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SM Ch05 SWFT2013

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SM Ch05 SWFT2013SM C

    CHAPTER 5

    CORPORATIONS: EARNINGS & PROFITS AND DIVIDEND DISTRIBUTIONS

    SOLUTIONS TO PROBLEM MATERIALS

     Status: Q/P

    Question/ Learning Present in Prior

    Problem Objective Topic Edition Edition

     *1 LO 2 Definition of earnings and profits Unchanged 1

     2 LO 1 Taxation of corporate distributions Unchanged 2

     3 LO 2 Effect of selected transactions in adjusting Unchanged 3

     taxable income (for determining E & P)

     4 LO 5 Effect of selected situations in adding to or New

     generating a deficit

     5 LO 2 Comparison of accounting methods under Unchanged 5

     E & P and income tax

     6 LO 3 Effect of distribution, taxable dividend Unchanged 6

     or return of capital, in selected situations

     7 LO 3 Planning corporate distributions: beginning New

     or end of tax year

     8 LO 4 Rationale for reduced tax rate on dividends Unchanged 8

     *9 LO 1, 2, 3, Factors affecting tax treatment of Unchanged 9

     4, 5 distribution to shareholder

     10 LO 5 Factors affecting tax treatment of distribution Unchanged 10

     to distributing corporation

     11 LO 5 Purpose of property dividend versus cash New

     dividend

     12 LO 5 Property distribution: choice of property Unchanged 12

     13 LO 5 Impact of property distributions on Unchanged 13

     corporation

     14 LO 5 Effect of property distributions on New

     corporation

     15 LO 6 Necessity of dividend distribution to meet Unchanged 15

     state legal requirements in determining

     tax treatment

     *16 LO 6 Reasonable compensation and constructive Unchanged 16

     dividends

     17 LO 6 Selected factors in determining Unchanged 17

     reasonableness of compensation

     18 LO 4, 8 Choice between dividend and deductible Unchanged 18

     payment

     19 LO 6, 8 Unreasonable compensation Unchanged 19

    5-1

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5-2 2013 Corporations Volume/Solutions Manual

     Status: Q/P

    Question/ Learning Present in Prior

    Problem Objective Topic Edition Edition

     20 LO 6, 8 Unreasonable compensation; ways to Unchanged 20

     draw funds from corporation

     21 LO 7 Election to receive common or preferred Modified 21

     stock dividend

     22 LO 7 Rationale underlying tax treatment of stock Unchanged 22

     distributions

     23 LO 7 Explain tax effects of nontaxable stock Unchanged 23

     rights; taxable stock rights

     24 LO 1, 4 Amount of dividend income Unchanged 24

     25 LO 2 Amount of taxable income; balance in E & P Unchanged 25

     26 LO 1, 2, 3 Deficit in E & P followed by sale on Unchanged 26

     installment method; taxation of dividend

     distribution

     LO 2 Compute E & P Unchanged 27 *27

     *28 LO 2 Effect of specified transactions on taxable Modified 28

     income; on E & P

     *29 LO 2 Effect of income tax refund on E & P Unchanged 29

     30 LO 1, 3 Amount of dividend income; deficit in Unchanged 30

     current E & P with positive balance in

     accumulated E & P

     31 LO 1, 3 Dividend distribution; effect on E & P Modified 31

     32 LO 1, 3 Dividend distribution; effect on E & P Unchanged 32

     33 LO 1, 3 Dividend distribution; effect on E & P Unchanged 33

     *34 LO 1, 3 Cash distributions; determination of taxable Modified 34

     amount

     35 LO 1, 3 Cash distributions; determination of taxable Unchanged 35

     amount

     36 LO 4 Choosing low tax on dividend or investment Modified 36

     interest expense deduction

     37 LO 4 Holding period requirement for qualified Unchanged 37

     dividend

     38 LO 1, 5 Property distribution; effect of gain, loss, Unchanged 38

     liability, and differing basis

     39 LO 1, 5 Tax treatment to shareholder and to Unchanged 39

     corporation on distribution of property

     subject to liability in excess of basis

     40 LO 1, 5 Tax treatment to individual shareholder Modified 40

     and to distributing corporation of

     property subject to a liability

     41 LO 1, 3 Taxation of dividend when E & P has Modified 41

     positive balance but corporation has

     current loss

     42 LO 1, 5 Property distribution where FMV is less Modified 42

     than adjusted basis

     *43 LO 1, 2, 3, Effect of distributions Unchanged 43

     4, 5

     *44 LO 1, 2, 5 Property dividend; liability assumed by Modified 44

     shareholder; determination of E & P;

     distribution of loss property

    ? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

     Corporations: Earnings & Profits and Dividend Distributions 5-3

     Status: Q/P

    Question/ Learning Present in Prior

    Problem Objective Topic Edition Edition

     45 LO 5 Property distribution to corporate share- Unchanged 45

     holder, basis in excess of FMV; liability

     assumed by shareholder

     46 LO 6 Bona fide loan to shareholder Unchanged 46

     47 LO 6 Constructive dividends Unchanged 47

     48 LO 7 Basis of taxable preferred stock dividend Unchanged 48

     49 LO 7 Stock dividend; basis allocation; gain on sale Modified 49

     *50 LO 7 Stock rights; basis allocation; gain on sale Unchanged 50

     51 LO 4, 8 Choosing between a dividend and a Modified 51

     deductible payment

     52 LO 1, 3, 8 Source of dividend distribution Unchanged 52

     *The solution to this problem is available on a transparency master.

     Status: Q/P

     Research Present in Prior

     Problem Topic Edition Edition

     1 Salary reimbursement (Oswald) agreement Modified 1

     2 Dividend in anticipation of corporate sale Unchanged 2

     3 Effect of large dividend on corporate shareholder Unchanged 3

     4 Effect of a change in accounting method on E & P Unchanged 4

     5 Internet activity Unchanged 5

     6 Internet activity Unchanged 6

     7 Internet activity Unchanged 7

    ? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5-4 2013 Corporations Volume/Solutions Manual

    CHECK FIGURES

    24. Dividend income $200,000 each, 38.b. Silver $12,000 gain; Heather $12,000

    Mason reduces basis in stock to dividend, $54,000 land basis; ending

    $12,000, Sarah reduces stock basis to E & P $0.

    zero and capital gain $12,000. 38.c. Silver $12,000 gain; Heather $8,000 25.a. $1,380,000. dividend; ending E & P $80,000; 25.b. $2,240,000. Heather land basis $54,000. 26. $500,000 taxable dividend; $300,000 38.d. Heather $54,000 dividend and $54,000

    capital gain. land basis; Silver ending E & P 27. $330,200. $14,000.

    28.a. $38.e. Silver $1210,000; no effect. ,800 taxable gain; Heather 28.b. ($24,000); $22,400. $14,000 dividend and $14,000 28.c. No effect; $120,000. furniture basis; ending E & P $70,800. 28.d. $6,000; $14,000. 39.a. $150,000.

    28.e. ($45,000); $45,000. 39.b. $0.

    28.f. ($100,000); $80,000. 40. Lime reduces E & P by $230,000;

    ,000 and 28.g. No effect; ($20,000). Harry taxable dividend $18028.h. ($80,000); ($10,000). land basis $300,000.

    28.i. No effect; ($80,000). 41. $28,000 dividend and $12,000 return 29. Subtract $12,000 in 2012; add $7,000 of capital.

    in 2013. 42. Roy dividend $55,000 and basis in land 30. $100,000 taxable dividend, $60,000 $55,000; Cornflower $0 loss

    capital gain. recognized and E & P reduced $70,000. 31. Return of capital $50,000. 44.a. $70,000.

    32. Taxable dividend $80,000 and return of 44.b. $202,500.

    capital $40,000. 44.c. $140,000.

    33.a. Taxable dividend $30,000 each. 44.d. $128,500 taxable dividend; E & P is 33.b. ($145,000) accumulated E & P balance. $202,500.

    34.a. $70,000; $60,000. 45.a. Dividend income $20,000, dividends 34.b. $30,000; $180,000. received deduction $16,000, basis 34.c. $150,000; $0. $100,000 in land.

    34.d. $60,000; $70,000. 45.b. $80,000.

    34.e. $90,000; $40,000. 48. Preferred stock basis is $40,000; 35. Mike dividend income $237,500, holding period starts at receipt.

    $62,500 reduces basis in stock and 49. $14,000 long-term capital gain.

    capital gain $112,500 on sale; Steve 50. Long-term capital gain on sale $1,935

    dividend $42,500 and $57,500 and new stock basis $7,560.

    reduction in basis. 51.a. $3,900.

    37. $1,000 ordinary income. 51.b. $10,200.

    38.a. Silver $12,000 gain; Heather $54,000 51.c. Kristen is better off with bonus; Egret

    dividend, $54,000 land basis; ending is better off with bonus.

    E & P $34,000. 51.d. Pay bonus.

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     Corporations: Earnings & Profits and Dividend Distributions 5-5

    DISCUSSION QUESTIONS

     1. Earnings and profits‖ is the factor that fixes the upper limit on the amount of dividend

    income shareholders recognize as a result of a distribution from the corporation. It represents

    the corporation‘s economic ability to pay a dividend without impairing its capital. ‗‗Earnings

    and profits‖ is similar to the accounting concept of ―retained earnings.‖ However, E & P and

    retained earnings differ because E & P is computed using tax rules while retained earnings is

    computed using financial accounting rules. For example, a stock dividend that decreases the

    retained earnings account does not decrease E & P. E & P is increased for all items of income.

    It is decreased for deductible and nondeductible items, such as capital losses, income taxes,

    and expenses incurred to produce tax-exempt income. p. 5-3 and Concept Summary 5.1

     2. At least six factors impact the tax treatment of corporate distributions. These factors are:

     The availability of earnings to be distributed.

     The basis of the stock in the hands of the shareholder.

     The character of the property being distributed.

     Whether the shareholder gives up ownership in return for the distribution.

     Whether the distribution is liquidating or nonliquidating in character.

     Whether the assets distributed are subject to any liabilities or whether the shareholder

    assumes any liabilities in the distribution.

     Whether the distribution is a ―qualified dividend‖ for purposes of the reduced tax rate on

    dividend income.

    p. 5-2

     3. a. Taxable income for 2013 is increased by the amount of the capital loss carryover

    because the loss reduced E & P in 2012.

    b. Taxable income is reduced by the nondeductible meal expenses.

    c. To determine current E & P for 2012, taxable income is increased by the interest

    received on municipal bonds.

    d. Taxable income is reduced by the nondeductible lobbying expenses.

    e. Taxable income is reduced by the loss on sale between related parties.

    f. Taxable income is increased by the Federal income tax refund when computing E & P

    for 2012.

    pp. 5-3 to 5-6 and Concept Summary 5.1

     4. a. In general, the payment of dividends can neither generate nor add to a deficit in E & P.

    Because the distribution of depreciated property does not create a loss at the corporate

    level, the general rule holds true: a deficit is neither generated nor increased.

     b. An operating loss can both generate and add to a deficit in E & P. Deficits can only

    arise through corporate losses.

     p. 5-15

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    5-6 2013 Corporations Volume/Solutions Manual

     5. The accounting methods employed when computing E & P are considerably more conservative than the methods allowed when computing taxable income. First, rather than allowing the taxpayer to carry forward NOLs, capital losses, and charitable contributions, these deductions are accelerated to the year realized. Second, the computation of E & P does not allow use of the installment method. Third, more conservative depreciation methods are usedin particular, ADS depreciation rather than MACRS is mandated. A portion of ? 179 expense is deferred when computing E & P (only 20% of the expense is allowed as a deduction each year over a five-year period). A variety of other more conservative accounting methods are required when computing E & P (e.g., cost depletion, percentage of completion for long-term contracts, and capitalization and amortization of mining exploration and development costs and intangible drilling costs). pp. 5-4 to 5-6

     6. a. If a distributing corporation has a deficit in accumulated E & P and a positive amount

    in current E & P, a distribution during the year is a taxable dividend to the extent of

    current E & P.

    b. If the corporation has a positive amount in accumulated E & P and a deficit in current

    E & P, a distribution either is a taxable dividend or a return of capital, depending on

    the resulting balance in E & P when current and accumulated E & P are netted. The

    accounts are netted at the date of distribution. If the resulting balance is zero or a

    deficit, the distribution results in a tax-free recovery of basis or capital gain. If a

    positive balance results, the distribution represents a dividend to that extent. For

    netting purposes, current E & P is determined as of the date of the distribution by

    ratably allocating the loss over the entire year, unless the loss can be shown to have

    otherwise occurred.

    c. If there is a deficit in both current and accumulated E & P, a corporate distribution is

    treated as a return of capital to the extent of the shareholder‘s basis in his or her stock.

    Any excess is a capital gain.

    d. If there is a positive amount in both current and accumulated E & P, to the extent of

    the positive balance in both amounts, the distribution is a taxable dividend. Concept Summary 5.2

     7. This is not a valid statement. When a deficit exists in current E & P and a positive balance exists in accumulated E & P, the accounts are netted at the date of distribution. Furthermore, unless the taxpayer can show otherwise, a deficit in current E & P is deemed to accrue ratably throughout the year. In this case, there is no deficit on January 1, so the distribution is a dividend to the extent of accumulated E & P. p. 5-9

     8. The reduced tax on dividends is intended to lessen the effect of several existing distortions and to stimulate the economy. The distortions arise from the double tax on corporate income and include (1) an incentive to invest in non-corporate businesses rather than corporations, (2) an incentive for corporations to finance operations through debt rather than equity, and (3) an incentive to retain more earnings than necessary. It has been estimated that reducing the tax on dividends will stimulate the economy significantly, leading to gains of up to $25 billion annually (if the tax were dropped completely). Because debt financing would not be as heavily relied upon, the reduced tax on dividends should make the economy more robust in economic downturns. The competitiveness of the U.S. in the international markets should also be improved. This comes about because most of our trading partners do not impose a double tax on corporate source earnings. p. 5-10 ? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

     Corporations: Earnings & Profits and Dividend Distributions 5-7

     9. A variety of factors should be considered, including:

     What is the E & P of Red Corporation?

     Has E & P been accurately determined for tax purposes?

     How much E & P is allocated to each shareholder‘s distribution?

     How will the distribution affect Red Corporation‘s E & P?

     Is the distribution in partial or complete liquidation of Red Corporation?

     Does the distribution qualify as a stock redemption for tax purposes?

     What is the tax basis to the shareholders of Red Corporation stock?

    Also important is the nature of the shareholder. In the case of a corporate shareholder (Orange

    Corporation in this situation), a dividends received deduction is available. In contrast, an

    individual shareholder may qualify for a reduced tax rate.

    pp. 5-10 to 5-15 and Chapter 2

    10. A variety of factors should be considered, including:

    ;

     Is the distributed property appreciated or depreciated?

     What is the character of the property being distributed?

     Is the distributed property secured by debt?

     Is the distribution in complete liquidation of Red Corporation?

     Does the distribution qualify as a stock redemption for tax purposes?

     pp. 5-12 to 5-15

    11. Ochre‘s board of directors may have decided to distribute a property dividend in lieu of cash

    for various reasons. For example, the shareholders could want a particular property that is

    held by the corporation, or the corporation may be strapped for cash but still wants to

    distribute a dividend to its shareholders. p. 5-12

    12. Distributing machine C triggers taxable gain of $8,000 for Seagull Corporation, while

    distributing A produces a nondeductible loss of $7,000. To preserve the loss on A and avoid

    recognizing gain on C, Seagull should consider selling A and then distributing cash to the

    second shareholder. Seagull should also distribute machine B because there will be no gain on

    the distribution and no nondeductible loss. pp. 5-13 and 5-14

    13. All distributions of appreciated property generate gain to the distributing corporation. In effect,

    the corporation is treated as if it had sold the property to the shareholder for its fair market

    value. The distributing corporation does not recognize loss on distributions of property. If

    the distributed property is subject to a liability in excess of basis or the shareholder assumes

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    5-8 2013 Corporations Volume/Solutions Manual

    such a liability, a special rule applies. For purposes of determining gain on the distribution, the fair market value of the property is treated as not being less than the amount of the liability.

    Further, corporate distributions reduce E & P by the amount of money distributed or by the greater of the fair market value or the adjusted basis of property distributed, less the amount of any liability on the property. E & P is increased by gain recognized on appreciated property distributed as a property dividend.

     Under no circumstances can a corporate distribution create/generate a deficit in E & P or add to an existing deficit in E & P.

     Examples 15 to 21

    14. For distributions of appreciated property, gain is recognized. But the classification of the gain does not matter as both capital gains and depreciation recapture gains are taxed at the same rate to corporations. However, a capital gain could be offset against unused capital losses. Thus, the character of appreciated property distributed would matter only if Tangerine has unused capital losses. A distribution of property with a fair market value less than adjusted basis does not trigger a loss, so the character of the property (capital asset versus depreciable property) does not matter. However, Tangerine might be better off disposing of the loss property before making a distribution to avoid losing the tax benefit of any built-in loss. Example 16 and see the discussion in Chapter 2.

    15. A distribution by a corporation to its shareholders can be treated as a dividend for Federal income tax purposes even though it is not formally declared or designated as a dividend. Also, it need not be issued pro rata to all shareholders. Nor must the distribution satisfy the legal requirements of a dividend as set forth by applicable state law. The key factor determining dividend status is a measurable economic benefit conveyed to the shareholder. This benefit, when described as a constructive dividend, is distinguishable from actual corporate distributions of cash and property in form only. p. 5-15

    16. Because of Mike‘s relationship with Judy, the IRS may argue that any excessive

    compensation paid to Mike or Judy is a constructive dividend. Imputed interest on the loan to Judy may also be a dividend. The following questions are relevant:

     Are the salary payments to Judy and Mike reasonable?

     What are Judy‘s and Mike‘s qualifications?

     What are the nature and scope of Judy‘s and Mike‘s work?

     How does the overall salary paid to Judy and Mike compare with the company‘s gross and

    net income?

     What is the corporation‘s salary policy towards all employees?

     Regarding the advance to Judy, was it a bona fide loan?

     Was the loan evidenced by a written instrument?

     Was collateral or other security provided?

     What is Judy‘s financial capacity to repay the loan?

    ? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

     Corporations: Earnings & Profits and Dividend Distributions 5-9

     What is Parakeet‘s dividend-paying history?

     What is the amount of imputed interest on the loan to Judy?

    pp. 5-16, 15-17, and Examples 22 and 30

    17. a. The determination of the reasonableness of compensation paid to an employee who is

    not a shareholder but is related to the sole owner of the corporate-employer should be

    made in the same manner as that for a shareholder-employee. The same factors used to

    determine the reasonableness of salary paid to the owner should be used to determine

    the reasonableness of salary paid to the related employees.

    b. That the employee-shareholder does not have a college degree should be relevant only

    with respect to the nature and scope of the employee‘s work. Is a college education

    usually required for the type of work performed?

    c. The fact that the employee-shareholder has another full-time job might indicate that

    salary paid is excessive.

    d. If the employee-shareholder was underpaid in the past, a portion of current salary

    could be for service rendered in prior years.

    e. If a corporation has substantial E & P and has never paid a dividend, it is more likely

    that a constructive dividend may be found.

    f. Disproportionately large year-end bonuses, related to profit, paid to shareholder-

    employees would be vulnerable to constructive dividend treatment.

    p. 5-16 and Example 30

    18. Danielle would prefer a dividend because she would have $42,500 after tax [$50,000 dividend ($50,000 × 15% tax rate)]. If paid a bonus, only $36,000 after tax [$50,000 bonus

    ($50,000 × 28% tax rate)] results. However, this ignores the effect of the payments on Orange Corporation. If Orange paid Danielle a deductible bonus, it would save $17,000 ($50,000 deduction for bonus payment x 34% tax rate) in taxes. (There is no deduction for a dividend payment.) Since Danielle is $6,500 better off with a dividend ($42,500 after tax from a dividend $36,000 after tax with a bonus) and Orange is $17,000 better off with a bonus, overall the two parties are $10,500 better off with a bonus ($17,000 benefit from bonus for Orange $6,500 benefit from a dividend for Danielle). As Danielle is the sole shareholder of the corporation, she is in a position to choose the bonus alternative. Examples 28 and 29

    19. The salaries paid to Chris and Joey are vulnerable to constructive dividend treatment since neither shareholder appears to have earned them. There is also a problem regarding the $600,000 salary payment to Samantha. Why is she receiving $350,000 more than Jack when it appears they share equally in managing the company‘s operations? Although Samantha is not

    a shareholder, her relationship to Chris and Joey is enough of a tie-in to raise the unreasonable compensation issue.

     Furthermore, Green Corporation has never distributed a dividend although it has substantial E & P. Given the dividend history and the salary disparities, the IRS might successfully argue that all of the salary paid to Joey and Chris, as well as the $350,000 paid to Samantha (beyond the amount paid to Jack), is unreasonable.

    Example 30

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    5-10 2013 Corporations Volume/Solutions Manual

    20. There would be a problem if Katrina makes the pledge because Condor Corporation will have satisfied Katrina‘s obligation. Condor‘s payment to the charity may be treated as indirect

    compensation to her. Thus, Katrina should not have made the pledge. Instead have the corporation make the contribution directly. In determining whether Condor has paid Katrina ―unreasonable‖ compensation, both the direct compensation of $500,000 and the indirect payment of $150,000 made on her behalf will be considered. Examples 31 and 32

    21. Hoffman, Raabe, Smith, and Maloney, CPAs

     5191 Natorp Boulevard

     Mason, OH 45040

    November 16, 2012

    Raptor Corporation

    1812 S. Camino Seco

    Tucson, AZ 85710

    Dear President of Raptor Corporation:

    This letter is in response to your question with respect to the stock dividend distributed to your shareholders. Our conclusion is based upon the facts as outlined in your November 14 letter. Any change in facts may cause our conclusion to be inaccurate.

    Your shareholders have taxable income equal to the fair market value of the stock dividend. Distributions of preferred stock to some common shareholders and of common stock to other common shareholders is a taxable event.

    Should you need more information or need to clarify our conclusion, do not hesitate to contact me.

    Sincerely yours,

    Jon S. Davis, CPA

    Partner

    TAX FILE MEMORANDUM

    November 16, 2012

    FROM: Jon S. Davis

    SUBJECT: Raptor Corporation

    Based on the facts summarized in a letter (dated November 14) from the president of Raptor Corporation, the following occurred. Raptor Corporation declared a dividend permitting its shareholders to elect to receive either 9 shares of cumulative preferred stock or 3 additional shares of Raptor common stock for every 10 shares of common stock held at the time of the dividend declaration. One shareholder elected to receive preferred stock while all other shareholders chose the common stock dividend.

    At issue: Is the distribution of a stock dividend taxable if some of the shareholders elect to receive preferred stock while others elect to receive common stock?

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