Sec. 301(e) - some unusual consequences.

• Author: Stalter, David J.
• Position: Internal Revenue Code; earnings and profits adjustments

Sec. 301(e) requires special adjustments to a corporation's earnings and profits (E&P) when it makes a distribution to a "20% corporate shareholder." Isolating the effect of Sec. 301(e) on the distributing corporation, its 20% corporate shareholders and its remaining shareholders can be difficult. The result might even be considered abnormal when Sec. 301(e) is coupled with the task of disentangling the taxable income consequences from the E&P consequences.

Why Sec. 301(e) Exists

In 1984, Congress enacted Sec. 301(e) out of concern that some corporations were taking advantage of the dividends-received deduction (DRD) under Sec. 243 to extract "phantom" earnings from other corporations at an inappropriately low overall tax rate. This potential arose because, to "more accurately reflect economic gain and loss," Congress had reduced or eliminated certain deductions corporations could claim in computing their E&P. As a result, corporations could generate positive current E&P, even though they had no taxable income or net operating losses.

Phantom E&P increases dividend income dollar-for-dollar for most shareholders, but the tax cost to corporate shareholders is much less because of the DRD under Secs. 243 and 245. As a general rule, corporations prefer to receive low-taxed dividends, preserving their tax basis in the distributing corporation's stock and reducing gain (or increasing loss) on a subsequent disposition. Sec. 301(e) denies corporate shareholders this potential advantage. Under Sec. 301(e), a corporation must recompute its E&P when it makes a distribution to any 20% corporate shareholder, thereby reducing the dividend available for the DRD in that corporate shareholder's hands.

Sec. 301(e)

Sec. 301(e) provides that, solely for purposes of determining the taxable income of any 20% corporate shareholder (and its adjusted basis in the stock of the distributing corporation), Sec. 312 is to be applied to the distributing corporation as if it did not contain subsections (k) and (n). For this purpose, a 20% corporate shareholder is defined, for any distribution, as a corporation that owns (directly or indirectly) either:

* Stock in the distributing corporation possessing at least 20% of the total combined voting power of all classes of stock entitled to vote; or

* At least 20% of the total value of all the stock of the distributing corporation (excluding nonvoting preferred stock).

Note: Sec. 301(e)(3) expressly preserves the application of...