In this video, we walk through 5 TCP practice questions teaching about C corporation cash distributions to shareholders. These questions are from TCP content area 2 on the AICPA CPA exam blueprints: Entity Tax Compliance.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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C Corporation Cash Distributions to Shareholders
A C corporation’s cash distributions to its shareholders can come from different financial sources: either from its E&P, which includes both current and accumulated earnings, or from the shareholders’ capital investment (i.e., return of capital). How these distributions are treated for tax purposes depends on the amount relative to the corporation’s E&P.
E&P and Distribution Classification
E&P is a measure of a corporation’s ability to pay dividends. It includes all earnings minus all losses and is similar to retained earnings but with several tax-specific adjustments. The classification of distributions depends on whether the corporation has sufficient E&P to cover them:
- Dividend Income: If a distribution does not exceed the E&P, it is considered a dividend. Dividends are typically taxable to the shareholder at the qualified dividend rate if held for more than 60 days.
- Return of Capital: If the distribution exceeds the E&P, the excess is treated as a return of capital. This reduces the basis of the shareholder’s stock. If a shareholder’s basis is reduced to zero, any further distributions are treated as capital gains.
Calculating Return of Capital
When a distribution exceeds E&P, you must calculate the return of capital. This involves several steps:
- Determine Total E&P: Add current year E&P to accumulated E&P.
- Measure Distribution Against E&P: Subtract total E&P from the total distribution amount.
- Adjust Shareholder Basis: The amount by which the distribution exceeds E&P reduces the shareholder’s stock basis.
Example:
Suppose a corporation with $50,000 in accumulated E&P and $20,000 in current year E&P makes a $100,000 distribution. The total E&P ($70,000) is less than the distribution amount, so $30,000 ($100,000 – $70,000) is considered a return of capital.
Capital Gains Calculation
If the return of capital exceeds the shareholder’s basis in their stock, the excess is taxed as a capital gain.
- Calculate Excess: Subtract the shareholder’s stock basis from the return of capital.
- Determine Gain Type: If the stock was held for more than a year, it’s a long-term capital gain; otherwise, it’s a short-term capital gain.
Example: Continuing from above, if the shareholder’s basis was $25,000, and the return of capital was $30,000, $5,000 ($30,000 – $25,000) is treated as a capital gain.
Pro Rata Allocation of Current Year E&P
When a C corporation makes multiple distributions throughout the year, it must allocate the current year E&P proportionally to each distribution. This means that each distribution receives a share of the current year E&P based on the ratio of the distribution amount to the total distributions made throughout the year.
Example: If a corporation earns $80,000 in current year E&P and makes two distributions of $60,000 and $40,000 respectively, the $60,000 distribution would be allocated ($60,000 / $100,000) x $80,000 = $48,000 of the E&P, while the $40,000 distribution would receive ($40,000 / $100,000) x $80,000 = $32,000 of the E&P.
Pro Rata Allocation of E&P Among Shareholders
E&P is allocated to different shareholders pro rata based on their share of the distribution. If a corporation has limited E&P relative to the total distributions, each shareholder receives a portion of the E&P proportional to their distribution relative to the total distributed.
Example: If total E&P is $100,000 and total distributions are $200,000, a shareholder receiving a $50,000 distribution would have an E&P allocation of ($50,000 / $200,000) x $100,000 = $25,000. This would be treated as dividend income, with any excess distribution handled as return of capital or capital gains, depending on the shareholder’s basis.
Preference of Preferred Shareholders in E&P Allocation
In the hierarchy of dividend distributions, preferred shareholders typically receive their dividends before common shareholders if the available E&P is not sufficient to cover all distributions. This preference impacts the allocation of E&P:
Example: Suppose a corporation with $100,000 in E&P makes distributions of $80,000 to preferred shareholders and $50,000 to common shareholders. The preferred shareholders would receive the first $80,000 of E&P as dividends. Only the remaining $20,000 of E&P would be available for the $50,000 distribution to common shareholders, resulting in $30,000 of that distribution being treated as a return of capital.
This system ensures that preferred shareholders, who often have dividend preferences stipulated in their share terms, receive their expected returns before common shareholders when E&P is limited. In many cases, preferred dividends are also cumulative, meaning if they are not paid in one year, the unpaid dividends accumulate and must be satisfied out of future earnings before any dividends can be paid to common shareholders.
Conclusion
Calculating and treating distributions that exceed E&P involves careful consideration of corporate earnings, shareholder equity, and tax implications. By accurately applying these principles, corporations can effectively manage distributions to maximize shareholder value and comply with tax regulations. Each scenario might involve complex calculations, especially with multiple shareholders with different shares of ownership and basis levels.
