Let’s say a company, a C corporation, is to make a distribution to you as a shareholder. With proper purpose and execution within the tax code, this is fine, so we leave out the why. This is also a serious matter, so it should be transacted under the IRC correctly. If you are a major shareholder, or exert control over the corporation, then you are considered a related party shareholder. If you own the majority of shares in a small business and your business is to distribute equipment to you, an old truck for example, that is not fully depreciated on the books of the company, then it has a book value. Let’s say, for example, it has been depreciated down to a basis of $25,000. Let us also say that the truck is worth something in the market, hypothetically $40,000, the fair market value (FMV). If the basis is less than the FMV, then we say the property is “appreciated.” If the company also distributes cash to you in this example, let’s say $5000, then that must also be valued and cared for in the transaction.
In this case, we need to describe the character and amount of the gain or loss to both the corporation and you as the recipient of a dividend of both cash and appreciated property. Also in this case we need to define the character of the gain given the corporation has no earnings and profits (for a good explanation of E&P, I suggest the following link written by Kaiser at http://www.thetaxadviser.com/issues/2013/oct/kaiser-oct2013.html.)
Let’s move on with our simplified example with some tax code in effect at the time of writing this blog (tax code does change so you should check with your accountant in a real life example).
Section 311(a) states, in general, that except as provided in 311(b), no gain or loss will be recognized to a corporation in its distribution of its stock or of property. Section 311(b)(1)(A) and 311(b)(1)(B) also provide that when a corporation distributes appreciated property to a shareholder the disposition of the property will be as if the corporation sold it. It states in part, “then gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value.” This means the difference between its FMV and its adjusted basis will be recognized as gain to the corporation.
Section 301(c)(1) states that the amount considered a dividend as defined in Section 316(a) shall be included in gross income. The amount not considered a dividend reduces the adjusted basis of the stock according to Section 301(c)(2). The amount not recognized as a dividend, and in excess of adjusted basis, shall be treated as a gain from sale of property per Section 301(c)(3).
Section 316(a)(1) and Section 316(a)(2) defines a dividend as “any distribution of property made by a corporation to its shareholders” out of current or accumulated earnings and profits.
In our hypothetical, the corporation made a current distribution of $5,000 cash and an appreciated truck worth $40,000, as defined in Section 311(b). Since this is a dividend distribution in relation to your stock holding in the corporation, the corporation must include the gain on the appreciated property as if it sold the property to you, and also must include in gross income per 301(c). This will be ordinary income as to the truck. Since the truck has a current FMV of $40,000, and it basis to the corporation is $25,000, the gain is $15,000, and it is ordinary income.
Per section 301(c) you must recognize the distribution, to him or her, first as dividend income if the corporation has any current or accumulated E&P. The corporation has no E&P. Thus, there is no dividend income. Next you must reduce your basis in the corporation stock. Since your total dividend is $45,000 your potential gain is reduced by first reducing your basis in stock as a shareholder. If your basis in stock was, let’s say $20,000, then your gain is reduced from $40,000 potential to $25,000, due to reduction first of your $20,000 stock basis to $0. The balance per Section 301(c)(3) is, therefore, recognized as capital gain of $25,000.
The corporation recognizes an increase in ordinary income of $15,000 on the distribution of appreciated property. It recognizes no gain on the $5,000 cash because it is not appreciated property.
You recognize a capital gain equal to the $25,000 balance of your distribution after the total $45,000 is first reduced by your $20,000 basis in stock. There is no dividend income recognized before reduction of your stock basis because the corporation has no E&P current or accumulated.
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