Corporate Taxation: Earnings & Profits, Distributions, 351, Partnerships

Chapter 18: Current & Accumulated E&P (CEP & AEP)

(TI ± its Adjustments = CEP) CEP is determined on the last day of the tax year, before calendar year distributions. Example: AEP = 20,000; Loss = 25,000; distribution = 10,000 on July 1. CEP at 7/1 = (25,000) × 1/2 = (12,500). Net = (12,500) + 20,000 = 7,500 taxable dividend and 2,500 nontaxable return of capital.

Corporate Distributions — Layered Tax Treatment

Corporate distributions are paid out of earnings and profits (E&P) unless otherwise shown, and they occur in layers:

• Earnings and Profits — Taxed as dividend income.
• Stock Basis — Nontaxable return of capital (reduces shareholder basis).
• Distribution in Excess of E&P and Basis — Taxed as capital gain.

E&P is similar to retained earnings (CEP → net income; accumulated E&P → beginning balance in retained earnings).

Computation of Earnings & Profits

Start with taxable income and then make adjustments:

• Additions to taxable income: items excluded from taxable income (for example, tax-exempt municipal bond interest income and life insurance proceeds) and items deducted for taxable income that should be added back for E&P purposes (for example dividends-received deduction, NOL carryforwards, net capital loss carryforwards, charitable contribution carryforwards).
• Subtractions from taxable income: items not deducted for taxable income (for example nondeductible portion of meals and entertainment expenses, related-party losses, expenses incurred to produce tax-exempt income, federal income taxes paid, nondeductible key-employee life insurance premiums to the extent that they increase cash surrender value, nondeductible fines and penalties, lobbying expenses, current year net capital loss).
• Timing adjustments: shift items from the year of deductibility to the year they have an economic effect for E&P (examples: immediate gain recognition, straight-line ADS depreciation differences, IRC §179 expense deductions not allowed for E&P and spread over five years, differences in gain/loss on sale of depreciable assets due to lower tax basis for taxable income vs E&P purposes, amortization of organizational expenditures not allowed for E&P, LIFO recapture amount = excess of FIFO over LIFO).

Installment Sale Example

BCC sells a yacht to Lisa. Lisa pays 20,000 on the date of sale and 20,000 over four years. Yacht tax basis is 50,000. Gain on sale = Adjusted Realization - Adjusted Basis = 100,000 - 50,000 = 50,000. Gross profit margin = Gain / AR = 50,000 / 100,000 = 50%. BCC must recognize 50% of each payment as profit for regular income tax purposes (50% × 20,000 = 10,000). For E&P, there is immediate recognition of 50,000; for regular tax purposes, the installment inclusion is 10,000 in the first year and in subsequent years. Thus E&P adjustment is 40,000 (immediate 50,000 recognized for E&P minus 10,000 recognized via installment method for regular tax).

Current vs. Accumulated E&P (Cash Distributions)

AEP is the total of all previous CEPs. The tax treatment of corporate distributions depends on the amount of CEP and the balance of AEP.

1. CEP Negative & AEP Negative — No E&P; distributions are either return of capital or capital gain.
2. CEP Positive & AEP Positive — Reduce CEP first, then AEP, then stock basis. If there are multiple distributions and the total distributed > CEP, allocate CEP on a pro rata basis: allocate each distribution = CEP × amount of individual distribution / amount of total distributions. AEP gets the allocated remainder in chronological order.
3. CEP Positive & AEP Negative — A taxable dividend to the extent of positive CEP, then reduce stock basis.
4. CEP Negative & AEP Positive — A loss (CEP) is deemed "earned" as of the date of distribution. Net CEP and AEP as of the date of distribution; if positive, it is a dividend to the extent of the positive balance; otherwise use stock basis.

(See the example at the top of the page.)

Noncash Property Distributions

A corporation recognizes gain on the distribution of appreciated property, but it cannot recognize a loss on distribution of depreciated property (no loss recognized for tax or CEP). If distributed property is subject to a liability greater than FMV, then FMV is deemed not less than the liability amount. Effect on E&P: gain recognized on appreciated property increases E&P; property distributions reduce E&P by the greater of FMV or basis less any liability associated, then net the E&P effect. No loss is recognized for E&P when distributed property has a built-in loss.

Stock Distributions

1. Proportionate Distributions — Nontaxable if shares are "identical" unless otherwise noted. Holding period of new shares tacks onto original shares and do not reduce E&P. If distributed stock is identical to original stock, new per-share basis = original basis / total number of shares now owned. If not identical, allocate basis in original stock to original and new stock based on fair market values (FMV): (FMV original / total FMV) × original basis and (FMV new / total FMV) × original basis.
2. Disproportionate Distributions — Taxable. FMV of shares received = new basis in stock; reduce E&P by the FMV of the distribution (example: 100 shares, FMV = 50,000; new basis = 50,000; reduce E&P by 50,000).

Stock Redemptions

1. Qualifying redemption — Treated as sale of property (capital gain or loss). Shareholder recognizes capital gain = cash + FMV received - stock basis. Related shareholders (related to the corporation with > 50% ownership) cannot recognize losses on qualifying redemptions.
2. Non-qualifying redemption — Treated as dividend distribution (dividend income). Shareholder recognizes dividend income = cash + FMV received.
3. Stock attribution rules (apply, then non-qualifying test) — Stock owned by related parties is attributed to the shareholder whose stock is redeemed (related parties include spouse, children, grandchildren, parents, partnerships, estates, trusts, corporations when the shareholder owns 50% or more, and similar relationships).

Example: Husband owns 15% and wife owns 10% of Aggie Corp. Husband has 15% directly and 10% constructively; wife has 10% directly and 15% constructively.

Substantially Disproportionate Redemptions

To qualify as a sale (then treat as qualifying redemption), two requirements must be met. Example: Ryan, Dan, and Brian (unrelated) own 30, 30, and 40 shares. Company has E&P of $1,000,000 and redeems 20 shares of Brian's stock for 60,000. Brian paid 100 per share years ago.

• 50% test: (shares owned after redemption belonging to redeemer) / (total shares after redemption). For Brian: (40 - 20) / (100 - 20) = 20 / 80 = 25% → 50% test passes if result < 50%.
• 80% test: 80% × redeemer's pre-redemption ownership = 80% × 40% = 32% > 25% (meets the comparison threshold in the example).

Sale treatment: Long-term capital gain = FMV - basis = 60,000 - (100 × 20 shares) = 60,000 - 2,000 = 58,000 (note: ensure basis calculation; original text units retained).

E&P reduction: Lesser of proportionate E&P reduction versus FMV distribution. Proportionate reduction = 20 / 100 × 1,000,000 = 200,000 versus FMV distribution = 60,000, so E&P after = 1,000,000 - 60,000 = 940,000.

When Not Substantially Disproportionate

If the tests fail (for example, if Brian is the father and attribution rules apply), then redemption is nonqualifying and treated as dividend income of 60,000. Basis and E&P adjustments follow the dividend treatment. Example calculations of per-share basis and E&P after redemption are provided in the original text and preserved here.

Effect of Redemptions on E&P

Qualified redemptions reduce E&P unless the E&P reduction exceeds the FMV of distributed property. Example: Corporation has 100 shares, redeems 25 shares for 50,000 when E&P = 120,000.

• If non-qualifying redemption: dividend treatment = 50,000; E&P after = 120,000 - 50,000 = 70,000.
• If qualifying redemption: lesser of proportionate E&P reduction vs FMV distribution = 25% × 120,000 = 30,000 vs 50,000, so E&P after = 120,000 - 30,000 = 90,000.

Chapter 19: Section 351 Transfers, Basis, and Liquidations

Section 351 applies during corporate formation and when property is exchanged for stock. If the requirements of §351 fail, the transfer may result in taxable sale or exchange (to avoid double tax). Below are key §351 concepts.

IRC §351 Transfers of Property to a Corporation

Transfers of property to a corporation in exchange for stock may constitute a nontaxable exchange if conditions are met.

1. Only stock exchanged: If a transferor receives only stock, recognized gain = FMV of property received - tax basis transferred (unless §351 applies and postpones recognition).
2. Gain recognized from boot received: If a taxpayer receives cash or property other than stock (boot), recognized gain is limited to the lesser of realized gain or boot received. Realized gain = FMV of property received (including boot) + liabilities assumed from transferor - tax basis of property transferred - FMV of boot paid - liabilities paid by transferor.
3. §351 control test: Mandatory nontaxable treatment if (A) property is transferred, (B) in exchange for stock, and (C) the property transferors are in control immediately after the exchange. "In exchange for stock" includes common and certain preferred stock, but not nonqualified preferred stock, stock rights, or stock warrants. Debt and other non-equity securities received are treated as boot. Basis in stock received = substituted basis + gain recognized - FMV of boot received (including liabilities assumed).

Control occurs when transferors have at least 80% of stock ownership and at least 80% of the total number of shares of all other classes. The control test applies to a single taxpayer or a group of taxpayers if they are parties to an integrated transaction (within a timeframe), with previously determined and orderly transfers. A member of the transferor group who provides services must transfer property with FMV at least 10% of the FMV of services given and must transfer a minimal amount of property relative to the amount of stock owned.

Basis Postponement Impact

When §351(a) postpones gain or loss until a shareholder disposes of stock:

• Basis of stock to shareholder: substituted basis + gain recognized on exchange - boot (including liabilities assumed).
• Basis of property to corporation: carryover basis + gain recognized on exchange (services received are ordinary income).

1. Basis adjustment for built-in loss property: When aggregate basis of assets transferred > their FMV, allocate proportionately [(built-in loss item) / total built-in losses] × net built-in losses and subtract from the tax basis. If shareholders and corporation elect to reduce basis to the stock, stock basis = substituted basis - net built-in losses (asset basis remains the same).

2. IRC §357(a) assumption of liabilities: No boot for gain recognition if the corporation assumes liabilities or takes property subject to a liability. In basis formulas, stock basis is reduced by the amount of liabilities assumed. Two exceptions: (b) if assumption is to avoid tax or has no bona fide business purpose, treated as boot received (one tainted liability taints all liabilities); (c) if sum of liabilities to the corporation > adjusted basis of property, the excess is recognized as gain (exclude accounts payable).

3. Holding period: For stock received in exchange for capital or §1231 assets, holding period of the stock includes the holding period of the property. For other property, the stock's holding period begins the day after the exchange. The corporation's holding period for the transferred property is the transferor's holding period. When no gain is recognized, depreciation recapture rules do not apply.

Capital Contributions and Small Business Stock

No gain or loss to the corporation when it receives money or property from a shareholder as a capital contribution. Corporation basis in property from a non-shareholder is 0. If a non-shareholder donates money, basis of new property acquired with donated money = cost of new property acquired during a 12-month period less donated money. Excess donated money over cost reduces the basis of other property in a specified order: depreciable property → property subject to amortization → property subject to depletion → all other remaining property. If donated money < cost of new assets, apply cash in that order.

Small business stock: To qualify: (1) total amount of stock issued at issuance (valued at adjusted basis) < $1,000,000; (2) only original holder of §1244 stock qualifies for ordinary loss treatment; (3) applies only to individuals (sharing shareholders). For losses, ordinary loss treatment may apply; for gains, it remains capital. In a §351 transaction where property has an adjusted basis > FMV, subtract FMV of property to determine ordinary loss. Capital gain or loss equals shareholder's total gain or loss on sale ± ordinary gain or loss.

Corporate Liquidations

In a liquidation, the liquidating corporation recognizes gain or loss on the distribution of property (sold at FMV less adjusted basis, or when subject to liability, FMV not less than the liability). If subject to a liability, FMV used cannot be less than the amount of the liability; if so, ignore the liability for purposes of the FMV floor.

Effect on shareholders: Shareholders treated as selling their stock to the corporation in a complete liquidation. Shareholder gain or loss = FMV of property received - tax basis of stock (character is capital). Anti-stuffing rules apply:

1. Related-party loss limitation — Disallows losses on distributions to related parties of the corporation when the distribution is not pro rata (each shareholder's share) or when stock owned by related persons is attributed to the shareholder receiving the liquidation distribution. Disqualified property includes property acquired by the liquidating corporation in a §351 transaction or as a contribution to capital during the five-year period ending on the date of distribution when the property had a built-in loss at time of liquidation.
2. Built-in loss limitation — Disallows losses from sale, exchange, or distribution to any shareholder of loss property transferred shortly before liquidation. Applies when property was in a §351 transaction or contribution to capital and the purpose was to recognize the built-in loss. Disallowed loss is limited to the built-in loss; if loss property is split between shareholders, multiply the subsequent decline by each shareholder's proportionate share of property distributed.

Installment obligations: Gross profit rate = Gain / Total proceeds. Recognize that percentage of all cash note receipts as gain (amount per note × rate% = recognized gain for each payment).

Parent-subsidiary situations: Nonrecognition of gains and losses may apply where the parent owns more than 80% of voting stock and value, the subsidiary distributes all property within the tax year of stock cancellation or within three years of the close of the tax year in which the first distribution occurred, and the subsidiary is solvent.

Minority interest: A liquidating corporation recognizes gain (not loss) on distribution of property to minority shareholders (when requirement 1 in parent-subsidiary is < 80%). Shareholder gain or loss = FMV - basis in stock. Basis in property received = FMV on date of distribution.

Indebtedness of subsidiary to parent: If a subsidiary transfers property to satisfy debt, it recognizes gain unless the subsidiary is liquidated pursuant to IRC 332 (complete liquidation). In a §332 liquidation, parent corporation recognizes gain or loss even if the subsidiary is liquidated to satisfy a debt.

Parent basis in corporate liquidation property: Property received by the parent from a subsidiary has a carryover basis to the parent (parent's gain or loss on difference of basis is not recognized and basis in stock disappears). Tax attributes that carry over from the subsidiary to the parent include E&P, NOLs, business credits, and capital loss carryovers.

Chapter 20: Partnership Taxation, Basis, and Loss Limitations

(A partnership cannot be a corporation, trust, or estate for these rules.) Partnerships do not pay tax at the partnership level. Each partner reports their allocable share (multiplied by their percentage) of the partnership's ordinary income, expenses, gains, and losses on their own tax return.

Partner's Ownership Interest and Allocations

Capital sharing ratio — A partner's percent ownership of partnership capital (percent of net asset value received upon liquidation). Profit and loss sharing ratio — A partner's percent allocation of current partnership income and losses. The partnership can make special allocations of certain items to partners that differ from general sharing ratios; for tax purposes, special allocations must have substantial non-tax economic effect for the partner receiving them.

Tax Basis in a Partnership Interest

Each partner has a basis in the partnership interest. When income flows through to a partner, their basis increases; when losses flow through, their basis decreases.

IRC §721 Partnership Formation

Under §721, partners can contribute property to a partnership in exchange for a partnership interest and defer gain or loss (effective when partner contributes capital). If cash received > adjusted basis, recognize gain equal to the excess.

Substitute basis: When a partner makes a tax-deferred contribution of property, substituted basis = partner's prior basis in contributed asset and the partnership takes a carryover basis.

§721 assumption of liabilities: If the partnership assumes a liability, the contributing partner does not recognize gain from the liability. The partner's basis is reduced by the total amount of liabilities assumed by others and increased by the amount of liabilities allocated to that partner.

Where §721 doesn't apply: (1) contribution of services (may be ordinary income or, if a profits interest, not taxed), (2) contribution to investment partnerships of appreciated securities, (3) taxable exchanges of property, (4) disguised sales of property.

IRC §704 Pre-Contribution Gain and Loss

(Applies to property contributed within seven years before date of sale.) When a partnership disposes of property that was once involved in a §721 transaction, allocate built-in gain among partners based on the difference between FMV and basis of the contributed property on the date of contribution. For non-depreciable property, the built-in gain at contribution is allocated to the contributing partner. If contributed property has a built-in loss on the date of contribution, allocate that loss only to the contributing partner (partnership basis in loss property = FMV on date of contribution).

Character of gain/loss on sale of contributed property: Determine the character of built-in gain or loss on the date of contribution; the partnership's use of the property after the contribution determines how remaining gain or loss is characterized. Applies to dispositions within five years of contribution.

Reversal allocation methods:

• Remedial method: Allocate built-in portion to contributing partner and allocate the remaining portion according to profit/loss sharing ratios.
• Traditional method: Allocate total gain or loss to the contributing partner.

Income Measurement and Separately Stated Items

A partnership is not allowed an NOL deduction, dividends received deduction, or standard deduction. Separately stated items that pass through to partners include net short- and long-term capital gains/losses, §1231 gains/losses, charitable contributions, portfolio income items (dividends, interest, royalties), expenses related to portfolio income, §179 deductions, special allocations, recoveries of previously deducted items (tax benefit items), AMT preference and adjustment items, self-employment income, passive activity items, taxes paid to foreign countries and U.S. possessions, non-business and personal items, and guaranteed payments. Guaranteed payments for services or use of capital are deductible by the partnership and create ordinary income for the recipient partner.

Inside and Outside Basis; Capital Accounts

Inside basis is the adjusted basis of each partnership asset. Outside basis is each partner's basis in their partnership interest. Each partner effectively owns a share of the partnership's inside basis for each asset. Capital accounts can be maintained using tax basis, §704(b), or GAAP methods.

Outside basis formula (order of adjustments): Initial basis + partner's subsequent contributions + partner's share of partnership's debt increases + taxable income items + tax-exempt income items + excess of depletion deduction over property basis - partner's distributions and withdrawals - partner's share of partnership debt decreases - nondeductible items not charged to capital account - special depletion deductions for oil & gas - deduction and loss items. Simplified: Partner's tax-basis capital account + partner's share of debt + tax-exempt income items - nondeductible items = outside basis. Outside basis cannot be negative.

Initial outside basis: For a new partnership interest = substituted basis of property transferred + debt allocated to partner + FMV of services if a capital interest is received. For a pre-existing interest: purchase from partner = cost; acquisition by gift = carryover basis; acquisition by inheritance = FMV on date of death.

Liability Sharing and Debt Allocation

Partnership debt is considered in basis calculations (except accounts payable of a cash-basis partnership). An increase in a partner's share of partnership debt is treated as a cash contribution; a decrease in share of debt is a cash distribution.

Recourse debt rules: Recourse debt is allocated to partners who are personally liable (typically general partners). If a limited partner personally guarantees the liability, it is recourse to that partner. With multiple general partners, follow the constructive liquidation scenario: assume partnership assets become worthless and are sold at FMV = 0, allocate losses, restore negative capital accounts by deemed contributions, and liquidate; this determines allocation of recourse liabilities.

Nonrecourse debt rules:

• Minimum gain — allocated to partners who share minimum gain (excess of nonrecourse debt over book basis of contributed property).
• IRC §704(c) debt — allocated to partners who contributed property (excess of nonrecourse debt over tax basis of contributed property).
• Any remaining nonrecourse debt is allocated according to the partners' profit-sharing ratios.

Loss Limitations

Losses from partnerships are subject to three limitations, applied in order: overall (tax basis), at-risk, and passive activity limits. Losses that exceed limits are suspended and carried forward indefinitely until a triggering condition occurs.

1. Overall (tax basis) limitation: Partners may deduct losses only to the extent of their adjusted outside basis. Basis is determined at year-end prior to applying losses but after income, contributions, and distributions.
2. At-risk limitation: Losses that pass the overall limitation are deductible only to the extent the partner is economically at risk. Nonqualified and most nonrecourse debt are excluded from at-risk amounts.
3. Passive loss limitation: Losses that survive the overall and at-risk limitations are subject to passive loss rules for partners that are individuals, estates, trusts, C corporations, or personal service corporations. The partner must materially participate to avoid passive loss limitation. If a loss exceeds the applicable limitation, compute the deductible portion in order, determine suspended losses, and carry them forward.

Related-party transactions: No loss recognition on sale of property if the buyer owns more than 50% of partnership capital/profits, and any gain realized is treated as ordinary income unless the property is a capital asset to both seller and purchaser.