State Tax Consequences to Shareholders on Distributions of Property

By David Friedel, J.D., and Yaw Awuah, J.D., Washington

Editor: Annette B. Smith, CPA

Corporations & Shareholders

When a company distributes property to its shareholders, tax consequences arise for the distributing corporation and the receiving shareholder. This item addresses the state tax consequences to the shareholder, which can differ between states with separate-return filing rules and states that follow the federal consolidated-return filing rules.

For the receiving shareholder, Sec. 301(c) requires that the amount of the distribution first be treated as a dividend to the extent of the company's earnings and profits (E&P), then as a return of basis, and finally as gain from the sale or exchange of property. In the case of a corporate shareholder owning at least 20% of the stock of the distributing company, a special rule under Sec. 301(e) applies to determine the amount of E&P available to fund any dividend, thereby affecting the taxable income of the corporate shareholder.

Corporate shareholders generally are permitted to claim a deduction under Sec. 243 to offset a portion of the dividend income they receive. The dividends-received deduction (DRD) generally is 70% for corporate shareholders that own less than 20% of the distributing corporation's stock, 80% for 20%-or-more-owned corporate shareholders, and 100% for 80%-or-more-owned corporate shareholders if the distribution is paid out of E&P generated in tax years in which the distributing and distributee corporations were part of the same affiliated group for every day of those years.

The examples below focus primarily on domestic companies. Example 1 analyzes the tax consequences of a simple distribution that disregards complications including the application of Secs. 1059 and 301(e). Example 2analyzes the application of Sec. 1059 but disregards application of Sec. 301(e). Sec. 301(e) is explored under Example 3, which circumvents the extraordinary-dividend rules by pushing the date of the distribution to more than two years after the corporation's acquisition of stock.

Example 1: P purchases 100% of S's stock on April 15, 2014, for $5,000. Both P and S are calendar-year, accrual-method taxpayers. P has no current or accumulated E&P, but S has current E&P of $800 for 2014 and accumulated E&P of $1,200 coming into 2014 (see Exhibit 1). S distributes $750 to P on July 1, 2014. What are the tax consequences of the distribution?

Tax Clinic Exhibit 1

States with separate-return filing rules:
In a state that has separate-return filing rules, P first treats the distribution as dividend income to the extent of S's E&P, pursuant to Sec. 301(c). P and S were not part of the same affiliated group for all of 2014 (the year with $800 E&P from which the distribution was made). Therefore, pursuant to Sec. 243, the dividend does not qualify for a 100% DRD. Instead, P is limited to an 80% DRD ($750 × 80% = $600) and will have the remainder as taxable income ($150) (see Exhibit 2).

Tax Clinic Exhibit 2

The impact of the distribution on E&P and stock basis is shown in Exhibit 3.

Tax Clinic Exhibit 3

Because there is excess E&P to cover the distribution, Sec. 301(c)(2) basis recovery will not apply. Therefore, P still has $5,000 basis in the stock at the end of the year.

States that follow the federal consolidated-return filing rules: Assuming that P and S are filing a consolidated return and that the distribution occurs in a consolidated-return year, S's E&P is irrelevant. Pursuant to Regs. Secs. 1.1502-13(f), the entire amount of the intercompany dividend is not included in the gross income of the distributee shareholder. Rather, P reduces its basis in the S stock by the full amount of the distribution ($750). Therefore, P's basis in the stock after the distribution is $4,250 ($5,000 − $750). (Note there are certain rare exceptions to this "dividend elimination" rule. For further discussion, see Friedel, "Intercompany Dividends Matter More Than You Might Think," 34 J. Corp. Tax'n 5 (September/October 2007).)

If the distribution exceeds P's basis in the S stock, the remainder of the distribution creates an excess loss account. This is one major difference from a state that has separate-return filing rules pursuant to which, after return of basis, any excess generally results in the current recognition of gain from the sale or exchange of property.

Note also that while P had $150 in taxable income in a separate-filing state, P had no income in a state that follows the federal consolidated-return rules.

Example 2: In this example, the facts are the same as in Example 1, except that P purchases the S stock on Dec. 31, 2013, for $5,000 instead of on April 15, 2014. What are the tax consequences when S distributes the $750 to P on July 1, 2014?

States with separate-returnfiling rules: With the transaction date moved up, P and S are now affiliated for every day of 2014 until the distribution is made on July 1, 2014. P now qualifies for a 100% DRD under Sec. 243 because all the E&P funding the dividend was generated in a year in which P and S were affiliated on every day (see Exhibit 4).

Tax Clinic Exhibit 4

Impact of the distribution on E&P and stock basis:
The impact of the distribution on E&P is the same as in Example 1 above for P and S. Also, the impact of the distribution is the same for P's basis in the stock as in Example 1 because the distribution did not exceed S's current E&P, and Sec. 301(c)(2) will not apply. Therefore, P still has $5,000 basis in the stock at the end of the year (see Exhibit 5).

Tax Clinic Exhibit 5

Observation
:
By changing the date of the transaction, P earns its way to a 100% DRD and eliminates $150 in taxable income.

Most states analyze distributions by first looking at taxable income. For states that apply the federal DRD, the results mostly would be in line with the description above. However, DRD results may differ depending on the starting point for application of Sec. 243 in the state and on application of other state rules that vary from the federal rules.

Moreover, as previously noted, Sec. 243 does not apply to intercompany dividends paid by one member of a consolidated group to another. Therefore, a state DRD is highly likely to differ from what is reported on a federal consolidated form. State corporate tax return preparers should watch for these issues.

Other consequences of distributions to shareholders: Other considerations come into play when a company distributes property to its shareholders. For example, the distribution may be considered an extraordinary dividend to P if certain conditions under Sec. 1059 are met, including (1) that the distribution exceeds 10% of P's basis in the S shares and (2) that the distribution occurs within two years of P's acquisition of the stock. If these requirements are met, P must currently reduce its basis in the S stock by the DRD it is claiming.

Therefore, in Example 2—where the Sec. 1059 requirements are met (the distribution exceeds 10% of P's basis in the S stock and occurs within two years of P's acquisition)—the distribution is considered an extraordinary dividend to P, and P must reduce its basis in the stock by the amount ($750) of the DRD. As a result, P's basis in the S stock is reduced to $4,250 ($5,000 ‒ $750).

Note that Sec. 1059 also applies in Example 1 (although its application was disregarded)—the $750 distribution in Example 1 exceeds 10% of P's basis in the stock, and the distribution occurs within two years of P's acquisition of the stock. In that case, though, P claimed only a DRD of $600 and therefore would have been required to reduce its basis in S's stock from $5,000 to $4,400.

Yet another consideration comes into play if the distribution is to a 20% corporate shareholder. Under Sec. 301(e), if the distribution is made to a 20% (by vote or value) corporate shareholder that is entitled to a DRD, the distributing corporation must recompute its E&P for purposes of determining the tax consequences of the distribution to the shareholder.

The adjustments required under Sec. 301(e) modify several of the E&P rules under Sec. 312. For instance, Sec. 312(k) ordinarily requires a straight-line allowance for depreciation for purposes of computing E&P. However, Sec. 301(e) "turns off" that part of Sec. 312(k), causing the (typically larger) accelerated depreciation deductions to be taken into account, thus generally resulting in a lower E&P amount to determine the tax consequences of the distribution to the 20% corporate shareholder. For further discussion, see Stalter and Friedel, "Sec. 301(e)—Some Unusual Consequences," 31 The Tax Adviser 463 (July 2000).

Example 3: P purchases 100% of S's stock on Dec. 31, 2010, for $5,000. P has no current or accumulated E&P. S has current E&P of $1,000 for 2014 and no accumulated E&P coming into 2014. Also, S has $200 in accelerated depreciation for 2014 that would be $50 under the straight-line method, resulting in a $150 difference between the two methods. S distributes $900 to P on July 1, 2014. What are the tax consequences of the distribution?

States that have separate-return filing rules: Sec. 1059 does not apply because the distribution occurs more than two years after P acquires the S stock. However, Sec. 301(e) applies because P, a corporate shareholder, owns more than 20% of S and is entitled to a DRD under Sec. 243. Therefore, S must recompute its E&P under Sec. 301(e) as shown in Exhibit 6. After adjusting for Sec. 301(e), S now has $850 of current E&P available instead of $1,000 of E&P when Sec. 301(e) does not apply. P has a 100% DRD because it was affiliated with S for all of 2014 (see Exhibit 7).

Tax Clinic Exhibit 6

Tax Clinic Exhibit 7

Impact of the distribution on E&P and stock basis:
For both S and P, the normal mechanics of E&P adjustment apply. Sec. 301(e) has no effect on the E&P adjustments and, as noted, applies only for determining P's taxable income from receiving the distribution (see Exhibit 8).

Tax Clinic Exhibit 8

Because S did not have sufficient E&P after the Sec. 301(e) recalculation to cover the distribution, for P, the remaining $50 from the distribution goes to reduce P's basis in the stock, pursuant to Sec. 301(c)(2).

For states that have conformed to the Internal Revenue Code, the above results will be the same on the state tax return. However, as previously noted, if the state has conformed only to part of the Code or has its own provisions that come into play, then a different calculation of state E&P may be necessary, resulting in a different taxable income amount on the state return.

Note that Sec. 301(e) actually applies in all three examples. However, its effect was disregarded in Examples 1 and 2 to facilitate understanding of the nuances that apply when distributions are made to corporate shareholders.

States that follow the federal consolidated-return filing rules: Sec. 301(e) does not apply within a consolidated group, and, as a result, S's E&P is irrelevant. Pursuant to Regs. Sec. 1.1502-13(f), the amount of the distribution in intercompany transactions is not included in the gross income of the distributee shareholder. Rather, P reduces its basis in the S stock by the full amount of the distribution ($900). Therefore, P's basis in the stock after the distribution is $4,100 ($5,000 ‒ $900).

Overall Observation

Many subtle differences come into play when a company distributes property to its shareholders, in particular, corporate shareholders. These nuances may cause the state return to differ from the federal return if the state has separate provisions that apply. Therefore, state tax return preparers should be aware of them and how they may cause a corporation's state return to differ from its federal return.

EditorNotes

Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 202-414-1048 or annette.smith@us.pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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