Cash and Property Distributions

• Pages: 103-139
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

103

Chapter 4

CASH AND PROPERTY

DISTRIBUTIONS

4.01 Introduction

A corporation generally determines income and deductions in

much the same ways as an individual. A corporation may retain its

earnings or distribute them to its shareholders, and much of what

follows in this and subsequent chapters focuses on the different ways

shareholders can obtain corporate earnings, including, most directly,

through distributions.

Many, but not all, corporate distributions are “dividends” for

federal income tax purposes, included in gross income under

§ 61(a)(7). Suppose that B forms X Corp., contributing $1,000 in

exchange for all X Corp. stock. In year 1, X Corp. has no income, gain

or loss, but makes a $200 distribution to B. Should B be taxed on the

distribution? B has experienced no accession to wealth. Nor has B

realized a previously unrealized gain. Before the distribution, B

owned X Corp. stock with a $1,000 basis and $1,000 fair market

value. § 358. After the distribution, B owns $200 in cash and stock

with a fair market value of $800. B has simply received a return of

her original investment and should not be taxed on the distribution,

but B’s stock basis in X Corp. should be reduced by $200, from $1,000

to $800.

Suppose instead that in year 1 X Corp. earned $200, which it

distributed to B. First, X Corp. would be taxed on its earnings.

1

What

about B? B would like to claim that the distribution comes from B’s

original $1,000 contribution. If so, the distribution would reduce B’s

basis in her X stock from $1,000 to $800. B would hold $200 in cash

and stock with an $800 basis and $1,000 fair market value, treatment

that would defer B’s tax on the $200 earned by X Corp. On the other

hand, one could argue that the distribution represents the earnings

of X Corp. in year 1 and should be taxable to B.

Note that the distribution itself does not increase B’s wealth.

Just before the distribution, B holds X Corp. stock with a $1,200 fair

market value. Just after the distribution, she holds $200 of cash and

stock with a $1,000 fair market value. Although B has “converted”

stock to cash, her “undeniable accession to wealth”

2

occurred as X

1

The quantitative effect of corporate taxes on amounts distributed or

available for distribution is ignored throughout this chapter.

2

Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).

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CASH AND PROPERTY DISTRIBUTIONS

Ch. 4

Corp. earned the $200. The question, simply put, is should B continue

to defer her tax until she sells the X stock or is the cash distribution

a significant enough event to justify taxing the previously accrued

accession to wealth.

Both ways of treating distributions draw strength from other

areas of tax law. For example, under the open transaction doctrine of

Burnet v. Logan,

3

a taxpayer can recover basis first if the amount

realized cannot readily be determined. Arguably, it is impossible to

determine how much will be distributed during the life of the

corporation. Following Burnet v. Logan, shareholders should be

allowed to recover their investment before reporting gain. On the

other hand, where a taxpayer receives periodic returns on its

property, those returns are taxed under the general principles of

Commissioner v. Glenshaw Glass Co.

4

Thus, rent is fully taxable to a

holder of real estate and interest is fully taxable to a holder of a debt

instrument.

The arguments supporting either treatment give way to a web

of statutory provisions. Section 301 addresses distributions of

“property,” as defined by § 317(a), with an assist from § 316, which

defines dividends. Note that § 317(a) defines property mostly by

negation, specifying that property excludes a corporation’s own stock

(or stock rights).

5

It does state that property includes cash, securities,

and (somewhat unhelpfully) other property.

Section 301(a) applies only when a corporation distributes

property with respect to its stock: that is, distributions to

shareholders in their capacity as shareholders. Other distributions

such as salaries or interest payments on debt obligations are not

addressed by § 301(a). If a corporation makes a distribution with

respect to its stock, the amount of the distribution is computed in

accordance with § 301(b). That amount equals the cash and the fair

market value of other property distributed, reduced (but not below

zero) by the corporate liabilities assumed by the shareholder in

connection with the distribution.

6

Note that the shareholder takes a

basis in any distributed property equal to its fair market value.

§ 301(d). For example, if X Corp. distributes land with a $100 fair

market value to B and B assumes a $40 X liability in connection with

the distribution, the amount of the distribution is $60 (i.e., $100 gross

3

283 U.S. 404 (1931).

4

Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).

5

Stock distributions are treated separately under § 305. See Chapter 6 infra.

6

To the extent the shareholder assumes a corporate liability, the shareholder

acquires the distributed property because of that assumption, not in her capacity as a

shareholder.

Sec. 4.01

INTRODUCTION

105

value of the land minus the $40 liability) but B’s basis in the land is

$100, its fair market value.

Once a shareholder determines the amount of a distribution, its

treatment is described in § 301(c)—a three-tiered provision.

7

The

shareholder treats that amount first as a dividend, then as a recovery

of stock basis (and to that extent is excluded from gross income), and

finally as gain from the sale or exchange of stock.

8

Section 301(c)(1)

states that the amount treated as a dividend is included in gross

income, referring to § 316 for the definition of a dividend. Section

316(a) provides that distributions out of specified “earnings and

profits” are treated as dividends. Earnings and profits help

distinguish a distribution of income earned by the corporation from

a distribution of a shareholder’s contribution to the capital of the

corporation. Despite the importance of the phrase “earnings and

profits,” no comprehensive definition appears in the Code.

If the amount distributed is not treated in full as a dividend, it

is next treated under § 301(c)(2) as a nontaxable return of the

shareholder’s investment in the corporation. Accordingly, that

portion reduces the basis of the shareholder’s stock. If the

shareholder fully recovers that basis, any remaining amount is

treated as gain from the sale or exchange of property ( i.e., stock),

generally producing capital gain for the shareholder. § 301(c)(3).

Distributions taxed under both (c)(1) and (c)(3) are includible in

the shareholder’s income but the (c)(1) component is includible as a

“dividend” while the (c)(3) component is includible as gain.

Historically, “dividend” income was taxable at ordinary rates, but

since 2003 most dividends (called “qualified” dividends) have been

taxed to individuals at the same rate as net capital gain (i.e., “net”

long-term capital gain); that is, at no more than 20 percent. See

§ 1(h)(11). However qualified dividends are not capital gain. In

particular, dividend income is includible without any offset for basis

and generally cannot be offset by capital loss. This special rule does

7

Note that the excise tax on corporate stock repurchases does not apply to a

non-redemptive distribution on stock to which § 301 applies. See Prop. Treas. Reg.

§ 58.4501–2(e)(5)(iv). That excise tax may apply only to redemptions within the

meaning of § 317(b) or economically similar transactions. § 4501(c)(1).

8

These determinations are made on a share-by-share basis. For example,

suppose that A owns two shares of X Corp., one with a $10 basis and one with a $100

basis, and X Corp. distributes $100 to A, $50 o n each of her X shares. If X Corp. has

no earnings and profits, A will r educe her basis on her first share from $10 to $0 and

recognize a $40 gain and reduce her basis on her second share from $100 to $50. Cf.

Regs. § 1.1367–1(c)(3) (providing that the basis of a share is reduced to account for the

shareholders pro rata share of losses and distributions but that if the reduction

exceeds the share’s basis, the remaining basis of other shares owned by the distributee

shareholder is reduced).