Question

Reading

Federal Income Taxation of Corporations and Shareholders

Text: Study Chapters 7 & 8 of the Bittker & Eustice text.

Penalty Taxes on Undistributed Corporate Income, Dividends and Other Nonliquidating Distributions

LESSON 6, PROBLEM #1

In not less than 1,000 words discuss "earnings and profits". Your discussion should include major differences between computing current earnings and profits and current taxable income as well as why earnings and profits should be calculated before a corporation decides to make a distribution to its shareholders.

LESSON 6, PROBLEM #2

Allan owns all of the stock of CadyCo. The stock’s basis is $100,000. CadyCo has a total of current and accumulated earnings and profits of $50,000. CadyCo distributes $200,000 cash to Allan “with respect to his stock” (i.e., as a state law “dividend”). How is the $200,000 taxed? What is Allan’s stock basis after the distribution? Alternatively, CadyCo distributes to Allan his note to CadyCo for $200,000 borrowed from CadyCo.

LESSON 6, PROBLEM #3

Assumptions: The stock of ChadCo is owned equally by two shareholders: SecondCo (a corporation) and Arnold (an individual). ChadCo and SecondCo use the accrual method, Arnold uses the cash method. All use a calendar taxable year. Assume § 1059 does not apply. Use a 34 percent corporate tax rate in this problem. During the current year, ChadCo accrued income and expenses as follows:

Gross income from business	$500,000
Dividends on AT&T stock (consider § 243)	100,000
Interest on municipal bonds (§ 103)	100,000
Capital gain	100,000
Total	$800,000
Deductible § 162(a)(l) business expenses	$430,000
Noncapital expenses not deductible under § 162(e)	90,000
Capital losses (see § 1211(a))	146,000
Total	$666,000
Net	$134,000

(1) On December 24 of the preceding year, SecondCo and Arnold incorporated ChadCo and capitalized ChadCo with cash of $100,000 each. On December 31 of that preceding year, SecondCo and Arnold received distributions from ChadCo of $5,000 each; ChadCo did not earn any income for that year. In addition, SecondCo and Arnold received distributions of $5,000 each, in the current year.

Which distributions should be gross income to SecondCo and Arnold, in what amounts, and why? What does E&P have to do with this?

(2) Alternative: Arnold just bought the ChadCo shares on December 30 of the current year from another shareholder for FMV of $145,000, before the declaration and payment of a

$5,000 distribution to Arnold on December 31 of the current year.

Should the distribution be taxable income to Arnold? Why?

(3) Now assume that SecondCo’s basis in its ChadCo stock is $100,000 and Arnold’s basis in his ChadCo stock is $40,000. On January 2 of the current taxable year, ChadCo distributes $100,000 in cash to SecondCo and $100,000 in cash to Arnold. As of the end of the preceding taxable year, ChadCo’s accumulated E&P was zero.

What are the tax consequences of this distribution to ChadCo, SecondCo, and Arnold? [Hint: First compute ChadCo’s current-year taxable income and then compute current- year E&P before reducing the E&P for the distribution (“interim E&P”); after reducing for the distribution, compute final accumulated E&P.]

(4) Variation: Assume Arnold’s shares were owned by a different shareholder every quarter and $50,000 was distributed ratably to all shareholders quarterly?

How much dividend would SecondCo and the holders of Arnold’s shares receive?

(5) Suppose under the basic facts in (3) above that ChadCo had an accumulated de?cit of

$100,000 in its E&P account as of December 31 of the preceding taxable year.

(6) If, on December 1 of the current year (the declaration date), ChadCo’s board of directors voted to pay the $200,000 distribution by mailing the checks on December 31 of the current taxable year (the payment date, the identi?cation of which is a practice generally used only by widely held corporations) to shareholders of record on December l5 of the current taxable year (the record date), such checks actually being received by SecondCo and Arnold in the mail on January 2 of the next year? Assume that SecondCo and Arnold are the public and that they are the only shareholders (as in the basic facts).

How would your answer to (3) above change?

(7) Suppose that SecondCo is an individual and that ChadCo has always been an S corporation.

What is ChadCo’s E&P‘? How is each shareholder’s personal income tax return affected for the current year by the tax items of ChadCo?                                     How will ChadCo distribution of

$100,000 to each shareholder in the current year affect shareholders?

Answer 1

#Problem 1

Earnings and profits:

Earnings and profit differ in terms of how they are calculated. Usually, earnings are the income a business earns, which may be calculated after subtracting the costs of making, purchasing, or providing the items or services it sells. Profit on the other hand is essentially the money a company keeps after taking care of all of its business-related expenses. As such, a company may have an impressive amount of earnings but have very little profit.

It may help to consider an example when trying to understand the difference between earnings and profit. A gift basket company, for example, may collect $5,000 for the sale of gift baskets in the course of a week. If it costs $2,500 USD to prepare these baskets, the gift basket company’s earnings may be $2,500 USD. The company may have $1,000 USD in other expenses, however, that reduce the amount of money it will actually keep. In such a case, the company’s profits may be $1,500 USD rather than the $2,500 USD that was left over after the cost of creating the gift baskets was subtracted.

Earnings and profit calculations are often used to determine the financial health of a business. They are typically used in reporting business income to tax authorities as well. Often, tax agencies want to know how much a business has collected over a period of time, the cost of the goods or services it sold, and the amount of profits it has earned.

#Problem 2:

Stock's basis 100,000

Dividend 200,000

After distribution of the dividend, the stock's basis remains the same, that is $100,000. Dividends received are normally taxed at income tax rates in US.