Taxation of Corporate Distributions to Shareholders

Introduction

Corporations are treated as “persons” for U.S. tax purposes, separate and distinct from their shareholders. Thus, the corporate taxpayer must file its own tax return as discussed previously, and must pay income tax on its income just as any other taxpayer. When that income is subsequently distributed to shareholders, the tax consequences, both to the corporation and the shareholder(s) depend on the nature and structure of the distribution. Compensatory payments to shareholders such as salaries, rent or lease payments for the use of property, interest on amounts loaned to the corporation, etc. are generally deductible by the corporation if reasonable in amount. Payments to shareholders to purchase assets are capitalized by the corporation, and may be amortized or depreciated depending on the nature of the asset sold. In contrast, the distribution of cash or property to shareholders in connection with their stock ownership will generally be treated as a distribution of corporate profits. The distribution of corporate profits is treated by the shareholder as a dividend, taxable to the shareholder but not deductible by the corporation.

Generally speaking, under Section 301(c)(1) distributions received by shareholders will be taxable as dividends to the extent paid from current or accumulated corporate “earnings and profits” (E&P). Distributions in excess of such E&Pconstitute a return of the shareholders’ capital investmentin the corporation. As such, they are nondeductible by the corporation and will generally be nontaxable to the shareholder(s) to the extent of the latter’s tax basis in stock owned in the issuing corporation. To the extent the distribution exceeds both the corporation’s E&P and the shareholder’s tax basis in stock, it will be taxable to the shareholder as a capital gain.

Example 1: Kyle is the sole shareholder of KPix, Inc. His tax basis in his KPix stock is $25,000. Assume that KPix had current and accumulated E&P of $50,000 at the end of the year. The company distributed $80,000 to Kyle. The distribution was made in connection with Kyle’s stock ownership; he did not provide any additional services, capital or other property in connection with receipt of the payment. The distribution will be reported by Kyle for tax purposes as follows:

Dividend income (to extent of E&P)$50,000

Nontaxable return of capital (to extent of stock basis) 25,000

Taxable capital gain (excess) 5,000

Total distribution$80,000

Under current law, the maximum tax rate on dividend and capital gain income for an individual taxpayer is 15%. Thus, Kyle’s tax liability will increase by $8,250 ($55,000 x 15%) as a result of the distribution (assuming Kyle does not have other losses to offset the income).

The distinction between the tax treatment of these different types of payments from the corporation to its shareholders is twofold. First, and most important, is the issue of deductibility on the corporate return. Payments to a shareholder that are deductible by the corporation essentially move the income from which such payments are paid off the corporate tax return and onto the shareholder return. That is, if a payment is deductible, the income from which it is financed will now be taxed to the shareholder rather than to the corporation. In contrast, where a payment is not deductible by the corporation (i.e., a dividend payment), the underlying income is now taxed on both the corporation’s and the shareholder’s returns. By not allowing corporations to deduct dividend payments, the U.S. income tax system is explicitly designed to subject corporate income to two levels of taxation: the first when the corporation earns the income and the second when that income is ultimately distributed to the shareholder. This is a common criticism of the U.S. taxation of corporate income—critics suggest that this system of double taxation puts U.S. corporations at a competitive disadvantage relative to their competitors from other countries. Any such disadvantage has been lessened in recent years as a result of the reduction of the dividend tax rate to 15 percent, but the system is still designed to impose two layers of tax. It is very important for taxpayers and their advisors to understand this characteristic of the corporate tax system in deciding how to structure their business operations, especially with regard to decisions regarding the amount and types of income-earning assets to transfer inside the corporate shell.

Example 2: Carlos is the sole shareholder of Rugged Corporation. Rugged Corporation had income of $1,500,000 before accounting for a $400,000 payment to Carlos. Assume that Carlos is in the 35 percent tax bracket and that the entire payment is taxable to him. If the payment is classified as a dividend, the combined income tax liability of Carlos and Rugged will be much higher than if the payment is classified as a compensatory payment, as illustrated below:

Payment Structured as: / Carlos’ Individual Tax Liability / Rugged Corp Tax Liability / Total
Compensation / $140,000 / $374,000 / $514,000
Dividend / $ 60,000 / $510,000 / $570,000
Difference / ($ 80,000) / $136,000 / $56,000

The other distinction between deductible and nondeductible payments from corporations to their shareholders, at least under current law, is the tax rate at which the distribution is taxed on the shareholder’s tax return. Dividends, which are nondeductible to the corporation, are taxed to the shareholder at a maximum rate of 15 percent. In contrast, compensatory payments to the shareholder, which are deductible by the corporation, are taxed to the shareholder at his or her (or its) marginal ordinary tax rate. For individuals, the maximum marginal tax rate is 35 percent under current law. Thus, individual shareholders potentially face much higher tax rates on compensatory payments received from corporations than on dividend payments.

Example 3: Miriam is a shareholder in Taxomics, Inc. She is in the maximum individual income tax bracket in the U.S. (currently 35%). This year, she received a distribution from Taxomics in the amount of $200,000. If the distribution is a dividend for income tax purposes, it will increase her individual income tax liability by $30,000 (15% of $200,000). In contrast, if the distribution is taxable to her as ordinary income, she will owe an additional $70,000 income tax liability (35% of $200,000). This amount may be further increased if the payment is subject to the Medicare or healthcare tax. Thus, Miriam may prefer the payment to be classified as a dividend, even though such classification will increase the corporation’s income tax liability (because it will not be deductible in computing corporate taxable income).

Although corporate taxpayers do not receive beneficial tax rates for dividend or capital gain income, they are subject to a lighter tax burden on dividend income as a result ofthe dividends received deduction. As discussed previously, under Section 243 the dividends received deduction is equal to 70 percent of domestic dividends received from other corporations in which the corporate recipient owns less than a 20 percent interest, 80 percent of dividends received from 20 percent or more owned companies, and 100% of dividends received if they own at least 80 percent of the dividend-paying company. Thus, the maximum corporate tax on eligible dividends is 10.5 percent (maximum corporate tax rate of 35% times (1-70% DRD)).

Measuring E&P

As noted above, a distribution to shareholders is distinguished from compensatory payments. Distributions are received by the shareholders in connection with their investment in corporate stock. Distributions represent a return to the shareholders of their capital investment in the corporation; the distribution can represent a return of either the shareholder’s original capital investment in the corporation or of his or her share of reinvested earnings (E&P). Only those distributionspaid from the corporation's E&P are taxable as dividends. For this purpose, Section 316 provides that distributions are generally deemed to be paid first from corporate E&P to the extent thereof. Thus, corporations are not free to determine the source of distributions paid to shareholders; if the corporation has E&P, the distribution is deemed to be derived from that E&P until it is fully distributed. Only if there is no remaining E&P will a distribution be deemed to come from contributed capital. (There are no other sources from which a distribution can be derived).

Earnings and profits are a federal tax concept intended to reflect the corporation’s undistributed “economic” earnings available for distribution to shareholders. Over time, E&P will closely mirror the GAAP measure “retained earnings” on the corporation’s balance sheet, though in any particular year the two measures may not be comparable.Section 312 is the primary source of the rules governing the measurement of E&P. The statute provides only limited guidance however and is not particularly useful for either taxpayers or their advisors. The Treasury Regulations under §312 provide greater insight. The starting point for computing the current year addition to E&P is taxable income. Adjustments are then made to this figure to compute the corporation’s “economic”income available for distribution to the shareholders. To compute E&P, the following types of adjustments are made to taxable income:

  1. Methodological adjustments. A number of provisions of the Internal Revenue Code are designed to encourage in investment in business activity (e.g., accelerated and bonus depreciation, the §179 deduction), or to more closely match the obligation to pay taxes with the cash flows available to the corporation (e.g., deferral of income from installment sales until cash is received under §453, deferral of income from discharge of indebtedness under §108, etc.). These accounting methods are not allowed in computing E&P. Thus, in computing E&P, a corporation must use straight-line depreciation, it must increase E&P to reflect discharge of indebtedness income in the taxable year that it is realized, it must recognize income from the sale of assets in the year of the sale, etc. A number of other methodological adjustments are necessary to adapt the amount reported as taxable income to a more economically justified figure.
  1. Inclusion of nontaxable income. Most items of nontaxable income must be added to taxable income in computing E&P. For example, interest on state and local government obligations excluded under §103 must be added to taxable income in computing E&P, as mustproceeds from life insurance on key officers excluded under §101.Although not subject to federal income taxes, these items constitute economic income that is available to be distributed to shareholders.
  1. Reduction for nondeductible expenditures. E&P is reduced by non-deductible expenditures of the corporation. Thus, E&P are reduced for fines and penalties disallowed under §162(f), excess executive compensation disallowed under §162(m), half of the cost of business meals and entertainment disallowed under §274(n), and any other non-deductible expenses. Similarly, charitable contributions in excess of 10 percent of a corporation’s taxable income, capital losses in excess of capital gains, and other expenses subject to similar limitations are fully deductible in computing E&P.
  1. Disallowance of “artificial” deductions. Earnings and profits are not reduced by the dividends received deduction allowed under §243, the domestic production activities deduction allowed under §199, or other such artificial deductions not attributable to actual expenditures.
  1. Disallowance of “carry forward” amounts. Because losses and expenses are deducted in computing E&P in the year incurred, regardless of taxable income limitations, carryforwards deducted in computing taxable income in the current year are disregarded in computing E&P. For example, capital loss carryforwards, charitable contributions carryforwards, and net operating loss carryforwards are disregarded in computing E&P. These amounts will have previously been subtracted from E&P in the years initially incurred; allowing a further reduction for carryforwards would double count such expenditures in measuring E&P.
  1. Reduction for income taxes paid or payable with Form 1120. Income taxes paid reduce the accumulated earnings available for distribution to shareholders. Since income taxes are not deductible in computing federal taxable income, they must be subtracted from that figure in computing E&P.

Because the rules governing the computation of taxable income change frequently, the rules governing the measurement of E&P are also frequently updated. The IRS frequently publishes guidance, either publicly (e.g., through Revenue Rulings), or privately (e.g. through letter rulings), explaining how new or unusual tax accounting rules are to be treated for purposes of calculating the corporation’s E&P. For example, Revenue Ruling 2001-1 (2001-1 CB 726)explains that the deduction allowed under §83 upon the exercise by an employee of a nonstatutory stock option is also allowed for purposes of computing the corporation’s E&P. Taxpayers or their advisors unsure about how to apply a particular accounting method should first review the regulations. If the answer is not evident in the regs, additional research may identify a ruling or other published guidance on whether or not such accounting method will be allowable for purposes of the E&P computation.

Example 4:Kinergy, Inc. reported taxable income this year of $4,350,000 and paid income taxes of $1,479,000. In computing taxable income, the corporation claimed a dividends received deduction of $40,000 and a domestic production activities deduction of $100,000. It had a net capital loss of ($32,000) that was not deductible this year due to a lack of capital gain income, and it deducted $48,000 in charitable contribution carryforwards from a prior year. Kinergy’scurrent E&P (i.e., the current year addition to E&P) will be $3,027,000, computed as follows:

Taxable income$4,350,000

Add back artificial deductions:

Dividends received deduction 40,000

Domestic production activities deduction 100,000

Add back charitable contribution carryforward 48,000

Less excess capital losses ( 32,000)

Less income taxes paid(1,479,,000_

Current year E&P$ 3,027,000

Because E&P is not reported on the corporation’s income tax return, it may not be computed on an annual basis. (Recall that E&P is not the same as retained earnings). Thus, it must often be computed for prior years in addition to the current year. Earnings and profits are not relevant to the corporation until it makes distributions to its shareholders that are significant in comparison to its earnings (or until it is acquired by another company, in which case the acquirer will generally want to know how much potential dividend income its shareholders will face with respect to future distributions). It is not difficult to retroactively compute E&P, however, as long as the corporation’s prior tax returns are available.

Determining the Source of Corporate Distributions

As noted above, §316(a) provides that distributions are deemed to have been made from E&P to the extent the company has E&P. The statute further provides that distributionsare presumed to come from the most recently accumulated E&P first. Under §316(a)(2) E&P for the current year (current E&P) is measured as of the close of the year without reduction for distributions made during the year. Thus a distribution will be taxable to the shareholder as a dividend if the corporation has E&P at the end of the current tax year, whether or not it had any E&P at the beginning of the year (generally referred to as accumulated E&P), and even if it had no E&P as of the date the dividend was actually distributed. Alternatively, a distribution may be deemed to come from accumulated E&P even when the corporation had no current earnings in the year the distribution occurred.

Example 5:Jenkins Corporation had accumulated E&P (AE&P) as of January 1 of $300,000. For the current year, the company incurred a substantial loss. Its current E&P (CE&P) was ($175,000). The company distributed $150,000 to its shareholders at year end. No part of the distribution can be derived from CE&P because there was none. As of year end, the net balance in E&P was $125,000 (beginning balance of $300,000 less current year deficit of $175,000). Thus, $125,000 of the year-end distribution will be taxable to the shareholders as a dividend. The balance in the company’s E&P account as of January 1 of the next year will be zero.

Example 6: Washington Corporation had a deficit in accumulated E&P (AE&P) as of January 1 of ($100,000). For the current year, the company earned a profit. Its current E&P was $75,000. The company distributed $150,000 to its shareholders at year end. The first $75,000 of this distribution will be deemed to have come from CE&P, regardless of when the distribution was made. It does not matter that the combined balance in the company’s E&P account would have been negative. Because CE&P is distributed before AE&P, the entire balance in CE&P can be distributed to shareholders in the current year. Thus, the shareholders will recognize $75,000 in dividend income in connection with the current year distribution. No part of the remaining distribution can be derived from AE&P because there was none. Note that in the above example, because no portion of the distribution came from CE&P, the current year deficit in E&P was netted against the company’s beginning balance in AE&P to determine the balance in AE&P as of the date of the distribution.

Special rules apply when a company makes multiple distributions in a given year, and the aggregate amount distributed exceeds the combined balances in current and accumulated E&P. In such cases, E&P must be apportioned among the different distributions. The apportionment rules, which differ for current vs. accumulated E&P, are described in the Treasury Regulations under §316. The regs provide that current E&P is allocated pro rata among all distributions made during the year, regardless of the actual date of the distributions. Accumulated E&P, in contrast, is apportioned among distributions chronologically—that is, early distributions are drawn from AE&P before later ones. The net effect of the AE&P apportionment rules is to apportion a greater percentage of AE&P to early distributions than to later ones.

Example 7: Snap, Inc. made two distributions to its shareholders during the year. The first distribution, in the amount of $100,000 was paid to shareholders on March 15, and the second, in the amount of $50,000, was paid to shareholders on December 1. Snap had AE&P at January 1 of $45,000. Its CE&P for the year was $60,000. Thus, only $105,000 of the current year distributions will be taxable to Snap’s shareholders as dividend income. The dividend portion of each distribution will be determined as follows.

First, current E&P will be apportioned pro rata among the two distributions. Two-thirds of the company’s total distributions were distributed on March 15 and one-third on December 1. Current E&P will thus be allocated 2/3rds to the first distribution and 1/3rd to the second. Accumulated E&P, in contrast, must be apportioned chronologically. Thus, the entire $45,000 of AE&P will be attributed to the first distribution and none to the second:

Distribution / CE&P / AE&P / Total Taxed as Dividend
March 15 / $40,000 / $45,000 / $85,000
December 1 / 20,000 / 0 / 20,000
Totals / $60,000 / $45,000 / $105,000
The balance in AE&P as of January 1 of the next year will be zero.

As illustrated in Examples 5 and 6, a deficit in current E&P will reduce accumulated E&P for purposes of determining the amount available for distribution to shareholders, but the reverse is not true: a deficit in AE&P is ignored for purposes of measuring the amount of E&P available for the shareholders. Where a CE&P deficit is applied against AE&P, the amount by which AE&P is reduced is determined as of the date of the distribution. For a distribution occurring on the 100th day of the year, for example, only 100/365ths of the deficit in CE&P will be applied against AE&P for purposes of determining the amount available at the date of the distribution. Finally, note that E&P is reduced by dividend distributions, but not by the portion of corporate distributions that is treated as a return of capital. That is, E&P is only reduced by that portion of a corporate distribution that is deemed to have been paid from E&P.