Question

Question: Reading Federal Income Taxation of Corporations and Shareholders Text: Study Chapters 7 & 8 o...

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, specifically retained earnings, and profit are often used as synonyms in corporate finance, although they are different terms and have different meanings. These differences largely center around accounting treatment.

Earnings vs. Profit

A company's earnings are equal to revenues, minus the costs of production over a given period of time. Profit is equal to total revenue less all expenses. In the right context, these could be equal to each other, although that is rare. A company may have a substantial amount of earnings, but have very little profit. Big gaps between earnings and profits might be a sign the company spends too much time and money on unproductive activities.

Consider an example where a toy manufacturer sells $10,000 worth of toys in one week. It did not make any money from other sources over the same week, and so its total revenue is $10,000.

If it cost $7,000 to manufacture those toys, the earnings for the company are $3,000 for the week, or $10,000 - $7,000. This does not take into account other fixed costs, however. The company may have paid interest on some debt, had to pay an accountant or fix a toilet at its facility. Suppose the company incurred $1,800 worth of these overhead expensesduring the week. Now, its weekly profit is only $1,200 even though earnings show $3,000.

This tells the company that it needs to focus on reducing miscellaneous costs. It is manufacturing and selling toys at a 30% margin, but it has to immediately sink a full 60% of its earnings into other expenses.

Consider the ramifications of a company (or investor) that ignores the difference between earnings and profit. If the toys had only sold at a 15% margin instead of 30%, those miscellaneous expenses would have resulted in a net loss for the week, but earnings still showed a $1,500 gain. This is a very different picture once the additional expenses are factored in.