Wassim Zhani Chapter 3 Corporate Disctructions Cash, Property, and Stock Dividends.pdf

Corporate Distributions: Cash,
Property, and Stock Dividends
Solutions to Tax Research Problems
TA X RE S E A R C H PR O B L E M S
3-36 The first step in this problem is to ascertain the objective of the plan. It is P’s hope that the pre-sale
distribution of cash by the subsidiary, T, will be accorded favorable dividend treatment. If the distribution
is treated as a dividend, it is wholly nontaxable due to the 100 percent dividends-received deduction
allowed for distributions from an affiliated company (see § 243). Because the distribution reduces the value
of T, the sales price is correspondingly reduced, thereby reducing the amount of capital gain to be reported
by P. In effect, P receives part of the sales price tax-free. On the other hand, if the distribution is considered
part of the proceeds received from the sale of T’s stock, unfavorable capital gain results.
5- This plan was unsuccessfully attempted in Waterman Steamship Corp., 70-2 USTC {9514, 26 AFTR2d
5185, 430 F.2d 1185 (CA-5, 1970). In this case, the prospective buyer originally offered $3.5 million for
Waterman’s two subsidiaries. The Waterman board rejected that offer and made a counter-proposal to sell
the two subsidiaries for $700,180, after a dividend of $2,799,820, to Waterman. Not only was this
reallocation of the purchase price clearly linked to the dividend, but the dividend was actually paid using
funds supplied by the buyer—the dividend was in the form of a note that the buyer subsequently
discharged. Accordingly, the court had no trouble in finding that in substance there had been no dividend,
and thus treated the purported dividend as part of the purchase price.
5- In the strictest sense, Waterman could support a holding of ignoring all dividends made in anticipation
of a sale of a subsidiary, even in those cases where the subsidiary distributed its own cash or other
assets (perhaps those undesirable to the buyer). This reading is supported by the decision in Casner
v. Comm., 71-2 USTC {9651, 450 F.2d 379 (CA-5, 1971) where the taxpayer used the Waterman argument
to his benefit. In Casner, the shareholders were individuals and argued that Waterman should apply to
cause dividends to be treated as part of the sales price and thus convert ordinary income into capital gain.
The Fifth Circuit stood by their decision in Waterman and granted favorable treatment to the taxpayer.
However, in Revenue Ruling 75-493, 75-2 C.B. 103, the IRS attempted to clarify its position, hoping
to prevent individual taxpayers receiving favorable capital gain treatment while at the same time
hoping to prevent corporations receiving favorable dividend treatment. In this ruling, an individual, A,
owned 100 percent of the outstanding stock of Y Corporation, which had substantial cash. X Corporation
wanted to purchase the Y stock but not the cash. Accordingly, the individual caused Y to pay a large
dividend and subsequently sold the stock of X. Because A and X were under no legal obligation at the
time the dividend was declared and paid, and because the distribution did not affect the agreed on
purchase price, the cash distribution was treated as a dividend rather than part of the sales proceeds. In
addition, the Service indicated that it would not follow the Casner decision, but would respect a dividend
paid before the ownership of the stock actually changed hands, provided the dividend was a true
distribution of corporate earnings. Ultimately, however, the result depends on the facts. This became
evident in TSN Liquidating Corporation, Inc. v. U.S. 80-2 USTC {9640, 624 F.2d 1328 (CA-5, 1980)
and, more recently, Litton Industries, Inc. v. Comm. 89 T.C. 1086 (1987).
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5- In TSN, the parent corporation caused its subsidiary to distribute 78 percent of its assets, consisting of
portfolio securities. TSN then proceeded to sell the stock of the subsidiary. The Fifth Circuit reversed the
lower court’s decision, holding that the distribution had a business purpose, in that the portfolio securities
were unwanted assets. The Court found the facts to be analogous to a group of cases where a dividend was
made to ease negotiation or facilitate a sale by adjusting the assets of the subsidiary corporation to be sold.
5- In Litton, the facts were very similar to those in Waterman. In early 1972, the chairman of Litton’s
board of directors and an executive of its subsidiary, Stouffer, discussed the possible sale of Stouffer. These
initial talks concerning the sale of Stouffer were followed by discussions by Litton’s board in July, 1972. On
August 23, 1972, Stouffer declared a $30 million dividend which it paid to Litton in the form of a
$30 million negotiable promissory note. Shortly thereafter in September, 1972, Litton began discussions
with underwriters regarding the feasibility of a public offering of the Stouffer stock. After several months of
negotiating with various underwriters, Stouffer filed in mid-December the appropriate documents with the
Securities and Exchange Commission to register a public stock offering. It was disclosed in the registration
statement that $30 million of the stock proceeds would be used to pay off the note to Litton. On March 1,
1973, Nestle Corporation made a separate offer to Litton and paid Litton over $74 million for all of
Stouffer’s outstanding stock and $30 million in cash for the note. Upon acceptance of the offer by Litton,
the work on the scheduled public stock offering halted.
5- As was the case in Waterman, the issue in Litton was whether the note distributed received from
Stouffer was truly a dividend or whether it should be considered part of the proceeds received by Litton
from the sale of all of Stouffer’s stock. At trial, Litton contended that the reasoning of Waterman should
not apply in its case. Despite the similar fact patterns of the two cases, the court agreed. The court focused
on the fact that in Litton the declaration of the dividend and the ultimate sale of the stock were
substantially separated in time. In contrast, the transactions in Waterman occurred essentially
simultaneously. The court noted that in Waterman it was clear that a dividend would not have been
declared if the sale had in fact not taken place. In Litton, however, Stouffer declared the dividend, issued
the note, and obligated itself to the dividend before even making a public announcement that Stouffer was
for sale. In effect, Stouffer was required to pay the note even if there were no subsequent sale. The
court acknowledged the fact that a possible sale of Stouffer had been discussed prior to the dividend
and recognized the salutary effects of a pre-sale dividend. Nevertheless, it explained that Litton had
“committed itself to the dividend and, thereby, accepted the consequences regardless of the outcome of the
proposed sale of the Stouffer stock.” In effect, the court was convinced that the dividend was not so
inextricably tied to a sale of the Stouffer stock that the two transactions should be collapsed. To bolster its
opinion, the court also recognized that some other business purposes of Litton might be served.
5- The result in Litton TSN and the Service’s position in Revenue Ruling 75-493 suggest that the plan
may be effective. For more discussion, see Ditkoff, “Intercorporate Dividends and Legitimate Tax
Avoidance,” 4 Journal of Corporate Taxation 5 (1977), and Mather, “TSN Liquidating Corporation, Inc.
v. United States—Negotiation Focus in Substance-Over-Form,” The Journal of Corporation Law, 7 (1981)
pp. 178-87.
3-2 Chapter 3 Corporate Distributions: Cash, Property, and Stock Dividends

Test Bank
True or False
1. T received a distribution with respect to his stock of $50,000. The corporation had neither
accumulated nor current earnings and profits. T is entitled to recover his basis before he reports any
gain or income because of the distribution.
2. A corporation’s balance in its earnings and profits account is equivalent in amount to the balance in
its retained earnings account.
3. During the year, F Corporation sold a parcel of land that it purchased several years ago for $10,000.
F received $20,000 in cash and an $80,000 note payable in eight annual installments beginning next
year. With respect to this sale, F must increase its E&P by $90,000 (i.e., an adjustment to taxable
income of $72,000).
4. Unlike other nondeductible expenses, Federal income taxes may not be deducted in computing E&P.
5. R owns 100 percent of F Corporation. In computing earnings and profits, artificial deductions such as
the dividends-received deduction are not allowed. Capital losses, including a loss on the sale of
property to R, however, are considered true economic losses and reduce earnings and profits even
though such losses are not deductible in computing taxable income.
6. During the year, X Corporation distributed $25,000 on March 1 and $75,000 on October 1. As long
as X Corporation has accumulated earnings and profits of at least $100,000 at the beginning of the
year, both distributions will be treated as dividends.
7. J Corporation had current earnings and profits of $10,000 and accumulated earnings and profits at the
beginning of the year of $20,000. Assuming three equal distributions of $60,000 are made during the
year, each distribution will be treated the same.
8. It is possible for a corporation to pay a taxable dividend even though there is a deficit in accumulated
earnings and profits.
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9. The General Utilities doctrine stands for the proposition that the corporation does not recognize gain
on the distribution of property.
10. The General Utilities doctrine is consistent with the theory of double taxation.
11. During the year, T Corporation distributed property to its sole shareholder. T must recognize any
gain or loss realized on the distribution.
12. During the year, DEF Corporation distributed land that it had used as a parking lot in its business
(value $40,000, basis $5,000). DEF will recognize gain on the distribution.
13. During the year, C Corporation distributed land worth $30,000 to its sole shareholder, S. The
corporation acquired the property five years ago for $50,000. C recognizes a loss of $20,000 on the
distribution of the land.
14. D Corporation distributed to its sole shareholder a truck worth $5,000 (basis $3,000). The net effect of
the distribution on D’s E&P (ignoring taxes) is a reduction of $3,000.
15. F Corporation distributed to its sole shareholder land worth $50,000. The land had a basis of $40,000
and was subject to a mortgage of $20,000. F must decrease its E&P by $30,000.
16. G Corporation distributed its own bonds to its shareholders as a dividend. The bonds had a face value
of $100,000. However, because the interest rate on the bonds at the date of issue was below the market
rate of interest, the bonds were worth $90,000. G must reduce its E&P by $90,000.
17. During the year, Y Corporation distributed property worth $10,000 (basis $6,000) to its sole
shareholder, R. If R assumes a liability to which the property is subject, both the amount of the
distribution and the basis of the property will be affected.
18. Distributing Corporation purchased land for $50,000 several years ago. The value of the land has
since declined because the adjacent land has been chosen as the site of a toxic waste dump. Good
planning would suggest that instead of selling the land and distributing the proceeds, the corporation
should distribute the land to its shareholders and allow them to sell it. (Ignore any possible assignment
of income problems.)
19. Dividends must be formally declared by the corporation’s board of directors before they will be
treated as a dividend for tax purposes.
20. During the year, T borrowed $7,000 from his wholly owned corporation. The loan was interest-free.
Under the operable Code section, T will automatically be deemed to have received a dividend for the
interest that he was not charged.
21. Normally, a stock dividend is nontaxable as long as it does not change the proportionate interests of
the shareholders.
22. A distribution of preferred stock on common stock is taxable because the distribution ultimately
changes the interest of the common shareholder.
23. T was granted one right for each share of stock that she owned. She elected to allocate basis to the
stock rights. T was unwilling to exercise the rights to buy new stock because of the outlook for the
company, and consequently they lapsed. Despite her views on the company’s future, she continued to
hold her original stock. She is not allowed to deduct a loss equal to the basis assigned to the rights.
24. RST Corporation declared a dividend this year. The dividend was payable in RST stock worth $40
per share, or the shareholders could elect to receive cash of $40. B received stock and C elected to
receive cash. B’s dividend is nontaxable, whereas C’s dividend is taxable.

Multiple Choice
25. The basic rules governing distributions contained in $ 301 cover the distributions of all property to a
shareholder, including all of those items below except
a. Money
b. Equipment
c. The corporation’s own bonds
d. The corporation’s own stock
e. All of the above
26. R received a distribution with respect to his stock during the past year. He should treat the amount received
a. First as a nontaxable return of capital to the extent of his basis and then a taxable dividend
distribution to the extent that any earnings and profits exist
b. First as a taxable dividend distribution to the extent that any earnings and profits exist and then a
nontaxable return of capital to the extent of his basis
c. Fully taxable as ordinary income without regard to his basis or the corporation’s earnings and profits
d. None of the above
27. Which of the following statements best describes accumulated earnings and profits?
a. Retained earnings as determined for financial accounting purposes and adjusted for distributions
b. Accumulated taxable income of prior years and adjusted for distributions
c. Accumulated net income as determined for financial accounting purposes for prior years and
adjusted for distributions
d. Accumulated economic income that can be distributed without impairing capital
28. Assuming current earnings and profits are computed by making certain modifications to current
taxable income, which of the following is false?
a. An adjustment is required if the corporation maintains its inventory using the LIFO method.
b. No adjustment is needed if capital losses exceed capital gains.
c. An adjustment is required when the installment sales method is elected.
d. An adjustment is required when the corporation sells property to its sole shareholder at a loss.
e. An adjustment is necessary if MACRS is used.
29. For which of the following items would an adjustment to taxable income not be required in computing
earnings and profits?
a. Federal income taxes
b. State of Indiana income taxes
c. Attorney’s fee for drafting articles of incorporation
d. Interest on City of Houston bonds
e. Depreciation using the accelerated percentages of ACRS
30. JKL Corporation had a balance of $25,000 in accumulated earnings and profits at the beginning of the year.
Its current earnings and profits for the year were $10,000. During the year, JKL made two distributions:
$30,000 on June 1 and $20,000 on October 1. The distribution on October 1 represents a dividend of
a. $0
b. $4,000
c. $5,000
d. $14,000
e. None of the above
31. HIJ Corporation had a balance of $100,000 in accumulated earnings and profits at the beginning of the
year. During the current year it had a deficit in current earnings and profits of $73,000, which was
attributable to poor performance throughout the year. The corporation made two distributions during
the year: $60,000 on February 1 and $40,000 on December 1. The distributions will be treated as follows:
a. A maximum of $27,000 of the distributions will be treated as a dividend.
b. A portion of both the first and second distribution will be treated as a dividend.
c. Only the first distribution will give rise to dividend income.
d. Neither of the distributions will give rise to dividend income, since there are no current earnings
and profits.
e. None of the above is true.
Test Bank 3-5

32. XYZ Corporation reported taxable income of $91,500 for the current year. It has provided the
following information for use in computing earnings and profits:
Dividends received (from 45% corporation) $10,000
Interest from tax-exempt municipal bonds 2,000
Depreciation, using accelerated cost recovery percentages under
MACRS (straight line, using ADS would have been $12,000) 15,000
Long-term capital gain 8,000
The corporation’s current earnings and profits before considering taxes is
a. $99,500
b. $104,500
c. $106,500
d. $102,500
33. ABC Corporation’s beginning balance of accumulated earnings and profits is a deficit of $100,000 and
had current earnings and profits of $20,000. On March 1, the corporation distributed $45,000 to its
sole shareholder, R, who had a basis in his stock of $30,000. R will report
a. No dividend income and a capital gain of $15,000
b. A dividend of $20,000
c. A dividend of $20,000 and a capital gain of $25,000
d. No dividend income and a capital gain of $25,000
34. During the year, P&B Construction Corp. distributed a crane used in its business to S, who owns
100 percent of the stock. The crane was worth $10,000 and had a basis of $19,000. The corporation also
distributed land worth $70,000 (basis $40,000). Assuming P&B has substantial earnings and profits, the
corporation will report
a. No gain or loss
b. $30,000 gain
c. $9,000 loss
d. $21,000 gain
35. During the year, T Corporation distributed land used in its business to its sole shareholder. The land
was worth $50,000 (basis, $10,000). Assuming the corporation has substantial earnings and profits, and
ignoring the effect of any taxes on the distribution, the net effect of the transaction on E&P will be
a. An increase of $40,000
b. A decrease of $50,000
c. An increase of $10,000
d. A decrease of $10,000
36. The net effect on E&P in all of the following cases is a net decrease equal to the adjusted basis of the
distributed property except for a distribution of
a. The corporation’s own bonds
b. Land that has declined in value relative to its purchase price
c. Land that has appreciated relative to its purchase price
d. Valuable equipment that has been completely depreciated
37. This year A&S Disposal Corp. distributed land that it had used as a garbage site to its sole
shareholder, J. The land was worth $30,000 (basis $10,000) and was subject to a $16,000 mortgage,
which J assumed. The corporation had $200,000 of earnings and profits. Ignoring any taxes that may
or may not arise on the distribution, the net effect of the distribution on earnings and profits of A&S
will cause it to
a. Increase by $20,000
b. Decrease by $10,000
c. Increase by $6,000
d. Increase by $10,000

38. This year, Corporation Z distributed land held for investment to its sole individual shareholder. The
land was worth $100,000 (basis $70,000) and was subject to a liability of $40,000. Assuming the
corporation has substantial earnings and profits, and ignoring the effect of any taxes on the
distribution, the net effect of the transaction on E&P will be a decrease of
a. $30,000
b. $100,000
c. $70,000
d. $60,000
e. $40,000
39. S Corporation distributed land used in its business worth $30,000 (basis $5,000) to its sole shareholder,
G. Assuming S has substantial earnings and profits, G’s dividend and basis for the property will be
a. $30,000 dividend, $30,000 basis
b. $5,000 dividend, $5,000 basis
c. $30,000 dividend, $5,000 basis
d. $5,000 dividend, $30,000 basis
40. T Inc. distributed land used in its business worth $21,000 (basis $18,000) to its sole shareholder,
Z Corporation. The land was subject to a mortgage of $5,000. Assuming T has substantial earnings
and profits, Z’s dividend and basis for the property will be
a. $21,000 dividend, $16,000 basis
b. $16,000 dividend, $16,000 basis
c. $21,000 dividend, $21,000 basis
d. $16,000 dividend, $21,000 basis
41. L is the sole shareholder of the X Corporation. L has received advances from the corporation totalling
$20,000. X did not charge any interest on the advances when the going rate was 9 percent. Which of
the following statements is false?
a. L may be charged with a dividend of approximately $1,800 but may have an offsetting interest
expense deduction of an equivalent amount.
b. L may be charged with a dividend of $20,000 but may have an offsetting interest expense
deduction of an equivalent amount.
c. L may be charged with additional compensation of approximately $1,800 but may have an
offsetting interest expense deduction of an equivalent amount.
d. All of the above are true.
42. Which of the following statements is true?
a. Before a shareholder is charged with dividend income there must be a formal declaration by the
corporation’s board of directors of its intent to make a dividend distribution.
b. Assuming a corporation makes a $5,000 interest-free loan to a corporate executive who is also a
shareholder, the mechanics of the governing provisions may impute a nondeductible dividend
payment made by the corporation to the individual.
c. Assuming a corporate executive, who also is a 40 percent shareholder, is given free use of the
company car, the use attributable to personal purposes may be deemed a dividend.
d. More than one but less than all of the above are true.
43. B owns 100 shares of T Corporation common stock, which he acquired on June 1, 2004 for $800. On
October 15 of this year he received a stock dividend of 25 shares of preferred worth $4 per share when
the common was worth $1 per share. What is B’s basis in his preferred stock and when does his
holding period begin?
a. $640; June 1, 2004
b. $400; June 1, 2004
c. $100; October 15, this year
d. $640; October 15, this year
Test Bank 3-7

44. During the year, R and his wife S both received a distribution of stock from XYZ Corporation. R will
report no dividend income
a. If the distribution is preferred stock on common
b. If the distribution is preferred on preferred
c. If he receives common while his wife receives preferre
d. More than one but less than all of the above
e. All of the above
45. M Corporation makes a distribution of $15,000 to its sole shareholder, Mr. Higgins. At the close of
the year the corporation had $8,000 of accumulated and current earnings and profits. Mr. Higgins’
basis in his stock is $5,000. He must report
a. $8,000 in dividends and $7,000 capital gains
b. $15,000 in dividends and no capital gains
c. $8,000 in dividends and $2,000 capital gains
d. $7,000 in dividends and $8,000 capital gains
e. $13,000 in dividends and $2,000 capital gains
46. R Corporation files its tax return on a cash basis and has a taxable income of $50,000. It received a
Federal income tax refund of $3,000. Interest income of $6,000 includes $2,000 that is tax-exempt.
Payroll tax penalties of $250 were assessed and paid. R Corporation’s current earnings and profits, as
calculated using these items only, would be
a. $54,750
b. $56,750
c. $50,000
d. $52,000
e. $52,750
47. Q Corporation files its tax return on the accrual basis and has a taxable income of $80,000. It files its tax
return showing an income tax of $15,450. It sold securities yielding a net short-term capital loss of
$30,000 during the tax year. Q Corporation’s current earnings and profits, as calculated using these
items only, would be
a. $64,550
b. $50,000
c. $80,000
d. $95,450
e. $34,550
48. In year one W Corporation paid an annual premium of $6,000 on an insurance policy covering its
president. The cash surrender value of the policy increased by $2,500. The policy has a $650,000 face
value and lists W Corporation as the beneficiary. In year 10, when the cash surrender value of the
policy has grown to $50,000, the president dies, before the corporation is required to pay the annual
premium. Which statement(s) of the following is(are) true?
a. In year one, the net effect of the annual premium paid out and the increase to cash surrender
value was a decrease to E&P of $3,500.
b. In year 10, the net effect of the annual premiums paid out and the increases to cash surrender
value has been a decrease to E&P of $4,000.
c. In year 10, $650,000 will be received by the corporation tax-free, with $600,000 being added to
E&P.
d. All of the above are true.
49. Which of the following statements is false?
a. E&P consists of two basic parts: current E&P and accumulated E&P.
b. A corporation can make taxable dividend distributions if it has current E&P, notwithstanding the
fact that it may have a deficit in accumulated E&P.
c. A dividend is defined as paid out of either current or accumulated E&P.
d. The presumption is that every distribution is first out of accumulated E&P and then from current
E&P.

50. At the end of the taxable year B Corporation has current E&P of $50,000 without reduction for any
distributions made during the year. The corporation also has accumulated E&P of $45,000. A
distribution of $40,000 is made on May 1 and another distribution of $60,000 is made on December 1.
B Corporation files on the accrual basis using a calendar year. The distributions are made to its sole
shareholder. The amount of current E&P allocated to the May 1 distribution of $40,000 is
a. $20,000
b. $40,000
c. $33,333
d. $0
51. At the end of the taxable year B Corporation has current E&P of $50,000 without reduction for any
distributions made during the year. The corporation also has accumulated E&P of $45,000. A
distribution of $40,000 is made on May 1 and another distribution of $60,000 is made on December 1.
B Corporation files on the accrual basis using a calendar year. The distributions are made to its sole
shareholder. The amount of accumulated E&P allocated to the December 1 distribution of $60,000 is
a. $50,000
b. $45,000
c. $0
d. $30,000
e. $25,000
52. H Corporation distributed land with a fair market value of $100,000 (basis $20,000) to Y
Corporation, a 70 percent shareholder. As a result, the amounts of the distribution to Y Corporation
and basis of land to Y Corporation are
a. $80,000 and $80,000
b. $100,000 and $100,000
c. $100,000 and $20,000
d. $80,000 and $20,000
53. In 1986 the General Utilities doctrine was repealed, resulting in a complete revision of the treatment of
the distributing corporation. As a result, corporations must
a. Recognize gain on the distribution of appreciated property distributed as a dividend
b. Recognize loss on the distribution of depreciated property distributed as a dividend
c. Recognize gain or loss on the distribution of property as a dividend
d. Defer gain or loss on the distribution of property as a dividend
54. To avoid recharacterization as a dividend, an advance to a shareholder must represent a bona fide
loan. A bona fide debtor-creditor relationship is generally suggested by
a. The advance being recorded on the books of the corporation and evidenced by a note
b. The shareholder making payments on the note according to a fixed schedule with the note bearing
a reasonable charge for interest
c. The note being secured by collateral with the due dates for payments enforced
d. All of the above
55. Constructive distributions arising from a payment for the shareholder’s benefit have been found where
the corporation paid for the following:
a. Shareholder’s debt
b. Shareholder’s financial and accounting services
c. Corporation’s financial and accounting services
d. Both a. and b.
Test Bank 3-9

56. Shareholders who receive stock rights have the following alternatives with respect to their use:
a. The rights may be sold, in which case the gain or loss is measured using the basis that was
assigned to the rights
b. The rights may be exercised, in which case any basis assigned to the rights is added to the basis of
the stock
c. The rights may lapse, in which case any basis that may have been assigned to the rights reverts
back to the original stock
d. Both a. and b.
e. All of the above
57. In allocating current earnings and profits, the IRS has ruled that they are
a. Allocated pro rata to distributions on stock on which dividends are paid
b. Allocated pro rata to all distributions made during the year and within two months of the close of
the year
c. First allocated to distributions on stock on which dividends must be paid before dividends can be
paid on other classes of stock
d. First allocated to distributions on stock on which dividends may be paid after required dividends
have been paid on other classes of stock
58. B Corporation has a deficit in accumulated and current earnings and profits. Despite its history of
recent losses, B Corporation expects operations to become profitable next year. Assuming that the
corporation plans to make a distribution, timing is critical because
a. A distribution in the current year would first be treated as a nontaxable return of capital to the
extent of the shareholders’ basis of the stock
b. A distribution in the following year would be taxable as a dividend to the extent of the
corporation’s current earnings and profits in that year
c. Both a. and b.
d. None of the above
59. Categories of corporate payments that avoid dividend treatment may include the following:
a. Charitable contributions not made to satisfy a shareholder pledge
b. Payments to qualified pension and profit-sharing plans
c. Salary payments that reasonably compensate shareholders for services to corporation
d. Both b. and c.
e. Choices a., b. and c.

Solutions to Test Bank
True or False
1. True. Under the statutory scheme, distributions are first considered to be from current or accumulated
earnings and profits, and taxable as ordinary income to the extent thereof. Distributions exceeding
earnings and profits are considered to be a return of capital that is taxable only to the extent the
distribution exceeds the shareholder’s basis. (See Example 1 and p. 3-3.)
2. False. Earnings and profits often substantially differ from retained earnings for a variety of reasons. For
example, a stock dividend is charged against retained earnings, although it has no effect on E&P.
Similarly, depreciation for book and tax purposes normally differs. (See p. 3-4.)
3. True. Although F’s taxable income increases by $18,000 ($20,000 $90,000/$100,000) for the gain on the
installment sale, its EP must be increased by the entire amount of the gain, $90,000. (See p. 3-5.)
4. False. Federal income taxes reduce EP. (See p. 3-9)
5. True. The dividends-received deduction is not allowed. Capital losses, including losses on the sale of
property to a related party, must be deducted in computing earnings and profits, even though such losses
do not reduce taxable income. (See Example 4 and p. 3-9.)
6. False. If a deficit occurs during the year, it is prorated on a daily basis against accumulated earnings and
profits at the date of distribution. Thus, if a deficit occurs during the year prior to the distribution, part of
the distribution will not be out of earnings and profits. (See Exhibit 3.6, Example 9 and pp. 3-10 through
3-13.)
7. False. Each distribution is deemed to consist of its pro rata share of current EP, but accumulated EP is
allocated chronologically. (See Exhibit 3.6, Example 7 and pp. 3-11 and 3-12.)
8. True. Distributions are deemed to come out of any current earnings and profits during the
year, undiminished by any deficits in accumulated earnings and profits. (See Exhibit 3.6, Example 10 and
pp. 3-10 through 3-13.)
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3-11
Solutions to Test Bank 3-11

9. True. In General Utilities Operating Co., the Supreme Court rejected IRS arguments to the contrary and
held that a corporation does not recognize gain on the distribution of property. Section 311(b) now
abandons this rule, requiring gain to be recognized on the distribution of appreciated property. This case
is no longer discussed in the text.
10. False. The General Utilities doctrine stands for the proposition that the corporation does not recognize
gain on the distribution of appreciated property. This is inconsistent with the double taxation theory in
that a gain on the sale of the same property followed by a distribution of the proceeds would have been
taxed twice, once on the sale and once when the shareholder received the distribution as a dividend. This
case is no longer discussed in the text.
11. False. Although all gains must be recognized on such distributions, losses are not recognized under the
general rule of 311. (See Example 12 and p. 3-14.)
12. True. Under § 311(b), the distributing corporation must recognize gain—but not loss—on a distribution of
property as a dividend. (See Example 12 and p. 3-14.)
13. False. Under § 311(b), the distributing corporation must recognize gain-but not loss-on a distribution of
property as a dividend. (See Example 12 and p. 3-14.)
14. True. On the distribution of appreciated property, the distributing corporation must recognize gain but
not loss. Thus, D must increase its EP for the gain recognized, $2,000 ($5,000 $3,000). The
corporation then reduces EP by the fair market value of the property, $5,000. Thus, the net effect on
EP is a $3,000 reduction ($5,000 $2,000 gain). (See Example 15 and p. 3-16.)
15. False. The corporation must recognize gain of $10,000 ($50,000 $40,000), which in turn increases EP.
EP then must be reduced by the value of the property, $50,000. This reduction is reduced for the
mortgage of $20,000. The net effect of the distribution is to reduce EP by $20,000 ($10,000 gain
$50,000 value þ $20,000 liability). (See Example 15 and p. 3-16.)
16. True. A corporation reduces its EP by the value of any securities distributed, not their face value. (See
Example 20 and Example 21 and p. 3-18.)
17. False. Liabilities reduce the amount of the distribution, but the basis for any distribution to a
noncorporate shareholder is the property’s fair market value. (See Example 11 and p. 3-14 and p. 3-17.)
18. False. A distribution of the property would step down the basis to its current FMV, and the loss
attributable to the decrease in value would never be recognized. (See p. 3-14 and p. 3-15.)
19. False. There is no requirement that there be a formal declaration of a dividend. A benefit informally
provided to a shareholder by a corporation may be construed as a constructive dividend. (See pp. 3-19 and
3-20.)
20. False. Section 7872 does not impute interest on loans between a corporation and a shareholder if the
aggregate loans outstanding during the year do not exceed $10,000. (See pp. 3-21 and 3-22.)
21. True. Since the shareholder’s interest remains unchanged, he has received nothing, and is consequently not
taxable. (See pp. 3-23 and 3-24.)
22. False. Because all of the common shareholders receive the preferred stock, their rights have not changed.
(See Example 24 and pp. 3-23 through 3-24.)
23. True. The basis allocated to the rights is returned or reverts back to the original stock. (See p. 3-26.)
24. False. Both dividends are taxable. If a shareholder may elect to receive the corporation’s stock or other
property, the stock dividend is taxable. (See p. 3-29.)

Multiple Choice
25. d. Section 305 governs distributions of a corporation’s own stock. (See pp. 3-4 and 3-24.)
26. b. The Code creates the presumption that all distributions are treated as dividends to the extent that any
earnings and profits exist at the date of distribution. The remainder is treated as a nontaxable return of
capital to the extent of the shareholder’s basis in his stock. (See Example 1 and pp. 3-3 and 3-4.)
27. d. Accumulated earnings and profits are designed to be a measure of the amount that a corporation can
distribute without impairing its capital. The calculation attempts to measure the corporation’s capacity to
pay dividends. The starting point is taxable income. However, this amount is generally adjusted to
determine the amount that the corporation could actually distribute without dipping into capital. (See
pp. 3-4 and 3-5.)
28. b. An adjustment is required when capital losses exceed capital gains, since the capital loss is not reflected
in taxable income but does reduce the ability of the corporation to pay dividends. (See p. 3-9.)
29. b. State income taxes are deductible as ordinary business expenses in computing taxable income. No
special adjustment is required for such taxes in computing earnings and profits. Adjustments are
required for each of the other items. (See pp. 3-4 through 3-10.)
30. c. Current earnings and profits are allocated pro rata to all distributions during the year, while
accumulated earnings and profits are allocated chronologically. The first distribution of $30,000
represents a distribution of $6,000 of current EP [$30,000/($30,000 þ $20,000) $10,000)] and
$24,000 of accumulated EP. The second distribution represents a distribution of $4,000 of current
EP (40% of current EP of $10,000) and $1,000 of accumulated EP ($25,000 $24,000 allocated to
first distribution). (See Example 7 and pp. 3-10 and 3-12.)
31. c. The deficit in current EP is prorated on a daily basis against any accumulated EP. The balance in
accumulated EP before the first distribution is $88,200 [$100,000 (59 days $73,000/365)]. Thus,
all of the $60,000 distribution is a dividend. The balance in accumulated EP before the second
distribution is zero, because the $100,000 beginning EP is eliminated by the $60,000 distribution and
the deficit that has occurred through November 30 of $66,800 (334 þ $73,000/365). (See Example 9
and pp. 3-11 through 3-13.)
32. b. Earnings and profits is computed as follows:
Taxable income $ 91,500
Dividends-received deduction 8,000
Tax-exempt income 2,000
Accelerated depreciation in excess of straight line 3,000
Total $104,500
The capital gain is included in taxable income and does not affect the computation of EP. (See
Exhibits 3.1 and 3.2 and pp. 3.4 through 3-10.)
33. b. The $45,000 distribution is first treated as a dividend to the extent of current earnings and profits, or
$20,000. The remaining $25,000 is treated as a return of the taxpayer’s basis, reducing it from $30,000
to $5,000. (See Example 10 and pp. 3-10 through 3-13.)
34. b. The corporation recognizes gain, but not loss, on the distribution of property. Thus, the corporation
recognizes the gain on the distribution of the land, $30,000. The loss on the distribution of the crane,
$9,000, is not recognized. (See Example 12 and pp. 3-14 and 3-15.)
35. d. EP must be increased by the $40,000 gain ($50,000 $10,000) and decreased by the $50,000 FMV of
the property for a net decrease of $10,000. (See Example 15 and p. 3-16.)
36. a. A distribution of a corporation’s own bonds reduces EP by the FMV of the bonds. In c and d, the
effect is to increase EP by the gain recognized by the distributing corporation on the distribution of
the property and then reduce it by the property’s FMV, a net decrease equal to the basis of the
property. In b, EP is simply reduced by the property’s adjusted basis. (See pp. 3-16 through 3-19.)

37. c. EP will increase by the amount of the $20,000 gain recognized, decrease by the $30,000 fair market
value of the property, and increase by the $16,000 of liabilities assumed by the shareholder. The net
effect is an increase of $6,000 ($20,000 $30,000 þ $16,000). Note that this is the same as a reduction
by the basis of the property as increased by the liabilities. (See Example 19 and pp. 3-16 through 3-18.)
38. a. Corporation must first increase EP by the $30,000 of gain recognized, which increases the adjusted
basis of the land to $100,000. EP is then reduced by the $100,000 value of the property. The relief of
the liability increases EP by $40,000. Thus, EP decreases by $30,000 ($30,000 $100,000 þ
$40,000). (See Example 18 and pp. 3-16 through 3-18.)
39. a. The amount of the distribution and the basis of the property to a shareholder is its fair market value,
$30,000. (See Example 11 and pp. 3-14 through 3-15.)
40. d. The amount of the distribution to a shareholder is the fair market value, reduced by any liability,
$16,000 ($21,000 $5,000). The basis is the fair market value, $21,000. (See Example 11 and p. 3-14.)
41. b. When interest is imputed under § 7872, the shareholder is deemed to receive either a dividend or
compensation equal to the amount of interest. In both cases, however, the shareholder is also deemed
to have made an equivalent payment of interest to the corporation. Thus, a. and c. are true. If L is
deemed to have received a constructive distribution of $20,000, there is no offsetting deduction. Thus,
item b is false. (See Example 22 and p. 3-21.)
42. c. Statement a. is false because a constructive dividend need not be formally authorized. Statement b.
is false because § 7872 only applies to interest-free loans exceeding $10,000. Statement c. is true. (See
pp. 3-23 through 3-24.)
43. b. The $800 basis is allocated based on the relative fair market values of the aggregate values of the stock,
or $200 [(100 $1) þ (25 $4)]. Because the preferred stock is worth $100, or 50 percent of the value
of the total value of the stock, 50 percent of the basis is allocated to the preferred, or $400 (50%
$800). Since the cost basis of the original shares carries over, the holding period also carries over to the
new shares. (See Exhibit 3.8, Example 24, and p. 3-23 and p. 3-24.)
44. a. A distribution of preferred on common is nontaxable, because the proportionate interest of the
common shareholders is unaffected. (See pp. 3-23 through 3-24 and 3-28.)
45. c. Distributions are treated as dividends only to the extent of earnings and profits. Therefore, of the
$15,000 distributed to Mr. Higgins, $8,000 is taxed to him as a dividend. Of the remaining $7,000
distributed to Mr. Higgins, $5,000 is treated as a nontaxable return of capital (limited to his basis in the
stock preceding the distribution) and $2,000 is treated as a capital gain. (See Example 1 and pp. 3-3.)
46. a. Because EP represents the corporation’s economic income, numerous adjustments must be made to
taxable income to arrive at the corporation’s EP. R Corporation’s taxable income of $50,000 does
not include a Federal income tax refund of $3,000 or tax-exempt interest income of $2,000. Conversely,
in the determination of taxable income R Corporation was not allowed a deduction for $250 it paid in
payroll tax penalties. These items each impact R Corporation’s economic income: $54,750 ($50,000 þ
$3,000 þ $2,000 $250). (See Exhibit 3.2 and pp. 3-4 through 3-10.)
47. e. An accrual basis taxpayer reduces current EP for the federal taxes imposed on current taxable
income. The corporation is not allowed a deduction in arriving at taxable income for a net capital loss.
Therefore, Q Corporation must subtract from its taxable income the accrued income tax of $15,450 and
the capital loss of $30,000 to determine its current-year EP of $34,550 ($80,000 $15,450 $30,000).
(See Example 5 and p. 3-9.)
48. d. Although the annual premium payments are not deductible, they do reduce EP. Similarly, increases
in the cash surrender value of the policy that are nontaxable are included for EP. In year 10, $54,000
in insurance premiums has been paid to date and cash surrender value has grown to $50,000, a net
decrease to EP of $4,000 that has been reflected in the EP of prior years. Because $50,000 of cash
surrender value has already been included for EP in prior years, only $600,000 is added to EP in
year 10. (See Example 6 and p. 3-9.)

49. d. The presumption is that every distribution is first out of current EP and then from accumulated EP.
(See p. 3-10.)
50. a. That ratio is $40,000 to $100,000 or 40 percent for the May 1 distribution. $50,000 of current EP
multiplied by 40 percent equals $20,000 of current EP allocated to the May 1 distribution. (See
Example 7 and pp. 3-10 and 3-11.)
51. e. Current EP is allocated in the same ratio that the distribution bears to the total current distributions.
As a result, $30,000 of current EP is allocated to the December 1 distribution. Accumulated EP is
then allocated to distributions made during the year in chronological order. Because $20,000 of the
total accumulated EP of $45,000 was allocated to the May 1 distribution, the remaining $25,000 is
then allocated to the December 1 distribution. (See Example 7 and pp. 3-10 and 3-11.)
52. b. For all distributions of property to corporate as well as noncorporate shareholders, the amount of the
distribution and the basis of the property distributed are each equal to property’s fair market value on
the date of distribution. (See Example 11 and p. 3-14.)
53. a. Corporations must recognize gain on the distribution of appreciated property. (See p. 3-14.)
54. d. All of the characteristics listed are those of a bona fide debtor-creditor relationship. In contrast,
advances on an open account, demand loans, loans that do not bear adequate interest, and loans that
have no fixed maturity date are likely to be treated as disguised dividends. (See pp. 3-21 and 3-22.)
55. d. Constructive distributions arising from a payment for the shareholder’s benefit have been found where
the corporation paid the shareholder’s debt, charitable contributions where shareholders or their
relatives receive benefits from the charity, the shareholder’s expenses for financial and accounting
services, and the shareholder’s travel and entertainment expenses. (See p. 3-22.)
56. e. A shareholder who receives stock rights has all three alternatives with respect to their use. (See
Example 25 and pp. 3-25 and 3-26.)
57. c. The IRS held that current earnings and profits are first allocated to distributions on stock on which
dividends must be paid before dividends can be paid on other classes of stock. (See Example 31 and
p. 3-31.)
58. c. A distribution in the current year would be a return of capital, whereas a distribution in the following
year would be taxable as a dividend to the extent of the corporation’s current earnings and profits. (See
Example 30 and p. 3-30.)
59. e. All three methods are acceptable. An alternative approach is to accept double taxation but attempt to
reduce the cost of the second tax. (See pp. 3-30 and 3-31.)

Comprehensive Problems
1. Ship Quick Corporation operates an overnight mail service. Bob Biggio owns 70 percent of the corporation’s
stock and also serves as the corporation’s president. This year Ship Quick moved its home office from
Houston to Memphis. The financial accounting records of the corporation show the following information
for the current year:
Gross profit $ 900,000
Dividends 20,000
Interest 10,000
Long term capital gain 8,000
Other income 1,000
Other operating expenses (300,000)
11-
Further talks with the corporation’s accountants revealed the additional facts given below.
1. The corporation uses the accrual method of accounting and reports on the calendar year.
2. The dividends were received from a temporary investment of working capital in Exxon stock. The
corporation owned a very small percentage of Exxon.
3. The interest income was from bonds issued by the State of New York.
4. The other income represented gain on the sale of equipment. All of the income from the sale was ordinary
under the recapture provisions of § 1245.
5. Included in the operating expenses is a $5,000 penalty paid for the late payment of Federal income taxes.
6. The operating expenses also reflect estimated bad debt expense of $30,000. Actual debts written off during
the year were $9,000.
7. The corporation has a long term capital loss carryover of $2,000 from the prior year which is not reflected
in the information given above.
8. The corporation exchanged a warehouse (basis $40,000) that it owned in Houston for similar property in
its new location in Memphis. The Memphis property was worth $90,000.
9. During the year the corporation distributed $45,000 to its shareholders.
Compute Ship Quick’s current earnings and profits.
3
3-17

2. Rock D. Jock has owned and operated MTV Corporation for many years. At the beginning of the year,
Rock had a basis in his stock of $2,500. On October 1 of this year he sold all of his stock to Ray Deo for
$60,000. During the year, the corporation made four distributions: $6,000 on April 15, $24,000 on July 15,
$15,000 on September 15 and $15,000 on December 15.
a. Assume that MTV had current earnings and profits of $40,000 and accumulated earnings and profits of
$11,000. Compute the following:
Rock’s income attributable to the distribution and its character
Rock’s basis in his stock prior to the sale
Ray’s income and its character
Ray’s basis in his stock
b. Assume that MTV had accumulated earnings and profits of $405,000 and a deficit in current earnings
and profits for the year of $730,000. Compute the following:
Rock’s income attributable to the distribution and its character
Rock’s basis in his stock prior to the sale
Ray’s income and its character
Ray’s basis in his stock
3. During the year, X Corporation distributed the following assets to its sole shareholder, Mrs. Jones.
1. Stock in IBM worth $12,000 (basis $15,000)
2. Ocean front property in Arizona worth $90,000 (basis $60,000) subject to a mortgage of $40,000
Assuming X has current and accumulated EP of $900,000, answer the following questions.
a. What is the amount of dividend income, if any, that Mrs. Jones must report during the year?
b. What is Mrs. Jones’s basis in each of the assets received?
c. What is the effect of each distribution on the corporation’s taxable income?
d. What is the effect of each distribution on the corporation’s EP?

Solutions to Comprehensive Problems
1. The starting point in computing Ship Quick’s current EP is the corporation’s taxable income. Taxable
income is $639,000 computed as follows:
Gross profit from sales $ 900,000
Dividends 20,000
Interest from State of New York bonds 0
Long-term capital gain 8,000
Long-term capital loss carryover (2,000)
Other income 1,000
Other operating expenses $300,000
Nondeductible late penalty (5,000)
Actual bad debts ($30,000 $9,000) (21,000)
Total deductible operating expenses (274,000)
Dividends received deduction (70% $20,000) (14,000)
Federal income tax (34% $639,000) $ 217,260
The corporation’s EP is $442,740 computed as follows:
Interest from State of New York bonds 10,000
Dividend-received deduction 14,000
Long term capital loss carryover 2,000
Late penalty (5,000)
Federal income tax (217,260)
Current EP $ 442,740
(See pp. 3-4 through 3-10.)
2. a. Rock will report dividend income of $41,000, capital gain of $1,500, and have a basis in his stock of
$0. Ray will report dividend income of $10,000 and have a basis in his stock of $55,000. Because there
is insufficient current EP to absorb the total distributions during the year, current EP must be
allocated to all four distributions on a pro rata basis. In contrast, accumulated EP is allocated to
distributions in chronological order. The allocation is made as shown below.
Date Amount CEP AEP
Return of
Capital Sale
4-15 $ 6,000 $ 4,000 $ 2,000
6-15 24,000 16,000 8,000
9-15 15,000 10,000 1,000 $2,500 $1,500
12-15 15,000 10,000 $5,000
$60,000 $40,000 $11,000
Because Rock received total distributions of $45,000 ($6,000 þ $24,000 þ $15,000) he is allocated
current EP of $30,000 ($45,000/$60,000 $40,000). Of the remaining $15,000 ($45,000 $30,000)
that he received, $11,000 is out of accumulated EP, resulting in total dividend income of $41,000
($11,000 þ $30,000). Of the remaining $4,000 ($45,000 $41,000 dividend) distributed to him, $2,500
represents a nontaxable return of his basis while the $1,500 balance is capital gain. The $15,000
received by Ray represents $10,000 of current EP and is therefore taxable to him as a dividend. The
remaining $5,000 is a nontaxable return of capital, reducing his basis to $55,000 ($60,000 $5,000).
(See Example 7 and p. 3-11.)
Solutions to Comprehensive Problems 3-19

b. The deficit is prorated on a daily basis (excluding the date of distribution) and reduces the accumulated
EP of $405,000 that is otherwise available for distribution. As computed below, all of the $6,000
distribution on April 15 is a dividend while only $9,000 of the $24,000 distribution on July 15 is a
dividend. Thus Rock has dividend income of $15,000, a $2,500 nontaxable return of basis, a capital
gain of $27,500 and a basis in his stock prior to the sale of $0. Because the deficit and distributions
eliminate accumulated EP prior to the distribution to Ray, he will have a nontaxable return of basis
of $15,000 and a basis in his stock of $45,000 ($60,000 $15,000).
Accumulated EP $ 405,000
Deficit through 4-15
[($730,000/365) (31 þ 28 þ 31 þ 14 ¼ 104)] (208,000)
Accumulated EP as of 4-15 $ 197,000
Accumulated EP $ 405,000
Deficit through 7-15
[($730,000/365) (31 þ 28 þ 31 þ 30 þ 31 þ 30 þ 14 ¼ 195)] (390,000)
4-15 distribution (6,000)
Accumulated EP as of 6-15 $ 9,000
3. a. $62,000. Under § 301, Mrs. Jones must report dividend income equal to value of the property received
less any liabilities assumed. Therefore, she will report a dividend of $62,000 ($12,000 þ $90,000
$40,000). (See Example 11 and pp. 3-15 and 3-16.)
b. The basis of the property received is its fair market value. Therefore, she will have a basis in the land
of $90,000 and a basis in the IBM stock of $12,000. (See Example 11 and pp. 3-15 and 3-16.)
c. $30,000. Under § 311, the distributing corporation recognizes gain, but not loss, on the distribution of
property. Therefore, the corporation will recognize the $30,000 ($90,000 $60,000) gain on the
distribution of the land. (See Example 12 and pp. 3-16 and 3-17.)
d. $35,000 decrease. Due to the distribution of the IBM stock, the corporation will reduce its EP by the
basis of the stock, $15,000. In addition, the land distribution will cause a decrease in EP of $20,000
computed as follows:
Increase by gain recognized $ 30,000
Decrease by value of land (90,000)
Increase by liability þ 40,000
Net decrease in EP $ (20,000)

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