is tax free to that extent. Then, when the shareholder is out of basis, it is treated a gain from the sale or exchange of property, and is thus a capital gain. The term "dividend" is defined in IRC 316(a), and there are two ways a distribution can be a dividend: (1) if the corporation as accumulated E&P from any time before 2/28/1913; or (2) if the corporation has E&P in the current year, and we don't know this until the year closes. Most corporations have a lot of E&P, and thus all distributions are dividends. But, this corporation is in is infancy, and thus maybe the shareholders can use some of their basis. We know that Distco has negative 150k in is E&P account. Distributions out of accumulated E&P go in order, and thus each might get different treatment.

So, we know that on July 1, Distco distributes $60k cash to Ruby, and $60k (and with a basis of $40k in the hands of Distco) of inventory to Sam. Even though it has negative accumulated E&P, these distributions are going to be dividends to some extent because we know that for 2015, Distco had gross income of $1,000,000 and deductions of $800,000. This, on its face, this means there is positive E&P of $200,000, and these will constitute nimble dividends to at least some extent. However, because all distributions in the same year get the same treatment, we have to continue on in the problem to figure out to what extent these distributions will be dividends to Ruby and Sam, and to what extent they can use their basis to offset.

For Distco, when a corporation distributes property to the shareholder, per IRC 311(b), the corporation recognizes gain to the extent of the gain, but it cannot recognize a loss. Thus, on this July 1 distribution, the corporation will have $20k of gain, and this constitutes E&P. Thus, in the running E&P tally, it has $20k from this transaction, and $200k from its gross income minus deductions. Distco does not recognize any gain on its cash distribution to Ruby, and thus E&P is unaffected for now by that transaction.

December 20:

Now, Distco pays bonuses to all employees. We know from what we've been given that Distco pays $30,000 to all nonshareholder employees, which is 3% of their base salaries. This means that Distco has a payroll of $1 million. Ruby and Sam each receive a bonus of $35k. To some extent, these "bonuses" have dividend potential. We do not know what Ruby and Sam's salaries are. Generally, with S corporations, per IRC 162(a)(1), only a "reasonable allowance for salaries and other compensation is allowed to shareholders for personal services actually rendered. The C Corp cannot pay unreasonably huge salaries and bonuses to shareholders that are actually just dividends. Unfortunately, the test here is a reasonableness test. A few things jump out--for one, Ruby and Sam are not equal "employees" to Discorp. Ruby works 50 hours per week. Sam, on the other hand, works part time, only 15 hours per week, and but he contributes a lot of value--he brings in customers and is at the helm of all of the strategic plans. I am assuming that because we do not have a fact about the salaries of the two, that they are simply not paid a salary. As an aside, the corporation probably should pay them a salary--it looks like they have the money, and the corporation can deduct the salary as an ordinary and necessary business expense. Also, paying them a salary gives the corporation a degree of reasonableness when it pays bonuses--if it pays a 3% bonus to all employees based on their salary, it has a good argument that the year end bonus is actually a bonus to Sam and Ruby, because it looks similar to the other payments that are definitely bonuses to the other employees, because they do not even own stock. Instead, here, there are no salaries to Sam and Ruby, and these $35k payments look more like dividends. If they were bonuses, they would be different for each of them to reflect the different amount of services each provided. Instead, they equal each other, and because each has an equal interest in the company, they definitely look more like dividends. If they are dividends, we treat them as described above. If not, they are wages, which are subject to FICA taxes--the corp will pay about half of 15.3% on them, and Ruby and Sam will pay the other 15.3%. Then, to Sam and Ruby, they are personal income. The corporation can deduct them as an ordinary and necessary business expense. Thus, the $30,000 bonus to the employees means total deductions are $830,000, and corporate income is thus $170k. If the bonuses to the shareholders were really bonuses, they would reduce profit, and thus E&P for this year, by another 35k. Unfortunately. this would not help the dividend potential of the July 1 distributions at all because 2015 profit would still exceed the $120k total dividend, but it gets them close. The bonuses to the other employees get the same treatment. However, if they are dividends, the corporation cannot deduct them, and instead they must come out of post corporate tax earnings. Further, if they are dividends, they get thrown in the pot of dividends from July.

Thus, going on the assumption that the bonuses paid to Ruby and Sam are not really bonuses, and instead income, DisCo does not get a deduction for them. Thus, E&P for this year $220k from above, minus the $30k bonus paid to the actual employees, and thus it is $190k for the year.

Dividends:

Thus, we have current E&P of $190k, and total dividends of $120k in July, and $70k in December. Thus, because the total amount of dividends does not exceed the total amount of E&P for the year, all of these distributions to Ruby and Sam are dividends under IRC 316(a)(2) and IRC 301(c)(1). Unfortunately for them, each of them cannot use their basis.

Ruby:

Ruby received $60k in July, and $35K in December. She cannot use any of her basis, and thus has capital gain of $95k.

Sam: Sam received property with an FMV of $60k in July, and $35k cash in December. Per IRC 301(b), when property is distributed to a shareholder, the potential gain to the shareholder is the FMV of the property, and the basis is the FMV of the property. Thus, Sam recognizes $60k on the transfer of the inventory as a capital gain, and he might have a cash flow problem. Further, he recognizes the full $35k bonus as a dividend and a capital gain, and owns that in capital gain as well.

Once the shareholders have paid tax on these dividends, the corporation can reduce its E&P by the amount of the dividend. Thus, to start 2016, the corporation will have a negative E&P of $150,000, which is the negative accumulated E&P it had started with.

If for some reason the bonuses that the corporation paid to Ruby and Sam in December were not treated as bonuses, and the corporation was smarted, we have a slightly different situation. Here, deductions for 2015 would be $900k, including all of the bonus money. Thus, if the corporation had paid even a modest salary to Sam and Ruby (totaling more than $100k in total salary and FICA and Medicare taxes), now its E&P for 2015 is also negative. Because it had negative accumulated E&P, now any money that it wants to pay out to Ruby and Sam is not a dividend, but instead a (c)(2) distribution that reduces the adjusted basis of the stock of the shareholders. Thus, In this situation, Ruby could get up to $100k tax free, and Sam could get up to $200k tax free. Obviously, the salary dynamic might change some of the choices the corporation made, and if Sam and Ruby are in high personal income tax brackets, they might be paying a higher tax rate on the salary then they are at the capital gain rate, (particularly Sam, because he probably spends the other 25 hours in his week doing other stuff and making money), but this is definitely something to think about. We can make this corporation look a lot less profitable than it looks right now, and in that case it itself would pay less tax. Also, with paying salaries to Sam and Ruby as described above, the corporation itself could potentially avoid corporate tax for 2015.

Exam No. 1023

The transactions at issue here is the current, non-liquidating distributions that are being made by Distco (D) to its shareholders, Ruby (R) and Sam (S).

July 1, 2015 Distributions

Distco

D does not recognize any income when it distributes the cash distribution to Ruby, and to the extent it is a dividend, it would not be deductible by D. The only impact of the cash distribution to D is a reduction in its E&P by the amount R is taxed on per § 312. D recognizes gain on the appreciated asset it is distributing to Sean per § 311(b). The 20k gain would be taxable as ordinary income based on the nature of the asset. This $20k gain (minus corp tax on it) would contribute to the taxable year's current E&P, which would be determined at the end of the year.

Ruby

Distco makes a cash distribution of $60k cash to Ruby. This amount would be taxable as a dividend (as defined under § 316) to R to the extent of D's current or accumulated E&P per § 301(c)'s pecking order. If there is no current or accumulated E&P, she would get to use her basis against the distribution, which would not be taxable to R. If it's not a dividend and the amount of the distribution is greater than her stock basis, she would realize a gain. Whether this cash distribution is a dividend to Ruby would not be determined until the end of the current taxable year. Because there is a deficit in accumulated E&P, any nimble dividend she receives would come out of current E&P, which would be taxable to R at capital gain rates.

Sam

Sam receives inventory - a distribution with respect to his stock under § 301. The question is whether this distribution is a dividend. The amount of the distribution is equal to the FMV = $60k. The $60k will be taxable as a divided at capital gain rates to S to the extent the D has current E&P (facts tell us there is a deficit of accumulated E&P). S can apply the amount of the distribution exceeding the available current E&P (if any) against the distribution and reduce the basis in his stock (§ 301(c)(2)). If the amount of distribution exceeds his stock basis, it will be treated as a gain from the sale or exchange of stock to S. Under § 301(d), S's basis in the property he received in the distribution is the FMV of the property = $60k.

December 20, 2015 Distributions

Distco

The main issue with the bonuses D is paying to R and S here is whether these bonuses are actually constructive dividends paid by D. Because S and R are both employees of D as well as shareholders, D has attempted to distribute earnings in a form that may be deductible at the corporate level as a business expense (payment of wages/salaries). The bonus is 3% of base salary, so it is highly suspicious that R and S are receiving the same bonus amount when R works about 50 hours per week, while S only works part time. This could be considered excessive compensation to S, which goes against the "reasonableness test" of salary deductions allowed under § 162(a)(1). The bonus to R will likely be considered a deductible business expense because it would be for services actually rendered and for a reasonable amount. However, it doesn't seem that S's 15 hours a week would earn him the same bonus when he is not rendering the same services - the amount of compensation is unreasonable. Thus S's bonus would not be deductible by D.

By paying out a salary/wages to shareholders who are also employees, D is gaining an advantage by zeroing out the corporate tax and increasing the shareholder tax by a lesser amount.

Ruby

The bonus R receives would be taxable to her as ordinary income. As discussed, it does not seem like there would be a constructive dividend issue with her considering she does render a significant amount of services to the corp and got reasonable compensation for that. This income, would be subject to social security and medicare taxes, half of which would be paid by R (and the other half by D).

Sam

The bonus S received would likely be considered a constructive dividend. Accordingly, this would be taxable to S (albeit at capital gain rates) to the extent that there is current E&P (no accumulated). If not, he would get to use his basis against it, and get taxed on the excess as a gain from a sale of an asset.

For 2015

The net income for the year is $200k, from which taxable income would be determined. After the adjustments described in § 312 are made to the taxable amount, that would give us current E&P for the year. The $20k gain (minus corp tax on it) recognized by D in its distribution of inventory to S would also be added to that current E&P. To the extent that amount covered R's cash distribution (60k) and S's constructive dividend from his bonus, they would be taxable dividends to the respective shareholders.

Created by: bojack@lclark.edu
Update:  6 Feb 16
Expires:  31 Aug 17