Distributions are a common part of a C corporation’s lifecycle, returning value to shareholders. Understanding their tax treatment is essential to avoid adverse consequences.
Generally, E&P is calculated as of the end of the year of the distribution, and federal taxable income (before net operating losses) serves as the starting point. Specific adjustments are made to align to a more “economic” result.3 One adjustment is tax depreciation, which for purposes of E&P must be recomputed using the alternative depreciation system (ADS) without regard to “bonus depreciation,” as defined in Internal Revenue Code (IRC) Sections 168(k) and 168(n).4 ADS uses straight-line depreciation over a longer class. Other common examples of alterations made to adjust taxable income to E&P include federal income taxes, tax-exempt income, interest expense disallowed under Section 163(j), and charitable contribution carryovers. Adjustments are required to modify taxable income and align the result to a more economic concept so the company can determine how much of a distribution will be considered a dividend. Additional adjustments may be necessary to the extent the company is involved in certain corporate transactions.
E&P is a “cumulative” concept broken out into current and accumulated E&P, with the latter rolled forward on a year-by-year basis. Under Section 301(c), distributions will be treated first as a taxable dividend to the extent of E&P, then as a return of basis to the extent of the shareholder’s tax basis, and then as capital gain to the extent the distribution exceeds both E&P and basis. The amount treated as a dividend depends on the balance of the company’s current and accumulated E&P.
To the extent the distributing corporation has current or accumulated E&P, the distribution will be treated as a taxable dividend to the recipient5 to the extent of such E&P and will be reported on the recipients’ income tax return in the year received. There is an ordering rule that dictates distributions will first come out of current E&P measured as of the close of the tax year in which the distribution is made. Thus, a dividend situation can arise where there is current E&P but a deficit in accumulated E&P. Distributions are allocated first from current E&P on a pro rata basis to all distributions made during the current year, and then from accumulated E&P on a chronological basis. To the extent the distribution exceeds current E&P, the excess will come out of accumulated E&P measured as of the beginning of the tax year of the distribution.6 It is important to note that current E&P is determined without regard to any distributions made during the year.
Complexities may arise when a corporation has an E&P deficit for the current year or if multiple distributions are made during the year. When there is a deficit in E&P for the tax year of the distribution, the current year’s deficit in E&P must be prorated to the distribution date (unless the exact amount on the distribution date can be proven) to determine whether there are accumulated earnings available for distribution. If the current year’s deficit in E&P exceeds the accumulated E&P at the beginning of a tax year, one would think that a distribution can be made that does not qualify as a dividend. However, the proration rule in Reg. Section 1.316-2(b) reduces that likelihood by causing a portion of the deficit to be allocated to the period after distribution, increasing the likelihood of accumulated E&P “available” on the date of distribution.
Should a distribution made to shareholders exceed E&P, the next “tier” of tax treatment is a return of stock basis, sometimes referred to as a nondividend distribution.7 If a corporation distributes amounts not supported by E&P, it is a return of invested capital (i.e., nontaxable). Because basis represents an amount already taxed (or rather invested with post-tax dollars), returning it does not generate additional tax to the shareholder. Generally, basis equals the purchase price paid by the shareholder for its shares plus capital contributions, adjusted for certain transactions but can never go below zero.
Once a distribution has exhausted all E&P and any remaining stock basis, the final tier would be capital gains.8 Capital gain distributions receive the same treatment as if the shareholder sold the stock.
Assuming the shareholder is an individual, capital gains receive the preferential treatment of a lower tax rate so long as the stock was held for more than one year. This could be anywhere from 0% to 20%, depending on the taxable income of the shareholder. Corporate shareholders do not receive preferential tax rates; all capital gains are taxed at 21%. Capital gain treatment may be beneficial if the corporate shareholder has otherwise unusable capital loss carryovers.9
Corporate distributions have reporting requirements for both the corporation (payor) and the shareholder (recipient). From a payor standpoint, if a distribution exceeds current and accumulated E&P, corporations must disclose the distribution and balance of E&P on Form 5452, Corporate Report of Nondividend Distributions, and attach the form with the corporate income tax return in the year of distribution. The corporation may be required to file Form 8937, Report of Organizational Actions Affecting Basis of Securities, to report nondividend distributions. Unlike Form 5452, which is an attachment to the corporate income tax return, Form 8937 must be directly filed with the IRS on or before the 45th day following the nondividend distribution or, if earlier, Jan. 15 of the year following the calendar year of the distribution. The corporation may also be required to provide a copy of the form to each of the shareholders of record as of the date of the distribution. A corporation is exempt from filing Form 8937 with the IRS if, by the due date, a signed Form 8937 is in a readily accessible format in an area of the corporation’s primary public website dedicated to this purpose and is kept accessible to the public for a period of 10 years. Shareholders receiving distributions treated as capital gains must report such gains on Schedule B, Interest and Ordinary Dividends,10 and Schedule D, Capital Gains and Losses, of their respective income tax returns.
There are additional nuances when corporations undergo a reorganization or restructuring. Taxpayers must understand what happens to the corporation’s E&P following the completion of these transactions. For example, in a Section 355 spinoff, E&P is generally allocated between the distributing corporation and controlled corporation based on the fair market value (or in some cases, net basis11) of the assets retained versus the assets distributed.12 The purpose of this allocation is to neutralize the effect of a divisive reorganization and ensure that post-spin-off distributions out of the controlled corporation are treated as they would have been had no spin-off occurred.13
Alternatively, suppose the corporation was transferred in a transaction described in Section 381(a), such as a Section 332 liquidation or asset reorganizations under Section 368(a)(1). Then, only the acquiring corporation succeeds to the E&P of the distributor or transferor corporation.
Another common scenario is the impact of when a member of a U.S. consolidated tax return leaves the group. When a subsidiary of an affiliated group earns E&P, it is tiered up to the common parent corporation filing the income tax return at the end of the tax year. Under current regulations, E&P generated while a corporation is a member of a group and reflected in higher-tier members’ hands is generally eliminated from that corporation’s E&P when it leaves the group.14 The reduction to a departing member’s E&P does not tier up, so the E&P of higher-tier members is not affected, nor is there any effect on any member’s E&P basis in other members’ stock.15
Corporate distributions can get complex if taxpayers do not properly track E&P as well as their tax basis in the underlying investment. A scenario that taxpayers often encounter is when a corporation that historically has not distributed earnings decides to make a distribution for the first time. The company soon realizes that it does not have proper documentation of their E&P and basis over the years. Going back multiple years and rebuilding E&P from inception is much more difficult than rolling E&P forward year to year, and often the records are inadequate. Taxpayers must anticipate potential distributions and be sure they have the correct data in place to assess the impact when a distribution is made. Failure to do this could result in significant consequences for the corporation and shareholders.
1 Internal Revenue Code Section 301(c). Unless otherwise indicated, all references to “Sections” are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.
2 Conference Report on the Tax Reform Act of 1984, H.R. Rep. No. 98-861, at 835 (1984): “In general, a corporation’s earnings and profits are intended to be a measure of the economic income of the corporation available for distribution to its shareholders.”; Estate of Uris v. Commissioner, 605 F.2d 1258, 1265 (2d Cir. 1979).
3 Section 1.312-6(a) provides “the amount of the earnings and profits in any case will be dependent upon the method of accounting properly employed in computing taxable income.”
4 Reg. Section 1.168(k)-2(g)(7).
5 The treatment of a taxable dividend is assuming the shareholder is an individual. Additional considerations should be given to recipients that are corporations or foreign shareholders.
6 Section 316(a); Reg. Section 1.316-2; GCM 35307 (April 16, 1973).
7 IRC Section 301(c)(2).
8 IRC Section 301(c)(3).
9 Corporate shareholders may be eligible to exclude or eliminate the dividend if the corporation has an ownership interest in the payor or the payor is a member of the same affiliated group under Section 1504(a).
10 If shareholder is an individual and interest or ordinary dividends exceed $1,500.
11 “Net Basis” is adjusted tax basis of assets less liabilities assumed or taken subject to.
12 Treas. Reg. Section 1.312-10.
13 The allocation rule can differ depending on whether the spinoff is preceded by a Section 368(a)(1)(D) reorganization. The guidance above assume that the spin-off is preceded by such a reorganization.
14 Treas. Reg. Section 1.1502-1(e)(1).
15 Treas. Reg. Section 1.1502-33(e)(1).
Anthony DiGiuseppe is a managing director in the Wayne office of Global Tax Management. He can be reached at adigiuseppe@gtmtax.com.