Corporate Distributions

Posted on May 21, 2024

Distributions from corporations to shareholders are taxable to the shareholders, if those distributions are classified as dividends:

DIVIDENDS , AS DEFINED BY THE IRC , IT'S SOURCES AND TAX EFFECTS TO SHAREHOLDERS

A dividend is a distribution of property by a corporation out of its earnings and profits (E&P), which is same as Retained Earnings, per GAAP

General Netting Rules

• Current and accumulated E&P are not netted
• Dividends are first drawn from the current E&P, then from accumulated E&P
• If current and accumulated E&P are positive:
• distributions are considered dividends to the extent of the current and accumulated E&P
• If there are no current and accumulated E&P or in a situation where the current and the E&P are both negative:
• distributions are not dividends and not taxable

Exception to the current rule

• If the current E&P is negtive and accumulated E&P is positive--we net the two amounts and if the resultant distributions re considered dividends if the net amount is positive
• Such distributions as dividends would be taxable

Dividends to Preferred vs. Common Shareholders

• Preferred shareholders are not common equity owners of a corporation and they get paid based on their preferred earnings only, which could be fixed at the shareholder's fixed percentage at purchase
• Common shareholders might or might not get the dividend paid but they are residual owners of a corporation and share in the earnings and profits of the corporation as well as the net assets. They are considered the true owners of the corporations and enjoy a comparatively bigger chunk of the profits.

Source and Tax Effects of Distributions

The order of dividends distributions can be elaborated below:

Current Earnings and Profits : This is the first and foremost source of declaring dividends by corporations

• Income to Shareholders - considered taxable dividends
• Effect on Shareholder's Stock Basis - None

Accumulated Earnings and Profits : If the Current E&P are not sufficient, then the Accumulated E&P are used to declare dividends

• Income to Shareholders - considered taxable dividends
• Effect on Shareholder's Stock Basis - None

Stock Basis : If there is not enough money in the Current E&P and Accumulated E&P to cover dividends, we start pulling from the stockholder's stock basis - which is also called the return of capital and is a non-taxable event

• Income to Shareholders - none ( because we are only returning to the shareholders only portion of their initial investment of money- as such non-taxable)
• Effect on Shareholder's Stock Basis - Reduction

Distributions in excess of E&P and Stock Basis : If there is no balance in the Current and Accumulated E&P and the stock basis of the shareholders is also zero, still if the company distributes dividends, it would be taxable at the capital gains rate and not at the ordinary tax rate.

• Income to Shareholder - Taxable Capital Gain
• Effect on Shareholder's Stock Basis - None ( Basis is $0)