State tax consequences to shareholders on distributions of property.

• Author: Friedel, David B.

When a company distributes property to its shareholders, tax consequences arise for the distributing corporation and the receiving shareholder. This item addresses the state tax consequences to the shareholder, which can differ between states with separate-return filing rules and states that follow the federal consolidated-return filing rules.

For the receiving shareholder, Sec. 301(c) requires that the amount of the distribution first be treated as a dividend to the extent of the company's earnings and profits (E&P), then as a return of basis, and finally as gain from the sale or exchange of property. In the case of a corporate shareholder owning at least 20% of the stock of the distributing company, a special rule under Sec. 301(e) applies to determine the amount of E&P available to fund any dividend, thereby affecting the taxable income of the corporate shareholder.

Corporate shareholders generally are permitted to claim a deduction under Sec. 243 to offset a portion of the dividend income they receive. The dividends-received deduction (DRD) generally is 70% for corporate shareholders that own less than 20% of the distributing corporation's stock, 80% for 20%-ormore-owned corporate shareholders, and 100% for 80%-or-more-owned corporate shareholders if the distribution is paid out of E&P generated in tax years in which the distributing and distributee corporations were part of the same affiliated group for every day of those years.

The examples below focus primarily on domestic companies. Example 1 analyzes the tax consequences of a simple distribution that disregards complications including the application of Secs. 1059 and 301(e). Example 2 analyzes the application of Sec. 1059 but disregards application of Sec. 301(e). Sec. 301(e) is explored under Example 3, which circumvents the extraordinary-dividend rules by pushing the date of the distribution to more than two years after the corporation's acquisition of stock.

Example 1: P purchases 100% of S's stock on April 15, 2014, for $5,000. Both P and S are calendar-year, accrual-method taxpayers. P has no current or accumulated E&P, but S has current E&P of $800 for 2014 and accumulated E&P of $1,200 coming into 2014 (see Exhibit 1). S distributes $750 to P on July 1, 2014. What are the tax consequences of the distribution?

States with separate-return filing rules: In a state that has separate-return filing rules, P first treats the distribution as dividend income to the extent of S's E&P, pursuant to Sec. 301(c). P and S were not part of the same affiliated group for all of 2014 (the year with $800 E&P from which the distribution was made). Therefore, pursuant to Sec. 243, the dividend does not qualify for a 100% DRD. Instead, P is limited to an 80% DRD ($750 x 80% = $600) and will have the remainder as taxable income ($150) (see Exhibit 2).

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