Liquidating Dividends - Ordering Rules

[Corduroy Frog]

This is messy.  Not sure I know the best way to present this without giving hypothetical numbers as an example:

Facts for a C Corp:

• 01/01/23 C corp Capital Stock $1,000
• 01/01/23 Retained Earnings $12,000
• CY2023 Taxable Loss  ($9,000)
• CY2023 Dividends (Distributions)  $7500

a)  If the dividends are applied FIRST, they are all taxed as Dividends, as beginning equity $13,000 accommodates dividend charges of $7500.

b)  If the dividends are applied AFTER the Y/E, there is only enough equity ($4000) to accommodate $4000 of taxable dividends, and the remaining $3500 are considered liquidating and non-taxable.

Which of the above a) or b) would be correct?  Or this there another answer?

Thank you for your patience in reading this messy situation, and for responding.

 

 

[kathyc2]

C corp dividends paid out are always taxable in the year where cash payment is made. 

If beginning equity is 13K, and company is liquidated where did the cash come from to pay out 7.5 dividends and have 9 loss?

[Corduroy Frog]

Good question Kathy, but cash could have come from non-taxable sources, such as a reduction in receivables, inventory, or disposal of fixed assets,,,,

 

[DANRVAN]

55 minutes ago, Corduroy Frog said:

Good question Kathy, but cash could have come from non-taxable sources, such as a reduction in receivables, inventory, or disposal of fixed assets,,,,

 

How do you convert any those to cash without generating income?

[DANRVAN]

5 hours ago, Corduroy Frog said:

Or this there another answer?

I hope this is not a real client situation you are working on without basic knowledge of corporate income taxation.

Dividends are taxable to the extent of E & P, excess is return of capital offset by stock basis.

Depending on how the transaction is structured, the entire liquidating distribution could be a payment for shareholder's stock.

[Corduroy Frog]

Dan, for a C Corp, Stock Basis of the shareholder is very basically the same as capital, with exceptions for non-taxable income and non-deductible expense, unless there are non-cash transactions such as donated equipment, etc.

For purposes of the question, one may assume basis is the same as capital balances.

[Corduroy Frog]

3 hours ago, DANRVAN said:

How do you convert any those to cash without generating income?

For an accrual basis taxpayer, reduction in receivables, inventory, etc. would be tax free so long as the income was recognized in a previous year.

By the way, I appreciate your posts, not withstanding your seeming doubt of my applications.  Your answers are accurate and thought-provoking, and for the most part, helpful..

[kathyc2]

4 hours ago, Corduroy Frog said:

For an accrual basis taxpayer, reduction in receivables, inventory, etc. would be tax free so long as the income was recognized in a previous year.

 

For an ongoing business, this would be true.  If the company was liquidated, assets would be zero, liabilities would be zero and different equity accounts would need to net to zero, not a negative amount.

[DANRVAN]

5 hours ago, Corduroy Frog said:

 for a C Corp, Stock Basis of the shareholder is very basically the same as capital

Not true.  Stock could have been purchased, inherited, or gifted.

That is important because distributions in excess of E and P are are subject to capital gains and offset by basis.

14 hours ago, Corduroy Frog said:

a)  If the dividends are applied FIRST, they are all taxed as Dividends, as beginning equity $13,000 accommodates dividend charges of $7500.

b)  If the dividends are applied AFTER the Y/E, there is only enough equity ($4000) to accommodate $4000 of taxable dividends, and the remaining $3500 are considered liquidating and non-taxable.

Those statements show a lack of understanding that a basic course would cover.

 

5 hours ago, Corduroy Frog said:

For an accrual basis taxpayer,

That is correct, I assumed cash basis.

[kathyc2]

9 hours ago, Corduroy Frog said:

Dan, for a C Corp, Stock Basis of the shareholder is very basically the same as capital, with exceptions for non-taxable income and non-deductible expense, unless there are non-cash transactions such as donated equipment, etc.

You are confusing S and C corps.  Basis in a C does not change with non taxable or non deducible items. Nor does it change with profits or losses.  

[DANRVAN]

34 minutes ago, kathyc2 said:

You are confusing S and C corps.

and the concept of a pass through entity vs a fully taxable one.

[Corduroy Frog]

Thanks for all comments.  Very instructive.

Yes there was confusion due to the introduction of basis.  If there is a $1000 initial contribution of cash for capital stock in a C Corp, that should be the end of the basis it if nothing else happens to capital stock.  Further income, loss, non-taxable income, non-deductible expenses should not change the basis.  If the issuance of dividends is taxable to the extent of E&P, the question becomes is the measurement of E&P effective at the beginning of the year or at the end of the year??

[jklcpa]

Have you actually tracked E&P each year and know what the accumulated E&P is?

Dividends are first paid out of current and accumulated earnings and profits. Current year E&P are considered first and are determined at the close of the current year.  Any distribution that exceeds the total of current and accum E&P is a return of capital and reduces shareholder's basis. Anything in excess of that is taxed as cap gain.

https://answerconnect.cch.com/topic/46dee5267c6b1000a17990b11c18cbab013/earnings-and-profits-limitation-for-dividends

[Corduroy Frog]

Judy, thank you so much.  That pretty well answers the question.  Apparently the ordering rules are:

1.   Reduce the Earnings and Profits to the extent they exist at year-end.
2.   Reduce the Basis
3.   Report Capital Gains

Great link also.

Ron J.