Shareholders recognize a taxable dividend to the extent a distribution is paid out of corporate earnings and profits (E&P). If the distribution exceeds E&P, the excess reduces the shareholder's stock basis. Any amount in excess of the shareholder's stock basis is capital gain (Secs. 301(b)(1) and (c)). The amount of the distribution is decreased (but not below zero) by liabilities assumed by the shareholder (e.g., a mortgage on a distributed piece of real estate).
The tax rates for qualified dividends are (1) 0% for taxpayers with a marginal tax rate on ordinary income of 10% or 15%; (2) 15% for taxpayers with a marginal tax rate on ordinary income of 25% or greater whose taxable income falls below the levels for the 39.6% regular tax rate (2014 inflation-adjusted $457,600 for married filing jointly, $406,750 for single filers, and $228,800 for married filing separately); and (3) 20% for taxpayers with taxable income above those levels.
Individuals with modified adjusted gross income above a certain threshold ($250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately) may also owe the 3.8% net investment income tax (Sec. 1411). Net investment income includes dividends less expenses properly allocable to the dividends. This means that the tax rate applicable to a redemption taxed as a nonliquidating corporate distribution (taxable dividend to the extent of the corporation's E&P) may actually be 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%).
Taxation of Cash Dividends
A cash distribution to a shareholder is a taxable dividend to the extent of the corporation's current or accumulated E&P. If the current E&P equals or exceeds the amount of the distribution, it is a fully taxable dividend to the shareholder even if the corporation has negative accumulated E&P (Regs. Sec. 1.316-1(a)). In other words, if there is sufficient current E&P to cover all distributions made during the year, all distributions are taxable dividends. Amounts treated as taxable dividends reduce the corporation's E&P balance, but not below zero.
Taxation of Noncash Dividends
When property (rather than cash) is distributed, the amount of the dividend equals the fair market value (FMV) of the property on the date of the distribution, reduced by any liabilities assumed by the recipient or to which the property is subject (Sec. 301(b)). In addition, as is the case with cash dividends, the distribution must be from current or accumulated E&P to be classified as a dividend. The recipient shareholder's basis in appreciated property received in a distribution equals the property's FMV (Sec. 301(d)). The shareholder's holding period begins on the date of distribution.
In January 2009, the IRS released proposed regulations that provide comprehensive guidance on the recovery of stock basis in distributions under Sec. 301, along with guidance on the resulting gain and the basis of stock or securities received (see Prop. Regs. Sec. 1.302-5). The regulations are designed to harmonize the tax treatment of economically similar transactions. Accordingly, the regulations adopt a single model for Sec. 301 (dividend equivalent) distributions and a single model for Sec. 302(a) sale or exchange (nondividend equivalent) transactions, regardless of whether Sec. 301 or 302(a) applies. Consistent with the premise that a share of stock is the basic unit of property that can be disposed of, the proposed regulations would, for example, treat a Sec. 301 dividend equivalent distribution as received on a pro rata, share-by-share basis with respect to the class of stock upon which the distribution is made.
Taxation of Stock Dividends
Distributions of a C corporation's own stock to its shareholders (stock dividends) are generally tax-free to the recipient shareholders (Sec. 305(a)). The term "stock" includes rights to acquire such stock. Tax-free treatment apparently applies to unissued and treasury stock, as well as common, preferred, voting, or nonvoting stock. Despite this general rule, stock dividends can be taxable if (Sec. 305(b)):
- Shareholders have an option to receive cash or other property instead of stock;
- Some shareholders receive cash or other property, and others receive stock and increase their proportionate ownership;
- Some shareholders receive preferred stock while others receive common stock;
- Shareholders receive distributions with respect to preferred stock; or
- Shareholders receive distributions of convertible preferred stock.
If a shareholder has stock redemption rights at a time when a stock dividend is declared, this may be construed as an option to receive cash or other property, which could render the stock dividend taxable (see Rev. Ruls. 83-68 and 90-98; however, in IRS Letter Ruling 9709044, the IRS concluded that the shareholders' ongoing right of redemption did not result in a stock split's being taxed to the shareholders).
If a shareholder receives a taxable stock dividend, the amount of the dividend is the FMV of the stock (Regs. Sec. 1.305-1(b)). This FMV becomes the basis of the new stock to the shareholder.
The following are considered distributions of stock (i.e., stock dividends):
- Distribution of rights to acquire stock of the distributing corporation (Sec. 305(d)(1));
- Bargain purchase of additional stock of the corporation by a shareholder to the extent of the excess of the value of the shares over the consideration paid (Rev. Rul. 68-43); and
- Reduction of par value of stock accompanied by a reduction in the amount due from shareholders on their stock subscriptions ( Whiting , T.C. Memo. 1984-142).
If stock distributions do not result in taxable income to the shareholders, E&P is not reduced. E&P is reduced only if the shareholders have taxable income (Sec. 312(d)(1)).
If the new stock is identical to the old stock, the basis of the old stock is reallocated to both the old and new stock (Regs. Sec. 1.307-1). If the new stock is not identical to the old stock (e.g., preferred stock distributed for shares of common stock), the basis of the old stock is allocated between the old and new stock based on their respective share of the total FMV of both types of stock. In either case, the new stock takes the same holding period as the old stock (Sec. 1223(4)).
Taxation of Constructive Dividends
Corporations sometimes enter into transactions that are not typically dividends but may be considered so by the IRS. The following are examples of potential constructive dividends:
- Payments made to others for the personal benefit of the shareholder;
- Payments to family members of shareholders;
- Excessive compensation/purported loans to shareholders;
- Loans to shareholders at "below-market" interest rates;
- Improvements to shareholders' property; and
- Bargain purchases of corporate property/free use of corporate property by a shareholder.
Constructive dividends do not have to be declared formally or designated as a dividend. They need not be paid pro rata to all shareholders. Legally, they do not even have to be a dividend under state law; all that is required is a finding by the IRS that a shareholder received some benefit from the corporation. From a tax point of view, there is no difference between a formal dividend and a constructive dividend.
Distributions After Termination of S Corp. Status
Distributions by C corporations are treated as dividends to the extent of the corporation's current or accumulated earnings and profits (AE&P). However, a special rule provides relief to the shareholders of a corporation that has terminated its S corporation status. During the post-termination transition period (PTTP), any distribution of money by the corporation to its shareholders is first applied to reduce the basis of the shareholder's stock to the extent the distribution does not exceed the corporation's accumulated adjustments account (AAA) (Sec. 1371(e)(1)). Generally speaking, the PTTP begins on the day after the last day of the final S corporation tax year and ends on the later of one year later or the due date, including extensions, of that year's tax return.
Example: H Inc. terminates its S election on Dec. 31, 2014. On that date, it has $21,000 in AAA and $12,000 in E&P. (The AAA represents undistributed net income that has been passed through and taxed at the shareholder level; the AAA balance generally can be distributed to the shareholder without causing additional shareholder-level tax.) J , the sole shareholder, has stock basis of $30,000 when the S election terminates.
Nontaxable cash distributions up to the amount of the ending AAA balance ($21,000) can be made to J during the PTTP—in this case the one-year period following revocation of the S election. This is true even though H is in C status and distributions would normally be distributions of AE&P. The distributions reduce H' s AAA balance and J' s stock basis.
The PTTP represents a last chance to bail previously taxed cash and basis out of the corporation in a tax-free manner. When a corporation has terminated or will terminate its S status, a distribution eliminating the previously taxed AAA should be considered, either in the final S corporation year or during the PTTP. However, the PTTP allows access only to AAA. If a distribution during the PTTP exceeds AAA, it first is considered from current C corporation E&P before being allowed as a return of stock basis.
Federal Tax Law vs. State Corporate Law
Federal income tax law governs how corporate payments to or for the benefit of shareholders are taxed for federal income tax purposes. However, state corporation statutes govern the property rights of a corporation's shareholders and creditors. Although applicable state corporation law and the federal income tax rules are sometimes compatible, they do not necessarily yield identical results. For example, state law generally requires that dividends be declared by the board of directors. Also, dividends may be allowed only if the corporation has a positive net worth.
For federal income tax purposes, state-law formalities are irrelevant. For example, a nonliquidating distribution paid by a C corporation to a shareholder will generally be a taxable dividend to the extent of the corporation's E&P, whether or not the distribution meets the state-law definition of a dividend. On the other hand, a corporate distribution might not be a taxable dividend for federal income tax purposes, even if it is designated as a dividend for state-law purposes.
This case study has been adapted from PPC's Tax Planning Guide—Closely Held Corporations, 27th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 (800-431-9025; tax.thomsonreuters.com).
Ellentuck is of counsel with King &
Nordlinger LLP in Arlington, Va.