Sec. 1059: adjusting more than basis.

• Author: Cotter, Matthew

Sec. 1059 requires a corporate shareholder to reduce the stock basis of its subsidiary when it receives an extraordinary dividend from the subsidiary within the first two years of owning the subsidiary's stock. The procedures for recalculating basis in that scenario are clear, but the effect of these basis adjustments on the corporate shareholder's earnings and profits (E&P) is not as clear.

Earnings and Profits

E&P essentially is a quantitative measure of a corporation's ability to make distributions to its shareholders in excess of distributions considered a return of capital. Although the Code refers to E&P numerous times, nowhere does it provide a comprehensive list of procedures necessary to calculate E&P. Certain Code sections that clearly have some effect on a corporation's E&P, including Sec. 1059, provide little or no guidance for calculating E&P. The lack of clear statutory guidance leads practitioners, as a pragmatic matter, to look elsewhere, including to the legislative history, IRS guidance, and case law, for an appropriate answer.

Economic Reality Problem With the Dividends-Received Deduction

Congress enacted Sec. 1059 in 1984 to prevent corporate shareholders from engaging in "dividend stripping" transactions. The following example illustrates Congress's concern when it passed the section.

Example: Prior to the enactment of Sec. 1059, corporation P purchased 50% of the common stock of corporation S for $500. S has undistributed E&P of $1,000. Shortly thereafter, S declares a dividend, with P receiving a $200 dividend distribution. P, upon receipt of the dividend, properly claims an 80% dividends-received deduction (DRD) under Sec. 243 equal to $160 (80% x $200) and includes the remaining $40 in taxable income. The distribution reduces the total fair value of S by the amount of the distribution, thus reducing the fair value of P's stock in S. Under the law in effect prior to the passage of Sec. 1059, P makes no adjustment to the basis in its S stock because the distribution is made out of S's E&P. When P subsequently sells its devalued S stock for $300 ($500 - $200), P could claim a $200 artificial capital loss ($300 proceeds - $500 basis). Here, P's $200 capital loss could not be used to offset the $40 of ordinary dividend income, but it could be used to offset P's capital gain to the extent it had any. Sec. 1059 is designed to prevent corporate shareholders from creating such artificial capital losses to offset capital...