When you own shares in a corporation, profits are the name of the game! Nothing beats a dividends cheque. However, not all “dividends” from a corporation are “dividends” for tax purposes. The type of corporate distribution can have vastly different tax consequences.
A “distribution” refers to any time that a corporation transfers funds, usually profits, from itself to one of its shareholders. Understanding the types and order of distributions is important because proper timing can lower your tax bill. This blog is geared towards corporations owned by a single or small number of shareholders because control of the corporation’s board of directors is required.
This blog first covers several assumptions and explains why they are important. It will then discuss distributions as dividends, return of capital, and distributions in excess of capital. It will conclude with a brief explanation of how and why timing corporate distributions can result in different tax outcomes.
Required Assumptions
To determine the tax consequences of a distribution, the net amount of the distribution, the corporation’s earnings and profits (“E&P”), and the shareholder’s basis in her shares must be known at the time of the distribution. Generally, a shareholder’s basis in her stock is equal to her cost to purchase a share. When a corporation only distributes cash, the distribution’s net amount equals the cash’s value. Calculating a corporation’s E&P is complicated, and warrants its own blog post. Additionally, corporate distributions must be analyzed in the order below. The two assumptions are as follows:
Assumption 1: The corporation only distributes cash.
Distributions of property or property encumbered by debt create complicated tax consequences beyond the scope of this blog. For this blog, what may be considered a dividend, (profits distributed from a corporation to its shareholders) will be referred to as a distribution to avoid confusion with the tax definition of dividend.
Assumption 2: The distribution is to a person.
If a corporation distributes cash to a shareholder that is a corporation or a partnership, many complex rules apply. Some of these include partnership accounting rules and dividends received by a corporation rules. These are beyond the scope of this blog.
Distribution #1: Dividends
When a shareholder receives a tax dividend, the distribution receives the long-term capital gains (“LTCG”) rate, if the shareholder held the stock for longer than one year. The rate is often 15%.
A tax dividend must come out of a corporation’s earnings & profits (“E&P”). Even though calculating E&P is complicated, understanding the types of E&P is simpler. This is important for timing a distribution to result in less tax owed.
Current E&P reflects the corporation’s E&P for the current taxable year. Current E&P is distributed to shareholders on a proportional basis. Current E&P is reduced before accumulated E&P. Calculating a shareholder’s allotted current E&P is simple:
(Shareholder’s Allotted Current E&P) = (amount of shareholder’s distribution) *[(corporations total current E&P) ÷ (total distributions to shareholders)]
The exact value of a shareholder’s allotted current E&P is effectively unknown until the very end of a taxable year because of E&P allocation and calculation rules.
Next, accumulated E&P is analyzed. Accumulated E&P reflects the corporation’s amassed but undistributed E&P from previous taxable years. Distributions reduce accumulated E&P only after current E&P is exhausted. Accumulated E&P is depleted by the value of the shareholder’s distribution on a first-come-first-served basis. Hypothetically, one shareholder could receive all of the corporation’s accumulated E&P, but the others receive none.
Distribution #2: Return of Capital
If the corporation has insufficient E&P to cover the shareholder’s distribution, then the distribution is treated as a return of the shareholder’s capital. A shareholder’s capital is equal to the basis in her shares in the corporation.
A shareholder’s basis in her shares generally equals the share’s purchase price. However, this could be reduced if the shareholder previously received a return of capital distribution. All return of capital distributions are tax free.
This step has two possible conclusions. First, if the shareholder’s basis exceeds the remaining distribution, then the analysis stops. If the shareholder’s distribution exceeds her basis, then the analysis continues to step 3.
Distribution #3: In excess of basis
This step is the simplest so far. The balance of the shareholder’s remaining distribution receives LTCG treatment, if the shareholder held the stock for longer than one year.
Why Understanding Corporate Distributions Matters
You might be asking yourself “Why does it matter?” After all, dividends and distributions in excess of basis both receive LTCG treatment, and return of capital distributions are tax free.
Here’s the rub. If you have excess of basis distributions, you will have less basis in your stock because your capital has been returned. Therefore, when you sell your shares in your business, you will pay more in tax.
Alternatively, you might have some personal long-term capital losses (“LTCL”) that can offset your LTCG. Personal LTCLs could be from the sale of stock or LTCLs from another business, like a partnership. If your personal LTCL exceeds your dividend, you will eat into your basis even though you had the LTCL to offset your LTCG.
Here, the solution is simple. If you wait until the following taxable year to pay out a tax dividend with sufficient E&P, then your remaining personal LTCL will carry over to that year to offset the LTCG. It is important to confirm that your LTCL is eligible for carryover. In this situation, your LTCGs have been offset by your personal LTCLs and your basis in your stock remains intact.
Closing Thoughts
Understanding corporate distribution rules empowers shareholders to time their corporate distributions to result in the least taxable impact for herself and other shareholders. Properly timed corporate distributions can save shareholders large amounts of tax. However, understanding the whole picture of both the corporation’s and the shareholder’s personal taxes is required to properly time corporate distributions. It is always a good idea to seek the advice of a tax professional before undertaking a complicated tax plan. Good luck and happy distributions!
Sources
I.R.C. § 301
www.leoberwick.com/leo-berwicks-math-lesson-of-the-day-calculating-earnings-and-profits/
www.irs.gov/taxtopics/tc409
www.irs.gov/newsroom/new-limits-on-partners-shares-of-partnership-losses-frequently-asked-questions
https://pixabay.com/photos/dollar-flying-concept-business-2891817/
https://pixabay.com/photos/school-a-book-knowledge-study-1661731/
https://pixabay.com/photos/entrepreneur-idea-competence-vision-1340649/
https://pixabay.com/photos/ledger-accounting-business-money-1428230/
https://pixabay.com/photos/money-grow-interest-save-invest-1604921/
This was really well written and easy to follow for readers of all backgrounds. I like how you broke down your assumptions and clearly explained why these assumptions are necessary in understanding the rest of your article. I also liked your explanation for dividends vs distributions. The organization of your article and the images chosen make the article more approachable and easy to read. I also liked that you explained why this is important and why this matters. This would be a great resource for those learning about investing!
Hi Nikolajs,
This is a very thorough and well-written analysis of a complex topic. You did a great job breaking down the concepts and clarifying the assumptions you made about the reader’s situation added to your credibility. I also think clarifying why the distinction mattered at the end was helpful because I hadn’t considered that a distribution that was effectively return on capital would reduce the taxpayer’s basis.
Great job, you’re going to be a great tax lawyer!
Hi Nikolajs,
As someone who know nothing about tax, this article was insightful and easy to read. The information was thoughtfully laid out and easily understood. The organization is logical and easy to follow. I think this article will be very helpful to corporations that have a single or a small group of shareholders. Your closing thoughts conclude the article well. I’ve learned a lot from your article.