Corporate Tax | Just Tax

Distribution Analysis and Constructive Dividends (§§ 301, 316)

This checklist guides the analysis of non-liquidating corporate distributions to shareholders under §§ 301 and 316, including constructive dividends, E&P determinations, stock distributions, and related reporting obligations. Use it whenever a corporation makes a distribution of property (cash or non-cash) to a shareholder, or when a shareholder receives an economic benefit from a corporation that may be recharacterized as a constructive dividend.

Step 1. When § 301 Governs a Corporate Distribution

"Except as otherwise provided in this chapter, a distribution of property (as defined in section 317(a)) made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c)." (§ 301(a))

• The default rule. § 301(a) applies to every distribution of property from a corporation to a shareholder with respect to stock unless another provision displaces it.
  • § 301(a) is the catch-all. It governs ordinary dividends, constructive dividends, and any other corporate transfer of property to a shareholder that is not recharacterized by a more specific Code section.
  • The phrase "Except as otherwise provided in this chapter" means § 301(a) yields whenever another subtitle C provision assigns a different tax treatment. (§ 301(a))
• The § 302 override. A stock redemption that qualifies under § 302(a) is treated as an exchange, and § 301 does not apply.
  • § 302(a) provides exchange treatment when any of the five tests in § 302(b) are met. (1) Not essentially equivalent to a dividend under § 302(b)(1). (2) Substantially disproportionate under § 302(b)(2). (3) Complete termination under § 302(b)(3). (4) Partial liquidation under § 302(b)(4). (5) Certain RIC redemptions under § 302(b)(5). (§ 302(a), § 302(b)(1)-(5))
  • If none of the § 302(b) tests apply, the redemption falls back to § 301 by operation of § 302(d). (§ 302(d) ("If a redemption is not within the provisions of subsection (a), it shall be treated as a distribution of property to which section 301 applies."))
  • CAUTION. A redemption that looks like a sale on its face still defaults to dividend treatment if the shareholder fails every § 302(b) test. Always run the § 302(b) gauntlet before concluding § 301 governs.
• The § 303 exception. Distributions in redemption of stock to pay death taxes are treated as exchanges even though no § 302(b) test is satisfied.
  • § 303 applies only where the stock being redeemed was included in a decedent's gross estate for federal estate tax purposes. (§ 303(a))
  • The amount eligible for exchange treatment is limited to the sum of estate taxes, funeral expenses, and administration expenses allowable as deductions under §§ 2053 and 2055. Amounts in excess of that cap are tested under § 302. (§ 303(a)(2)(A))
• "Property" includes more than cash.
  • § 317(a) defines property as "money, securities, and any other property" but excludes stock (or rights to acquire stock) in the distributing corporation. (§ 317(a))
  • Indebtedness of the corporation to its shareholder counts as property. When a corporation distributes its own note to a shareholder, the note is property under § 317(a) and the distribution triggers § 301. (Treas. Reg. § 1.317-1)
  • A corporation's own stock is not property for this purpose, so a stock dividend or stock split generally falls outside § 301 unless § 305(b) pulls it back in. (§ 317(a)) See Step 10 for § 305(b) analysis.
• Constructive distributions. A transfer from a corporation to a shareholder at less than fair market value is recharacterized as a § 301 distribution to the extent of the bargain element.
  • Treas. Reg. § 1.301-1(j) states that when a corporation transfers property to a shareholder for an amount less than FMV in a sale or exchange, the shareholder is treated as having received a distribution. The distribution amount equals the difference between the amount paid and the FMV of the property.
  • Common fact patterns include below-market loans (see Step 15), excessive compensation (see Step 13), bargain purchases of corporate assets (see Step 14), use of corporate property without charge (see Step 14), and payments of personal expenses by the corporation (see Step 14). Each is tested under § 301 if the payment or benefit flows to a shareholder in their shareholder capacity.
  • TRAP. The constructive distribution rules apply even when the transaction is structured as a loan, lease, compensation payment, or sale. Form does not control substance for § 301 purposes.
• The beneficial owner is taxed, not the record holder.
  • Distributions made to a nominee or record holder are taxed to the beneficial owner. (Helvering v. Eubank, 311 U.S. 122 (1940) (income from property assigned to another is taxable to the assignor under the anticipatory-assignment principle)) (Lucas v. Earl, 281 U.S. 111 (1930) (income is taxed to the person who earns it, not to the recipient of an assignment of that income))
  • In the corporate context, this means a dividend check payable to a shareholder's spouse, trust, or partnership is still includible in the gross income of the shareholder who beneficially owns the stock.
• Timing of inclusion.
  • A distribution is includible in gross income when cash or property is "unqualifiedly made subject to the demands of the shareholder." (Treas. Reg. § 1.301-1(c))
  • A mere credit to a shareholder's loan account on the corporate books is not enough if the corporation retains the right to refuse payment. The shareholder must have an unconditional right to demand and receive the property.

Step 2. The Distribution Amount Under § 301(b)

"For purposes of this section, the amount of any distribution shall be the amount of money received, plus the fair market value of the other property received." (§ 301(b)(1))

• The baseline amount is money plus FMV of non-cash property.
  • "Money received" includes cash, checks, wire transfers, and any other medium denominated in U.S. currency. (Treas. Reg. § 1.301-1(b))
  • "Other property" means everything that is not money but is property under § 317(a). Securities, real estate, tangible personal property, and corporate notes all fall here. The shareholder measures the amount of the distribution by the FMV of what they receive. (§ 301(b)(1)) (Treas. Reg. § 1.301-1(b))
  • FMV is determined as of the date of distribution. (§ 301(b)(3) ("For purposes of this section, fair market value shall be determined as of the date of the distribution."))
• Liabilities reduce the distribution amount, but not below zero.
  • § 301(b)(2) reduces the distribution amount by (A) any liability of the corporation assumed by the shareholder in connection with the distribution, and (B) any liability to which the property is subject immediately before and immediately after the distribution.
  • The reduction cannot drive the distribution amount below zero. If the liability exceeds the sum of cash plus FMV, the excess does not create a loss or further tax benefit. The distribution amount is simply zero for § 301 purposes. (§ 301(b)(2))
  • The shareholder's basis in distributed property is its FMV as of the distribution date, without reduction for liabilities. This creates a basis mismatch. The distribution amount (net of liabilities) may differ from the shareholder's basis in the property received. (§ 301(d))
  • EXAMPLE. Corporation distributes real estate with FMV $50,000 to a shareholder. The property is subject to a $30,000 mortgage. Under § 301(b)(2), the distribution amount is $50,000 FMV minus $30,000 liability = $20,000. The shareholder takes a $50,000 basis in the property under § 301(d). The shareholder reports $20,000 of potential dividend income (subject to E&P and basis limits in § 301(c), analyzed in Step 3). The $30,000 difference between basis and distribution amount matters on a later sale of the property.
• The constructive distribution amount on a below-FMV transfer.
  • When a corporation transfers property to a shareholder for less than FMV, the distribution amount is FMV minus the amount actually paid by the shareholder. (Treas. Reg. § 1.301-1(j) ("the shareholder is treated as having received a distribution to which section 301 applies. The amount of the distribution is the difference between the amount paid for the property and the amount of its fair market value"))
  • This rule applies whether the transfer is cast as a sale, lease, loan, compensation payment, or any other form. The key is that the shareholder received property worth more than what they gave up.
  • The shareholder's basis in the property for this type of transfer is its FMV, just as with any other § 301 distribution. The amount paid does not affect basis. (Treas. Reg. § 1.301-1(j)) (§ 301(d))
• Corporate notes distributed to shareholders.
  • A note of the distributing corporation is property under § 317(a) and its principal amount generally fixes the distribution amount. (Treas. Reg. § 1.317-1)
  • The corporation's earnings and profits are reduced by the principal amount of the note at the time of distribution, not when the note is later paid. (Treas. Reg. § 1.317-1)
  • If the note bears adequate stated interest and is issued at par, the principal amount equals FMV and the analysis is straightforward. If the note is non-interest-bearing or below market, § 7872 or original issue discount rules may impute additional income. See Step 15 for the § 7872 overlay.
• Valuation disputes and litigation risk.
  • FMV of non-cash property is often the battlefield in § 301 cases. The IRS frequently challenges taxpayer valuations of closely held stock, real estate, and intangible property distributed by corporations.
  • "Fair market value" means the price at which property would change hands between a willing buyer and a willing seller, neither being under compulsion to buy or sell and both having reasonable knowledge of relevant facts. (Treas. Reg. § 20.2031-1(b)) (this standard definition is imported into § 301(b)(3) analysis by judicial convention)
  • Courts look to comparable sales, income capitalization, and replacement cost methods depending on the asset class. Appraisals from qualified valuation professionals should be obtained for any non-cash distribution with subjective FMV. Failure to document FMV invites an IRS challenge and potential penalties under § 6662.

Step 3. The Three-Tier Tax Treatment Under § 301(c)

"That portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income." (§ 301(c)(1)) "That portion of the distribution which is not a dividend shall be applied against and reduce the adjusted basis of the stock." (§ 301(c)(2)) "Except as provided in subparagraph (B), that portion of the distribution which is not a dividend, to the extent that it exceeds the adjusted basis of the stock, shall be treated as gain from the sale or exchange of property." (§ 301(c)(3)(A))

• Tier 1. Dividend income to the extent of earnings and profits.
  • § 301(c)(1) requires that the dividend portion of a distribution shall be included in gross income. This produces ordinary income unless a preferential rate applies. (§ 301(c)(1)) (§ 316(a))
  • The dividend characterization depends solely on the corporation's E&P position. The shareholder's stock basis does not cap the dividend amount at this tier. (§ 316(a))
  • § 1(h)(11) taxes qualified dividend income at capital gain rates of 0%, 15%, or 20% depending on the shareholder's taxable income bracket. Qualified dividends include dividends from domestic corporations and from qualified foreign corporations. The dividend must also meet the holding period requirement of § 1(h)(11)(B)(iii), which generally requires the shareholder to hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. (§ 1(h)(11)) (§ 1(h)(11)(B)(iii))
• The nimble dividend rule under § 316(a)(2). A corporation with no accumulated E&P may still fund a dividend entirely out of current E&P.
  • § 316(a)(2) provides that in the case of a corporation which has no accumulated earnings and profits at the time of the distribution, if the earnings and profits for the taxable year (computed as of the close of such year without diminution by reason of any distributions made during the year) are not less than the amount of the distribution, the distribution shall be a dividend. Current E&P is computed at year-end before any reduction for distributions during the year. (§ 316(a)(2))
  • The practical effect of the nimble dividend rule is that a corporation can distribute its full current E&P as a dividend even if the distribution occurs early in the year when interim books reflect a deficit. So long as the corporation generates sufficient E&P by year-end, the distribution is a dividend. (§ 316(a)(2) ("without regard to the amount of the earnings and profits at the time the distribution was made"))
  • The shareholder has no dividend income under Tier 1 to the extent the distribution exceeds the corporation's total current and accumulated E&P. The excess drops to Tier 2. (§ 301(c)(2))
• Tier 2. Return of capital to the extent of stock basis.
  • § 301(c)(2) provides that the non-dividend portion of a distribution shall be applied against and reduce the adjusted basis of the stock. This basis reduction is not a taxable event and produces no current gain or loss. (§ 301(c)(2))
  • Basis is reduced dollar for dollar by the Tier 2 amount. If the distribution exceeds the shareholder's total stock basis, the basis is reduced to zero and any further excess drops to Tier 3. (§ 301(c)(2)) (§ 301(c)(3)(A))
  • The basis reduction under Tier 2 is applied on a block-by-block basis. Each separate block of stock with a different basis must be tracked individually under § 1012 and Treas. Reg. § 1.1012-1(c)(1). (§ 1012) (Treas. Reg. § 1.1012-1(c)(1))
• Tier 3. Capital gain on any remaining excess.
  • § 301(c)(3)(A) treats the excess as gain from the sale or exchange of property. Because stock is a capital asset in the hands of a non-dealer shareholder, the resulting gain is capital gain under § 1221. The character (short-term or long-term) depends on the shareholder's holding period in the stock. (§ 301(c)(3)(A)) (§ 1221)
  • § 301(c)(3)(B) provides that any portion of the distribution attributable to a pre-March 1, 1913 increase in value is exempt from tax. This provision is of historical significance only and does not apply to any distribution from a modern corporation. (§ 301(c)(3)(B))
  • TRAP. A shareholder with zero stock basis will skip Tier 2 entirely. Any portion of the distribution that is not a dividend converts directly to capital gain under Tier 3. Verify the shareholder's basis before concluding that a non-dividend distribution is merely a return of capital. (§ 301(c)(3)(A))
• The § 301(c) waterfall is applied separately for each shareholder.
  • Tier 1 is determined at the corporate level by the corporation's total current and accumulated E&P. All shareholders receiving distributions share proportionately in the available E&P pool. (§ 316(a))
  • Tiers 2 and 3 are determined at the shareholder level based on each shareholder's individual stock basis. Two shareholders receiving identical distribution amounts may have different tax outcomes if their bases differ. (§ 301(c)(2)-(3))
  • A non-pro-rata distribution can produce dividend income for some shareholders and return of capital or capital gain for others depending on their respective bases and the corporation's aggregate E&P. (§ 301(c))
• EXAMPLE. The three-tier waterfall with $10,000 stock basis, $5,000 current E&P, and a $17,500 cash distribution.
  • S owns C stock with an adjusted basis of $10,000. C Corporation has $5,000 of current E&P and no accumulated E&P. C distributes $17,500 in cash to S during the current year.
  • Under Tier 1, $5,000 is a dividend under § 316(a)(2) because C's current E&P ($5,000) is not less than the distribution amount. Current E&P is computed at year-end without diminution for the distribution itself.
  • Under Tier 2, $10,000 reduces S's stock basis from $10,000 to zero under § 301(c)(2). S recognizes no gain or loss on this return of capital portion.
  • Under Tier 3, the remaining $2,500 is treated as gain from the sale or exchange of property under § 301(c)(3)(A). S includes $5,000 of dividend income and $2,500 of capital gain in gross income. S's adjusted basis in the C stock is reduced to zero. If S later receives an additional distribution from C in a year with no E&P, the entire amount will be capital gain under Tier 3 because S's basis is already zero.
• CAUTION. Mismatched taxable years between shareholder and corporation.
  • The shareholder and the corporation may have different taxable years. A distribution received by a shareholder in their taxable year 2024 may fall within the corporation's taxable year 2023 or 2024 for E&P purposes.
  • Always verify which corporate taxable year's E&P governs the Tier 1 dividend determination before applying the waterfall. The relevant year is the corporation's taxable year in which the distribution is made.
  • Current E&P is generally computed under the corporation's method of accounting (cash or accrual) under Treas. Reg. § 1.312-6. A change in the corporation's accounting method can alter the current E&P computation and thus the Tier 1 dividend amount.

Step 4. Basis and Holding Period of Distributed Property

"The basis of property received in a distribution to which subsection (a) applies shall be the fair market value of such property." (§ 301(d))

• The fair market value basis rule.
  • § 301(d) provides that the basis of property received in a distribution to which § 301(a) applies shall be the FMV of such property. This produces a stepped-up basis if the corporation's basis was lower, or a stepped-down basis if the corporation's basis was higher. (§ 301(d))
  • The distribution amount for purposes of the § 301(c) waterfall in Step 3 is the FMV of the property on the date of distribution. The same FMV measure determines both the amount of the distribution and the shareholder's basis in the received property. (§ 301(b)(1)) (§ 301(d))
  • This rule applies regardless of how the distribution is characterized under the three-tier waterfall. Whether the distribution is a dividend under Tier 1, a return of capital under Tier 2, or capital gain under Tier 3, the shareholder's basis in the received property is always its FMV. (§ 301(d))
• The holding period begins on the date of distribution.
  • The shareholder's holding period in distributed property commences fresh on the distribution date and does not tack from the corporation's holding period. (§ 1223)
  • Because § 301(d) provides a basis equal to FMV rather than a substituted or carryover basis, no tacking provision under § 1223 applies to extend the corporation's holding period to the shareholder. The property is treated as newly acquired by the shareholder. (§ 1223)
  • § 1222 defines long-term and short-term capital gain by reference to the property's holding period in the taxpayer's hands. The shareholder must hold the distributed property for more than one year to obtain long-term capital gain treatment on a subsequent sale. (§ 1222)
• Distinction from reorganization exchanges.
  • In a reorganization exchange under § 368, the shareholder typically receives non-recognition treatment under § 354 and takes a substituted basis under § 358. The holding period in the received stock or securities tacks under § 1223(1). (§ 354) (§ 358) (§ 1223(1))
  • In a § 301 distribution, by contrast, the shareholder takes a basis equal to FMV under § 301(d) with no tacking. The shareholder may recognize dividend income, return of capital, or capital gain at the time of distribution. (§ 301(d))
  • The critical distinguishing factor is the applicability of § 301(a). If the distribution is described in § 301(a), the FMV basis rule of § 301(d) governs. If the transaction instead qualifies as a reorganization under § 368 and § 354 applies, the substituted basis rule of § 358 governs. (§ 301(a)) (§ 368) (§ 354)
• EXAMPLE. Inventory distribution with $20,000 FMV and subsequent sale for $22,000.
  • S receives a distribution of inventory from C Corporation. The inventory has a fair market value of $20,000 on the distribution date. The distribution amount under Step 3 is $20,000.
  • S takes a basis of $20,000 in the inventory under § 301(d). If S later sells the inventory to a customer for $22,000, S recognizes only $2,000 of additional gain (or ordinary income if S is in a trade or business) on the subsequent sale. (§ 301(d))
  • S's holding period for the inventory begins on the distribution date. If C had held the inventory for three years before the distribution, that prior holding period does not tack to S's holding period under § 1223. (§ 1223)
• TRAP. The shareholder's basis in distributed property is always FMV, never the corporation's basis.
  • Do not confuse the shareholder's basis in the distributed property with the corporation's basis in that property before distribution. The corporation may have a very different basis for its own tax purposes, including a substituted basis from a prior transaction. (§ 301(d)) (§ 362)
  • None of the corporation's basis carries over to the shareholder. The shareholder's basis is exclusively determined by § 301(d) and is always the property's FMV at the time of distribution. (§ 301(d))
  • If the distributed property has a built-in loss at the corporate level (corporate basis exceeds FMV), the corporation does not recognize that loss on the distribution under § 311(a), and the shareholder cannot claim it. The shareholder simply takes the lower FMV basis. (§ 311(a)) See Step 8 for the § 311(a) nonrecognition rule.

Step 5. The Dividend Definition Under § 316(a)

"For purposes of this subtitle, the term 'dividend' means any distribution of property made by a corporation to its shareholders (1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits." (§ 316(a))

• The § 316(a) two-tier sourcing rule.
  • A distribution is a dividend only to the extent it is paid from either accumulated earnings and profits ("AEP") or current earnings and profits ("CEP"). (§ 316(a)(1)-(2))
  • CEP is measured at year-end without reduction for distributions made during that year. (§ 316(a)(2) ("computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year"))
  • Distributions are deemed to come first from CEP, then from AEP. (§ 316(a) ("from the most recently accumulated earnings and profits"))
• The CEP-first ordering produces the nimble dividend rule.
  • If CEP for the taxable year is positive but AEP is negative, distributions during the year are still taxable dividends to the extent of CEP. (§ 316(a)(2))
  • The rule operates because CEP is determined at year-end without diminution for the distributions themselves. A corporation can thus distribute its current profits as dividends even while carrying a large accumulated deficit. (§ 316(a)(2))
  • TRAP. A client with negative retained earnings and a large accumulated deficit may still face dividend treatment on every distribution if the current year is profitable. Always compute CEP before concluding that a distribution is a non-dividend return of capital. (§ 316(a))
• Pro rata allocation when multiple distributions occur in a year with positive CEP.
  • If total distributions during the year do not exceed total CEP, each distribution is treated as coming proportionately from CEP and is a dividend in full. (Treas. Reg. § 1.316-1(e), Example 1)
  • EXAMPLE. Corporation M had an operating deficit of $200,000 and CEP for the year of $100,000. It made quarterly distributions of $25,000. Each quarterly distribution of $25,000 was a taxable dividend in full because the total distributions ($100,000) did not exceed total CEP ($100,000). (Treas. Reg. § 1.316-1(e), Example 1)
  • If total distributions exceed CEP, the excess is sourced to AEP if available. Any remaining excess after AEP is exhausted is treated as a return of capital under § 301(c)(2) and then capital gain under § 301(c)(3). (§ 316(a)) (§ 301(c)(2)-(3))
• E&P is the exclusive measure of dividend capacity.
  • E&P is an economic concept the tax law uses to approximate a corporation's power to make distributions that are more than just a return of investment. (Henry C. Beck Co. v. Commissioner, 52 T.C. 1 (1969), aff'd per curiam, 433 F.2d 309 (5th Cir. 1970))
  • E&P is NOT taxable income. A corporation may have substantial taxable income but minimal E&P, or vice versa. (Henry C. Beck Co. v. Commissioner, 52 T.C. 1 (1969))
  • E&P is NOT retained earnings under financial accounting standards. Retained earnings and E&P often diverge materially. (Henry C. Beck Co. v. Commissioner, 52 T.C. 1 (1969))
• The § 316(b) exceptions to the dividend definition.
  • § 316(b)(1) excludes from the § 316(a) definition insurance company dividends paid to policyholders under subchapter L. Those distributions are governed by the rules of subchapter L rather than § 301. (§ 316(b)(1))
  • § 316(b)(2) provides a special rule for personal holding companies. For PHC purposes, the term "dividend" also means any distribution to the extent of the corporation's undistributed personal holding company income under § 545. This expands the class of distributions treated as dividends beyond what § 316(a) alone would cover. (§ 316(b)(2))
• Domestic and foreign corporations are both covered.
  • The term dividend under § 316 comprises any distribution of property made by a domestic or foreign corporation to its shareholders out of accumulated E&P or current E&P. (Treas. Reg. § 1.316-1(a)(1))
  • The source of the distribution in a foreign corporation's hands (foreign-source or U.S.-source income) does not affect whether it constitutes a dividend under § 316. The E&P analysis controls. (Treas. Reg. § 1.316-1(a)(1))

Step 6. Computing Current and Accumulated E&P

"Earnings and profits is an economic concept which the tax law has utilized to approximate a corporation's power to make distributions which are more than just a return of investment." (Henry C. Beck Co. v. Commissioner, 52 T.C. 1 (1969), aff'd per curiam, 433 F.2d 309 (5th Cir. 1970))

• E&P computation starts with taxable income and adjusts.
  • CEP for a taxable year is computed by starting with the corporation's taxable income and then making the additions and subtractions required under § 312 and the regulations. (§ 312) (§ 316(a))
  • AEP is the running balance of E&P from prior years, increased by CEP and reduced by prior distributions to the extent they were dividends under § 316. (§ 316(a))
  • The accounting method used for computing taxable income (cash or accrual) is also used for computing E&P. (Treas. Reg. § 1.312-1(a))
• § 312(k)(1) mandates straight-line depreciation for E&P.
  • Depreciation for E&P purposes is computed as though all property were subject to § 168 and the alternative depreciation system ("ADS") using the straight-line method. (§ 312(k)(1))
  • No bonus depreciation applies for E&P purposes. The § 168(k) bonus depreciation allowance is disregarded in the E&P computation. (§ 312(k)(1))
  • The recovery period used is the ADS recovery period, which is generally longer than the general depreciation system ("GDS") recovery period. This produces smaller depreciation deductions and higher E&P than taxable income for most corporations. (Treas. Reg. § 1.312-15)
  • TRAP. A corporation that claims bonus depreciation and GDS on its tax return will have significantly lower taxable income than E&P in the acquisition year. Do not assume a corporation with taxable losses has negative CEP. Run the full E&P schedule. (§ 312(k)(1))
• § 312(n) overrides several favorable tax accounting methods for E&P.
  • Intangible drilling costs ("IDCs") under § 263(c) and mineral exploration and development costs under § 616(b) must be capitalized and deducted ratably over 120 months beginning with the later of the month the expenditure is paid or incurred, or the month of production. (§ 312(n)(1))
  • § 173 (circulation expenditures) and § 248 (organizational expenditures) do not apply for E&P purposes. Those expenditures must be capitalized and amortized under the general E&P rules. (§ 312(n)(2))
• § 312(n)(3)-(5) mandate additional accounting method overrides.
  • LIFO recapture. A corporation using the last-in, first-out ("LIFO") inventory method must make an annual adjustment to E&P to account for the difference between LIFO and FIFO inventory valuations. (§ 312(n)(3))
  • Installment sales. E&P is computed as if the installment method under § 453 were not used. All gain on an installment sale is recognized in the year of sale for E&P purposes. (§ 312(n)(4))
  • Completed contract method. A corporation using the completed contract method of accounting must compute E&P using the percentage of completion method. (§ 312(n)(5))
  • CAUTION. Each of these § 312(n) overrides accelerates income recognition for E&P relative to taxable income. A corporation deferring income under installment sales or completed contract method may have substantial CEP even with low taxable income. (§ 312(n)(4)-(5))
• Tax-exempt income increases E&P despite being excluded from taxable income.
  • All income exempted by statute increases E&P. (Treas. Reg. § 1.312-6(b))
  • Municipal bond interest, life insurance proceeds, and other excluded income items must be added back to taxable income in the E&P computation. (Treas. Reg. § 1.312-6(b))
  • The related expenses that produced the exempt income are deductible for E&P purposes even though they may be nondeductible under § 265. This produces a net addition to E&P equal to the exempt income less allocable expenses. (Treas. Reg. § 1.312-6(b))
• Federal income taxes reduce E&P.
  • Federal income taxes paid or accrued are not deductible in computing taxable income but do reduce E&P. (§ 312) (Treas. Reg. § 1.312-6)
  • State and local income taxes that are deductible in computing taxable income already reduce taxable income and thus automatically reduce E&P through that channel. (§ 164)
  • Federal income taxes must be subtracted from taxable income as an additional E&P adjustment. Failure to make this adjustment systematically overstates E&P. (Treas. Reg. § 1.312-6)
• The § 179 expense deduction is amortized over five years for E&P.
  • A corporation that elects to expense property under § 179 must amortize that amount ratably over five years for E&P purposes. (§ 179) (Treas. Reg. § 1.312-15)
  • In year one, only 20% of the § 179 deduction reduces E&P. The remaining 80% reduces E&P over the next four years. (§ 179)
  • TRAP. A corporation taking a full § 179 deduction on its tax return will have much lower taxable income than the E&P reduction in the first year. The E&P addback in years two through five means E&P exceeds taxable income in those years. Track the § 179 E&P adjustment schedule across all five years. (§ 179)
• Net operating loss carryovers reduce E&P in the year absorbed.
  • An NOL carryover that reduces taxable income under § 172 also reduces CEP in the year it is utilized. (§ 312) (Treas. Reg. § 1.312-6)
  • The NOL carryback or carryforward itself does not reduce E&P in the year the loss arose. The reduction occurs only in the year the NOL is actually applied against taxable income. (Treas. Reg. § 1.312-6)
  • A corporation that pays dividends while carrying an NOL may still have positive CEP if current operations generate income exceeding the available NOL. Always compute the interaction of NOL absorption and CEP before concluding dividend treatment is unavailable. (§§ 172, 312)

Step 7. The E&P Sourcing and Ordering Rules

"For the purpose of income taxation every distribution made by a corporation is made out of earnings and profits to the extent thereof and from the most recently accumulated earnings and profits. In determining the source of a distribution, consideration should be given first, to the earnings and profits of the taxable year; second, to the earnings and profits accumulated since February 28, 1913..." (Treas. Reg. § 1.316-2(a))

• Every distribution is sourced from E&P to the extent thereof.
  • Treas. Reg. § 1.316-2(a) treats each corporate distribution as coming first from current E&P and second from accumulated E&P. This ordering determines whether a distribution constitutes a taxable dividend under § 316(a) or instead is treated as a return of capital or capital gain. (Treas. Reg. § 1.316-2(a))
  • The phrase "from the most recently accumulated earnings and profits" means that accumulated E&P is drawn on a last-in, first-out basis. More recently accumulated layers are exhausted before older layers. (Rev. Rul. 74-550, 1974-2 C.B. 209)
• If current E&P equals or exceeds total distributions, every dollar distributed is a dividend.
  • Treas. Reg. § 1.316-2(b) provides this simplest case. The shareholder includes the full distribution amount in gross income under § 301(c)(1) to the extent of the corporation's current E&P. (Treas. Reg. § 1.316-2(b))
  • The corporation reduces its current E&P account by the total amount distributed. No accumulated E&P is affected. (Treas. Reg. § 1.316-2(b))
• If total distributions exceed current E&P, allocate current E&P proportionately across all distributions.
  • Treas. Reg. § 1.316-2(b) requires a pro rata allocation of current E&P when distributions in the aggregate exceed the current-year amount. (Treas. Reg. § 1.316-2(b))
  • The proportion allocated to each distribution equals the amount of that distribution divided by total distributions, multiplied by current E&P. (Treas. Reg. § 1.316-2(b))
  • The remainder of each distribution is then sourced from accumulated E&P available on the date of the particular distribution.
• The nimble dividend rule. Even when a corporation has an accumulated E&P deficit, distributions are still taxable as dividends to the extent of current E&P. Current E&P alone is sufficient to trigger dividend treatment.
  • A corporation with $100,000 of current E&P and $500,000 of accumulated deficit can still pay a fully taxable dividend up to $100,000. (§ 316(a)(2))
  • CAUTION. Do not assume that an accumulated deficit shields distributions from dividend treatment. Always compute current E&P separately before concluding that a distribution is a return of capital. (§ 316(a)(2))
• The snapshot rule applies when current E&P is a deficit.
  • If the corporation has a current E&P deficit, accumulated E&P is measured as of the date of each individual distribution. (Rev. Rul. 74-164, 1974-1 C.B. 74)
  • The current-year deficit is allocated pro rata against accumulated E&P. The pro rata allocation reduces the accumulated E&P available to support each distribution throughout the year. (Rev. Rul. 74-164)
  • TRAP. A corporation with positive accumulated E&P at year-start and a current deficit may still have dividend capacity for early-year distributions even though year-end accumulated E&P is negative. Measure accumulated E&P at each distribution date after accounting for the ratable portion of the current deficit. (Rev. Rul. 74-164)
• Accumulated E&P is allocated chronologically, not pro rata.
  • Once current E&P has been allocated pro rata, any remaining accumulated E&P is applied to distributions in chronological order on a first-come, first-served basis. (Rev. Rul. 74-164, 1974-1 C.B. 74)
  • The first distribution in time receives accumulated E&P up to its remaining amount. Subsequent distributions receive whatever accumulated E&P remains after prior distributions have been satisfied. (Rev. Rul. 74-164)
  • TRAP. This ordering can produce dramatically different tax consequences for shareholders receiving equal distributions at different times. The first shareholder may receive a fully taxable dividend while the later shareholder receives return of capital. (Rev. Rul. 74-164)
• Numerical example under the ordering rules.
  • Corporation M has $30,000 of current E&P and $12,000 of accumulated E&P. It makes four quarterly distributions of $15,000 each ($60,000 total). (Rev. Rul. 74-164, 1974-1 C.B. 74)
  • Current E&P is 50% of total distributions ($30,000 current / $60,000 total). Therefore $7,500 of each $15,000 distribution is sourced from current E&P ($15,000 times 50% = $7,500).
  • The remaining $7,500 of each distribution is sourced from accumulated E&P on a first-come, first-served basis. Distribution 1 gets the full $7,500 from accumulated E&P (exhausting $7,500 of the $12,000 balance). Distribution 2 gets the remaining $4,500 from accumulated E&P (fully exhausting the $12,000 balance). Distributions 3 and 4 get nothing from accumulated E&P.
  • Results. Distribution 1 is fully taxable as a $15,000 dividend ($7,500 from current + $7,500 from accumulated). Distribution 2 is taxable as a $12,000 dividend ($7,500 from current + $4,500 from accumulated) with $3,000 as return of capital. Distributions 3 and 4 are each taxable as $7,500 dividends (from current E&P only) with $7,500 as return of capital. Total dividend income across all four distributions is $42,000. Total return of capital is $18,000.
• Accumulated E&P deficits reduce the most recently accumulated layers first.
  • Under the LIFO approach of Rev. Rul. 74-550, when an accumulated deficit exists, it erodes the most recently accumulated E&P before touching older layers. (Rev. Rul. 74-550, 1974-2 C.B. 209)
  • Cross-reference Step 8. The sourcing determination under this step governs whether the shareholder recognizes dividend income. The corporate-level gain recognition rules of § 311 apply independently and may produce additional income at the corporate level even when a distribution is fully sourced from E&P and taxable as a dividend to the shareholder.

Step 8. Corporate-Level Gain Recognition Under § 311

"Except as provided in subsection (b), no gain or loss shall be recognized to a corporation on the distribution (not in complete liquidation) with respect to its stock of (1) its stock (or rights to acquire its stock), or (2) property." (§ 311(a)) "If (A) a corporation distributes property (other than an obligation of such corporation) to a shareholder in a distribution to which subpart A applies, and (B) the fair market value of such property exceeds its adjusted basis (in the hands of the distributing corporation), then gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value." (§ 311(b)(1))

• § 311(a) provides the default rule of nonrecognition.
  • A corporation generally recognizes no gain or loss on the distribution of property with respect to its stock. This rule applies to distributions of both the corporation's own stock and other property. (§ 311(a))
  • The nonrecognition rule applies only to distributions "not in complete liquidation." Distributions in complete liquidation are governed by §§ 336 and 337 instead. (§ 311(a))
• § 311(b)(1) overrides nonrecognition when appreciated property is distributed.
  • If the FMV of distributed property exceeds its adjusted basis in the distributing corporation's hands, the corporation must recognize gain as if it had sold the property to the shareholder at FMV. (§ 311(b)(1))
  • The amount of recognized gain equals the excess of the property's FMV on the date of distribution over the corporation's adjusted basis. The character of the gain depends on the nature of the property in the corporation's hands. (§ 311(b)(1))
  • CAUTION. The shareholder's basis in the property under § 301(d) is its FMV. The corporation's recognized gain under § 311(b) and the shareholder's FMV basis are independent determinations that both use the same FMV number.
• § 311(b)(2) incorporates liability rules similar to § 336(b).
  • If the distributed property is subject to a liability or the shareholder assumes a liability in connection with the distribution, the FMV for gain computation purposes is treated as not less than the amount of the liability. (§ 311(b)(2))
  • If the liability exceeds the corporation's basis in the property, the excess triggers gain recognition even if the property's FMV (absent the liability rule) would not produce gain. (§ 311(b)(2))
  • EXAMPLE. Corporation X distributes real property with a basis of $40,000 and a fair market value of $35,000 to a shareholder. The property is subject to a mortgage of $50,000. Under § 311(b)(2), the deemed FMV is at least $50,000. Corporation X recognizes $10,000 of gain ($50,000 deemed FMV minus $40,000 basis) despite the property actually declining in value.
• Losses on depreciated property are not recognized.
  • § 311 contains no provision allowing loss recognition when the corporation distributes property with a basis exceeding FMV. (§ 311(a))
  • The corporation's loss is permanently disallowed. The shareholder takes a FMV basis under § 301(d), which may be lower than the corporation's basis. The built-in loss disappears for federal income tax purposes at the corporate level. (CCA 201421015)
  • TRAP. Do not net gains and losses across multiple properties distributed together. Each property stands alone for gain and loss recognition purposes.
• Gains and losses on multiple properties are not aggregated.
  • Morris Investment Corp. v. Commissioner, 156 F.2d 748 (3d Cir. 1946). The Third Circuit held that when a corporation distributes multiple properties in a single distribution, gains on appreciated properties must be recognized while losses on depreciated properties are disallowed. The gains and losses may not be netted against each other. (Morris Investment Corp. v. Commissioner, 156 F.2d 748 (3d Cir. 1946))
  • In Morris, the taxpayer corporation distributed a portfolio of securities with both built-in gains and built-in losses in a single pro rata distribution to shareholders. The corporation argued that the transaction should be viewed as a whole and that losses should offset gains. The court rejected this argument. It held that § 311 requires property-by-property treatment. Gains on appreciated securities were taxable. Losses on depreciated securities were nondeductible. (Morris Investment Corp. v. Commissioner, 156 F.2d 748 (3d Cir. 1946))
  • The Morris rule applies to all distributions of property under § 311. Each property stands alone for gain and loss recognition purposes.
  • TRAP. A corporation planning to distribute a mixed portfolio of appreciated and depreciated property cannot rely on netting to reduce or eliminate corporate-level gain. Consider distributing appreciated and depreciated properties in separate transactions if nonrecognition treatment is available for the depreciated property through another provision.
• The character of gain recognized under § 311(b) follows the property's character in the corporation's hands.
  • § 311(b) treats the corporation "as if" it sold the property. The resulting gain retains whatever character the sale would have produced. (§ 311(b)(1))
  • Gain on the distribution of inventory or dealer property produces ordinary income. Gain on the distribution of § 1231 property produces § 1231 gain (potentially capital if § 1231 gains exceed losses). Gain on capital assets produces capital gain. (§ 1221) (§ 1231)
  • Depreciation recapture under §§ 1245 and 1250 applies to § 311(b) gain to the extent of prior depreciation deductions. The recapture characterization is computed as if the corporation had actually sold the property. (§ 1245) (§ 1250)
• § 311 applies only to distributions motivated by the corporation-shareholder relationship.
  • Treas. Reg. § 1.311-1 limits the scope of § 311 to distributions "with respect to its stock" made in the capacity of shareholder. (Treas. Reg. § 1.311-1)
  • A distribution made in satisfaction of a bona fide debt owed to the shareholder is not a distribution under § 301 and therefore § 311 does not apply. Instead, the corporation may recognize gain or loss under general sale or exchange principles. (Treas. Reg. § 1.311-1)
  • TRAP. The shareholder-corporation relationship is determinative, not the label placed on the transaction by the parties. A purported debt satisfaction that is in substance a dividend distribution will fall within § 311. (Treas. Reg. § 1.311-1)

Step 9. Effect of Distributions on Corporate E&P Under § 312

"Except as otherwise provided in this section, on the distribution of property by a corporation with respect to its stock, the earnings and profits of the corporation (to the extent thereof) shall be decreased by the sum of (1) the amount of money, (2) the principal amount of the obligations of such corporation, and (3) the adjusted basis of the other property, so distributed." (§ 312(a))

• The general rule. E&P is reduced by the sum of money, obligations, and adjusted basis of other property distributed.
  • § 312(a) mandates a three-component calculation. Money distributions reduce E&P dollar-for-dollar. (§ 312(a)(1)) Distribution of the corporation's own obligations reduces E&P by the principal amount of the obligation. (§ 312(a)(2)) Distribution of other property reduces E&P by the adjusted basis of that property. (§ 312(a)(3))
  • The aggregate reduction cannot exceed the corporation's current and accumulated E&P. The phrase "(to the extent thereof)" in § 312(a) functions as a floor. It prevents distributions from creating negative E&P. (§ 312(a))
• The appreciated property rule under § 312(b).
  • When a corporation distributes property whose FMV exceeds its adjusted basis, the E&P computation proceeds in two stages. (§ 312(b))
  • Step one. E&P is increased by the built-in gain. The corporation first increases its E&P by the amount of gain recognized on the distribution. For this purpose, the gain equals the excess of the property's FMV over its adjusted basis. The corporation recognizes this gain under § 311(b) as if the property were sold to the shareholder at FMV. (§ 312(b)(1))
  • Step two. E&P is decreased by FMV (not basis). The corporation then decreases its E&P by the FMV of the distributed property. The statute achieves this by directing that FMV is substituted for adjusted basis in the § 312(a)(3) computation. (§ 312(b)(2))
  • Net effect. The two steps produce a net E&P reduction equal to the FMV of the property. The gain inclusion and FMV reduction occur in the same taxable year. The net result is that appreciated property reduces E&P by its full FMV. Depreciated property follows the general rule and reduces E&P only by adjusted basis. (§ 312(b))
  • EXAMPLE. Corporation X distributes property with adjusted basis of $20 and FMV of $250 to its sole shareholder. Step one. E&P increased by $230. This is the built-in gain ($250 FMV minus $20 basis). (§ 312(b)(1)) Step two. E&P decreased by $250. This is the FMV of the property. (§ 312(b)(2)) Net result. E&P is reduced by $250. The $230 gain inclusion is more than offset by the $250 FMV reduction. This produces the same result as if the corporation had sold the property for $250 cash and distributed the proceeds.
• The liability assumption rule under § 312(c).
  • When distributed property is subject to a liability or the shareholder assumes a liability in connection with the distribution, the E&P reduction is adjusted to account for the liability. (§ 312(c))
  • This adjustment prevents a double benefit. Without § 312(c), the corporation would reduce E&P by the full basis or FMV of the property while also having the shareholder treat the liability assumption as part of the amount realized under § 301(b)(2). The provision coordinates the corporate and shareholder sides of the transaction. (§ 312(c)) (§ 301(b)(2))
• Stock dividends and E&P.
  • Nontaxable stock dividends under § 305(a) do NOT reduce E&P. The corporation makes no E&P adjustment when it distributes a nontaxable stock dividend. (§ 312(d)(1))
  • Taxable stock dividends under § 305(b) DO reduce E&P. If the stock dividend falls within one of the five exceptions in § 305(b), the corporation reduces its E&P by the FMV of the stock distributed. (§ 312(d)(2))
  • CAUTION. A practitioner must first classify the stock dividend under § 305 before applying § 312(d). The same distribution yields opposite E&P results depending on which subsection governs. (§ 312(d)(1)-(2))
• Redemptions and partial liquidations.
  • Redemptions qualifying under § 302(a) or § 303 receive limited E&P reduction. The reduction is limited to the ratable share of the corporation's accumulated E&P attributable to the redeemed stock. (§ 312(n)(6)) This prevents a redemption from wiping out E&P that should remain available for continuing shareholders.
  • Partial liquidations under § 302(e) receive favorable treatment. Amounts distributed in a partial liquidation that are properly chargeable to capital account are not treated as distributions of E&P. (§ 312(e)) This reflects the capital-return character of a genuine partial liquidation.

Step 10. Stock Distributions Under § 305

"Except as otherwise provided in this section, gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock." (§ 305(a))

• The § 305(b)(1) election exception.
  • A stock distribution is taxable if any shareholder has an election to receive the distribution in stock or in property (including cash). (§ 305(b)(1))
  • The exception applies even if all shareholders actually elect stock. The mere existence of the election taints the distribution. The statute uses the phrase "at the election of any shareholder." One shareholder's election is sufficient to trigger taxable treatment for all shareholders receiving the distribution. (§ 305(b)(1))
  • The distribution is treated as a § 301 distribution of property to the extent of the FMV of the stock received. The corporation reduces E&P under § 312(d)(2), not § 312(d)(1). (§ 305(b)(1)) (§ 312(d)(2))
  • TRAP. A stock dividend with a cash-put option or cash-in-lieu mechanism may implicate this exception even if the intent is an all-stock distribution. Any arrangement giving a shareholder a choice between stock and cash falls within § 305(b)(1). (§ 305(b)(1))
• The § 305(b)(2) disproportionate distribution exception.
  • A stock distribution is taxable if it is part of a distribution (or series of distributions) having the result that some shareholders receive property and other shareholders receive an increase in their proportionate interest in the corporation's assets or E&P. (§ 305(b)(2))
  • The critical inquiry is the aggregate effect of the distribution. The statute looks at the transaction as a whole. If one class of shareholders receives cash or other property while another class receives stock, the latter group's proportionate interest increases relative to the former. This triggers § 305(b)(2). (§ 305(b)(2))
  • This exception commonly arises in dividend recapitalizations or where some shareholders take cash dividends and others participate in a dividend reinvestment plan (DRIP). The DRIP participants increase their ownership percentage relative to cash-takers. (§ 305(b)(2))
  • Cross-reference Step 9. If § 305(b)(2) applies, the distribution is taxable under § 301 and the corporation reduces E&P under § 312(d)(2) by FMV. If § 305(b)(2) does not apply, no E&P reduction occurs under § 312(d)(1). (§ 305(b)(2)) (§ 312(d))
• The § 305(b)(3) common-and-preferred exception.
  • A stock distribution is taxable if it is a distribution by a corporation of stock to a shareholder who holds common stock, and the distribution includes both common and preferred stock. (§ 305(b)(3))
  • The exception targets distributions that alter the capital structure in ways that can shift value among shareholders. A distribution of preferred stock to common shareholders creates a priority interest that changes the economic arrangement among the common holders. (§ 305(b)(3))
  • The exception does NOT apply to a distribution of common stock only to common shareholders. Nor does it apply to a distribution of preferred stock only to preferred shareholders. The forbidden combination is common plus preferred distributed to common shareholders. (§ 305(b)(3))
• The § 305(b)(4) preferred-stock distribution exception.
  • A stock distribution is taxable if it is a distribution of stock (or rights to acquire stock) on preferred stock. (§ 305(b)(4))
  • This exception reflects the principle that distributions on preferred stock function economically as dividend substitutes. Preferred shareholders have a fixed return expectation. Stock distributions on preferred stock are treated as the equivalent of cash dividends. (§ 305(b)(4))
  • The antidilution adjustment safe harbor. A distribution on preferred stock is NOT taxable if it is made pursuant to a bona fide antidilution adjustment based on a reasonable formula. (§ 305(b)(4))
  • Treas. Reg. § 1.305-3 provides that antidilution adjustments under a bona fide reasonable formula are NOT deemed distributions for purposes of § 305. The regulation requires that the adjustment formula be designed to maintain the economic position of the preferred shareholder relative to common shareholders in the event of stock splits, stock dividends to common shareholders, or similar events. If the adjustment is reasonable and bona fide, it escapes § 305(b)(4) treatment. (Treas. Reg. § 1.305-3)
• The § 305(b)(5) convertible preferred exception.
  • A distribution of convertible preferred stock is taxable unless the corporation establishes to the satisfaction of the Secretary that the distribution will not have the result described in § 305(b)(2). (§ 305(b)(5))
  • Convertible preferred stock creates risk of disproportionate results because conversion rights may alter proportionate interests upon exercise. The statute places the burden of proof on the distributing corporation to demonstrate that the § 305(b)(2) result will not occur. (§ 305(b)(5))
  • A corporation seeking to avoid taxable treatment should document the analysis supporting the conclusion that no disproportionate result will arise. This may include projections of conversion patterns and their effect on ownership percentages. (§ 305(b)(5))
• The § 305(c) constructive distribution regulations.
  • § 305(c) grants the Secretary broad authority to treat certain non-distribution transactions as constructive stock distributions if they have the effect of increasing one shareholder's proportionate interest relative to others. (§ 305(c))
  • The statute specifically authorizes regulations covering changes in conversion ratio, changes in redemption price, and differences between redemption price and issue price. These transactions are treated as distributions to the shareholders whose proportionate interest is increased. (§ 305(c))
  • CAUTION. § 305(c) is an anti-avoidance provision. It catches transactions that achieve the economic equivalent of a taxable stock distribution without a formal distribution. Practitioners must examine recapitalizations, redemption price adjustments, and conversion ratio changes for § 305(c) exposure even when no actual stock distribution occurs. (§ 305(c))
  • The constructive distribution is treated as a § 301 distribution to the benefited shareholders. This may trigger dividend income, E&P reduction, and basis consequences. (§ 305(c)) (§ 301)
• Basis allocation under § 307 for nontaxable stock dividends.
  • When a stock dividend qualifies as nontaxable under § 305(a), the shareholder must allocate basis between the old and new shares. (§ 307(a))
  • § 307(a) requires allocation in proportion to fair market values. The shareholder allocates the basis of the original stock between the old shares and the new shares in proportion to their respective fair market values at the time of distribution. If the stock dividend consists of shares of the same class as the stock held, the holding period of the new shares includes the holding period of the old shares under § 1223(5). (§ 307(a)) (§ 1223(5))
  • § 307(b) contains a de minimis rule for stock rights. If the FMV of stock rights distributed is less than 15 percent of the FMV of the old stock at the time of distribution, the basis of the rights is zero unless the taxpayer affirmatively elects to allocate basis. The election must be made on the taxpayer's return for the year in which the rights are received. (§ 307(b))
  • TRAP. Failure to elect means a zero basis in the rights. If the rights are later exercised, the zero basis carries into the new shares acquired, producing a higher gain or lower loss on a subsequent sale. (§ 307(b))

Step 11. § 306 Stock and the Preferred Stock Bailout Rules

"If a shareholder sells or otherwise disposes of section 306 stock ... the amount realized shall be treated as ordinary income ... to an amount equal to the fair market value of the stock of the issuing corporation which would have been a dividend at the time of such distribution if in lieu of such stock money had been distributed in proportion to such stock." (§ 306(a)(1))

Step 11A. The Definition of § 306 Stock

• § 306(c)(1)(A). Stock distributed as a purportedly nontaxable stock dividend.
  • This provision covers stock (other than common issued with respect to common) distributed to a shareholder to the extent that by reason of § 305(a) any part of the distribution was not includible in gross income. If a common shareholder receives preferred in a distribution to which § 305(a) applies, the preferred is § 306 stock. (§ 306(c)(1)(A))
  • EXAMPLE. A corporation with common stock outstanding distributes preferred stock to its common shareholders. Because the preferred stock is not common issued with respect to common, and because § 305(a) excludes the distribution from gross income, the preferred stock received by each shareholder is § 306 stock. (§ 306(c)(1)(A))
  • EXAMPLE. A corporation with common stock outstanding distributes preferred stock to its common shareholders. Because the preferred stock is not common issued with respect to common, and because § 305(a) excludes the distribution from gross income, the preferred stock received by each shareholder is § 306 stock. (§ 306(c)(1)(A))
• § 306(c)(1)(B). Non-common stock received in a reorganization or spinoff.
  • This covers non-common stock received in a reorganization under § 368 or a § 355 distribution where gain was not recognized, but only to the extent the effect of the exchange was substantially the same as the receipt of a stock dividend. This prevents the preferred bailout accomplished through a tax-free reorganization or spinoff. (§ 306(c)(1)(B))
  • This provision targets transactions where a shareholder contributes appreciated property to a controlled corporation and receives preferred stock in exchange, achieving the economic equivalent of a dividend without current tax. The nonrecognition treatment of § 351 or § 368 does not protect the preferred stock from § 306 taint. (§ 306(c)(1)(B))
  • This provision targets transactions where a shareholder contributes appreciated property to a controlled corporation and receives preferred stock in exchange, achieving the economic equivalent of a dividend without current tax. The nonrecognition treatment of § 351 or § 368 does not protect the preferred stock from § 306 taint. (§ 306(c)(1)(B))
• § 306(c)(1)(C). Stock with a substituted basis from § 306 stock.
  • This covers any stock the basis of which is determined by reference to § 306 stock. If a shareholder exchanges § 306 stock in a § 1036 tax-free exchange, the new stock received takes the § 306 taint in the transferee's hands. (§ 306(c)(1)(C))
  • The § 306(c)(1)(C) taint is not subject to the no-E&P exception in § 306(c)(2). Even if the original distribution occurred when the corporation had no E&P, stock with substituted basis from § 306 stock remains § 306 stock indefinitely until a terminating event occurs. (§ 306(c)(1)(C)) (§ 306(c)(2))

Step 11B. The No E&P Exception

• § 306(c)(2) safe harbor. Stock described in § 306(c)(1)(A) or (B) is not § 306 stock if the corporation had no earnings and profits at the time of the stock distribution. (§ 306(c)(2))
  • The exception applies only to stock described in (A) or (B). Stock described in (C) (substituted basis) is not eligible for this exception and retains § 306 status regardless of the E&P position. (§ 306(c)(2))
  • TRAP. The § 306(c)(2) exception requires a factual inquiry into the corporation's E&P position at the time of the stock distribution. A practitioner must verify E&P calculations independently and cannot rely on the absence of current E&P in later years. The exception does not apply retroactively if E&P is generated after the distribution date. Document the E&P analysis contemporaneously. If the IRS challenges the § 306(c)(2) exception, the taxpayer bears the burden of proving the corporation had no E&P at the time of distribution. (§ 306(c)(2))

Step 11C. Sale or Other Disposition of § 306 Stock

• § 306(a)(1) ordinary income rule.
  • On a sale of § 306 stock (as distinguished from a redemption), the amount realized is treated as ordinary income up to the stock's ratable share of what would have been a dividend had cash been distributed at the time of the original stock distribution. (§ 306(a)(1))
  • The formula measures the hypothetical dividend that would have resulted from a cash distribution in proportion to the stock. This amount is the ceiling on ordinary income. (§ 306(a)(1))
  • Any excess of the amount realized over the sum of the ordinary income amount and the shareholder's adjusted basis is treated as gain from the sale of the stock. This excess gain is capital gain if the stock is a capital asset. (§ 306(a)(1))
  • No loss is recognized on the sale of § 306 stock. The loss-disallowance rule applies even if the stock has declined in value below the shareholder's basis. (§ 306(a)(1))
• § 306(a)(1)(D) qualified dividend rate overlay.
  • The amount treated as ordinary income under § 306(a)(1) is treated as a dividend for purposes of the qualified dividend income rate under § 1(h)(11). (§ 306(a)(1)(D))
  • This means the § 306 ordinary income may be taxed at the favorable capital gains rate (20% for high-bracket taxpayers, plus the 3.8% net investment income tax where applicable) rather than at ordinary income rates up to 37%. (§ 306(a)(1)(D)) (§ 1(h)(11))

Step 11D. Redemption of § 306 Stock

• § 306(a)(2) treats a redemption as a § 301 distribution.
  • If § 306 stock is redeemed, the entire distribution is treated as a distribution of property to which § 301 applies. (§ 306(a)(2))
  • Unlike a sale, a redemption does not produce ordinary income under the § 306(a)(1) formula. Instead, the distribution is tested under the normal § 301 and § 302 framework. (§ 306(a)(2))
  • If the redemption fails to qualify under any § 302(b) exception (for example, because it is essentially equivalent to a dividend under § 302(b)(1)), the full distribution is taxable as a dividend to the extent of current and accumulated E&P. (§ 306(a)(2)) (§ 302(b)(1))

Step 11E. The § 306(b) Exceptions

• The complete termination sale exception under § 306(b)(1)(A).
  • TRAP. A sale to a related party or a sale where the corporation provides financing to the buyer may be treated as a redemption in substance. If the transaction is recharacterized as a redemption, the § 306(b)(1)(A) exception fails and the § 306(a)(1) ordinary income rule applies. Document the buyer's independence and the source of purchase funds. (§ 306(b)(1)(A))
  • § 306(b)(1)(A) excepts a disposition other than a redemption that is not in substance equivalent to a dividend and that qualifies under § 302(a). The transaction must be a complete termination of the shareholder's interest in a sale to an unrelated third party. If the sale is in substance a redemption (for example, the buyer is a related party or the corporation funds the purchase), the exception does not apply and § 306(a)(1) governs. (§ 306(b)(1)(A))
  • TRAP. A sale to a related party or a sale where the corporation provides financing to the buyer may be treated as a redemption in substance. If the transaction is recharacterized as a redemption, the § 306(b)(1)(A) exception fails and the § 306(a)(1) ordinary income rule applies. Document the buyer's independence and the source of purchase funds. (§ 306(b)(1)(A))
• The qualifying redemption exception under § 306(b)(1)(B).
  • The shareholder must fully satisfy every requirement of the applicable § 302(b) subsection. If the redemption fails any single requirement of § 302(b)(3) or (b)(4), the § 306(b)(1)(B) exception does not apply and the § 306(a)(2) § 301 distribution rule governs. (§ 306(b)(1)(B))
  • § 306(b)(1)(B) excepts a redemption that qualifies under § 302(b)(3) (complete termination of interest) or § 302(b)(4) (partial liquidation). The redemption must fully satisfy every requirement of the applicable § 302(b) subsection. (§ 306(b)(1)(B))
• The complete liquidation exception under § 306(b)(2).
  • TRAP. A step-transaction or integrated plan that includes a liquidation followed by a reincorporation or acquisition by a related entity may be treated as not a true complete liquidation. The § 306(b)(2) exception requires a genuine liquidation under § 331 or § 332 with no continuing interest. (§ 306(b)(2))
  • § 306(b)(2) excepts a distribution in complete liquidation of the corporation. The exception applies only to liquidations under § 331 or § 332. It does not apply to distributions that are merely step transactions in a reorganization. (§ 306(b)(2))
• The nonrecognition transaction exception under § 306(b)(3).
  • The § 306 taint carries over to the stock or securities received in the exchange by operation of § 306(c)(1)(C). The shareholder cannot cleanse the stock through a § 351 incorporation or a § 368 reorganization. The taint remains until a terminating event occurs. (§ 306(b)(3)) (§ 306(c)(1)(C))
  • § 306(b)(3) excepts a transfer in a nonrecognition transaction under § 351, § 354, § 355, or § 356. The exception shields the transfer itself from § 306(a) immediate tax. However, the § 306 taint carries over to the stock or securities received in the exchange by operation of § 306(c)(1)(C). (§ 306(b)(3)) (§ 306(c)(1)(C))
• The tax avoidance plan exception under § 306(b)(4).
  • Courts have construed this exception narrowly. The burden of proof rests on the taxpayer to demonstrate that tax avoidance was not a principal purpose. Most dispositions of § 306 stock will not qualify under this exception. (§ 306(b)(4))
  • § 306(b)(4) excepts a transaction that is not in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax. This is a narrow facts-and-circumstances exception. The taxpayer bears the burden of proving that tax avoidance was not a principal purpose of the transaction. Courts have construed this exception strictly. (§ 306(b)(4))
• CAUTION. The § 306(b) exception analysis requires independent evaluation of each provision.
  • Most practitioners plan to satisfy § 306(b)(1)(A) or § 306(b)(1)(B) because they offer the clearest objective standards and the most predictable outcomes. Document the analysis for whichever exception is relied upon. (§ 306(b))
  • The § 306(b) exceptions are mutually independent and a practitioner must analyze each one separately. The failure of one exception does not preclude the applicability of another. Most practitioners plan to satisfy § 306(b)(1)(A) or § 306(b)(1)(B) because they offer the clearest objective standards and the most predictable outcomes. (§ 306(b))

Step 12. The Constructive Dividend Doctrine

"Where a corporation confers an economic benefit on a shareholder without the expectation of repayment, that benefit becomes a constructive dividend, taxable to the shareholder, even though neither the corporation nor the shareholder intended a dividend." (Magnon v. Commissioner, 73 T.C. 980 (1980))

• The economic benefit definition.
  • A constructive dividend arises when a corporation confers an economic benefit on a shareholder without the expectation of repayment. (Truesdell v. Commissioner, 89 T.C. 1280, 1295 (1987)) (Noble v. Commissioner, 368 F.2d 439, 443 (9th Cir. 1966))
  • The benefit need not be in cash. Any measurable economic advantage satisfies this standard. (Truesdell v. Commissioner, 89 T.C. 1280, 1295 (1987))
• The two-part test from P.R. Farms.
  • A constructive dividend exists only if two conditions are satisfied. (P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084, 1088 (9th Cir. 1987))
  • First, the expenditure must not give rise to a deduction on the corporation's return. If the expenditure is an ordinary and necessary business expense under § 162(a), no constructive dividend arises even if the shareholder incidentally benefits. (P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084, 1088 (9th Cir. 1987))
  • Second, the expenditure must create an economic gain, benefit, or income to the shareholder. The shareholder need not receive cash. Any measurable economic advantage satisfies this prong. (P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084, 1088 (9th Cir. 1987))
• No formal dividend declaration is required.
  • This principle applies regardless of state corporate law. A distribution may be a constructive dividend for federal tax purposes even if state law would require formal board action for a dividend. Boulware holds that federal tax law looks to economic substance, not state law formalities. (Boulware v. United States, 552 U.S. 421 (2008))
  • Boulware v. United States, 552 U.S. 421 (2008). The Supreme Court held that "characterization of a distribution as a dividend does not depend upon a formal dividend declaration." The presence or absence of a formal corporate dividend resolution is irrelevant to the federal tax analysis. (Boulware v. United States, 552 U.S. 421 (2008))
• The Paramount-Richards nonproportionality principle.
  • A constructive dividend need not be pro rata and need not follow stock ownership proportions. (Paramount-Richards Theatres v. Commissioner, 153 F.2d 602, 604 (5th Cir. 1946))
  • "The disbursement of corporate earnings serving the ends of stockholders may constitute a dividend to such shareholders notwithstanding that ... it is not in proportion to stockholdings, or even that some of the stockholders do not participate in its benefits." (Paramount-Richards Theatres v. Commissioner, 153 F.2d 602, 604 (5th Cir. 1946))
• The Magnon intent-irrelevance rule.
  • Neither the corporation's intent nor the shareholder's intent controls the constructive dividend analysis. (Magnon v. Commissioner, 73 T.C. 980 (1980))
  • The corporation's characterization of the transaction on its books (as a loan, compensation, travel expense, or capital expenditure) does not control the tax result. The IRS and the courts will look through the label to the economic substance. (Magnon v. Commissioner, 73 T.C. 980 (1980))
• Amount and measurement.
  • The amount of a constructive dividend equals the fair market value of the benefit conferred on the shareholder. (Challenge Mfg. Co. v. Commissioner, 37 T.C. 650, 663 (1962))
  • For personal use of corporate property, the constructive dividend equals the rental value or usage value of the property. For a bargain purchase of corporate property, the dividend equals the excess of FMV over the price paid by the shareholder. (Challenge Mfg. Co. v. Commissioner, 37 T.C. 650, 663 (1962))
• The E&P requirement under § 316.
  • A constructive dividend is treated as a dividend under § 316 only to the extent of the corporation's current and accumulated earnings and profits. (§ 316(a)) (§ 301(c)(1))
  • If the corporation has sufficient E&P, the constructive dividend is fully includible in the shareholder's gross income under § 301(c)(1). The income retains its character as dividend income and potentially qualifies for the reduced rate under § 1(h)(11). (§ 301(c)(1)) (§ 1(h)(11))
  • If the corporation has no E&P, the constructive dividend is treated as a return of capital to the extent of the shareholder's basis under § 301(c)(2), and any excess is capital gain under § 301(c)(3). (§ 301(c)(2)-(3))
  • TRAP. The absence of E&P does not eliminate the shareholder's income recognition. The constructive dividend merely changes character from dividend income to return of capital or capital gain. A shareholder who receives a $100,000 constructive dividend from a corporation with no E&P and with $40,000 of stock basis recognizes $40,000 of tax-free return of capital and $60,000 of capital gain. The shareholder's basis in the stock is reduced by the return of capital portion under § 301(c)(2). (§ 301(c)(2)-(3))
• Gift versus income analysis.
  • A transfer from a corporation to a shareholder is not a constructive dividend if it constitutes a bona fide gift. (Duberstein v. Commissioner, 363 U.S. 278 (1960))
  • The Supreme Court held that the critical inquiry is whether the transferor acted with "detached and disinterested generosity." The presence of any business purpose (compensatory, charitable, or promotional) negates gift treatment. (Duberstein v. Commissioner, 363 U.S. 278 (1960))
• The corporate deduction denial and double tax detriment.
  • A constructive dividend produces no deduction for the corporation because the expenditure serves the personal ends of the shareholder rather than a legitimate business purpose. It fails the ordinary and necessary business expense requirement of § 162(a). (§ 162(a))
  • The corporation may also face accuracy-related penalties under § 6662 if it claimed a deduction for an amount later recharacterized as a constructive dividend. (§ 6662)
  • TRAP. A constructive dividend creates the same double-tax result as a formal dividend. The shareholder pays income tax on the FMV of the benefit. The corporation receives no deduction for the amount paid or the benefit conferred. This result often surprises taxpayers who expected the expenditure to produce a corporate deduction (as compensation, interest, or rent). (§ 162(a)) (§ 301(c)(1))

Step 13. Excessive Compensation as Constructive Dividends

"Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries." (Treas. Reg. § 1.162-7(a))

• The threshold question is whether the payment is compensation or a distribution.
  • If the payment is genuine compensation for personal services actually rendered, it is deductible under § 162(a)(1). (§ 162(a)(1))
  • If the payment exceeds reasonable compensation and represents a distribution of earnings to a shareholder-employee, the excess is recharacterized as a constructive dividend under § 316(a). (Treas. Reg. § 1.162-7(a))
  • The consequence is double taxation. The corporation loses the deduction for the excessive amount, and the shareholder reports the excess as dividend income. (Treas. Reg. § 1.162-7(a))
• The reasonable compensation standard.
  • Reasonable compensation means "such amount as would ordinarily be paid for like services by like enterprises under like circumstances." (Treas. Reg. § 1.162-7(b)(3))
  • This is an objective standard. The taxpayer may not substitute its own judgment for what the market would pay. (Treas. Reg. § 1.162-7(b)(3))
• The Mayson Manufacturing eight-factor test.
  • The Mayson test evaluates the totality of the circumstances surrounding the compensation arrangement. No single factor controls. The court examines both objective data (company financials, comparable salaries) and subjective elements (employee qualifications, scope of work). (Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949))
  • Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949). The Sixth Circuit articulated eight factors, stating that "the situation must be considered as a whole with no single factor decisive." (Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949))
  • Employee qualifications, including education, experience, and unique skills.
  • Nature, extent, and scope of the employee's work.
  • Size and complexity of the business.
  • Prevailing general economic conditions.
  • Dividend history of the corporation.
  • A comparison of salaries paid with the gross and net income of the corporation.
  • Compensation of other employees.
  • Compensation paid in prior years.
• The Owensby & Kritikos nine-factor test.
  • The Owensby test expands the Mayson framework by adding a comparison between salaries and shareholder distributions. This factor is particularly significant in closely held corporations where the shareholder-employee controls both compensation and dividend policy. (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987))
  • Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987). The Fifth Circuit articulated nine factors, stating that "no single factor is determinative" and requiring "the totality of the facts and circumstances." (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987))
  • Employee qualifications.
  • Nature, extent, and scope of the employee's work.
  • Size and complexity of the business.
  • A comparison of salaries paid with gross and net income.
  • Prevailing economic conditions.
  • A comparison of salaries with distributions to shareholders.
  • The prevailing rates of compensation for comparable positions in comparable concerns.
  • The salary policy of the taxpayer as to all employees.
  • The amount of compensation paid to the particular employee in previous years.
• The Elliotts Inc. five-category test and the independent investor concept.
  • The Elliotts test introduced the independent investor concept that Judge Posner later refined in Exacto Spring. The core question is whether a hypothetical independent investor would find the shareholder's compensation reasonable in light of the return on equity. (Elliotts Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983))
  • Elliotts Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983). The Ninth Circuit organized the analysis into five categories. (Elliotts Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983))
  • Employee's role in the company, including position, duties, and hours worked.
  • External comparisons with compensation in similar companies.
  • Character and condition of the company, including size, complexity, and financial condition.
  • Conflict of interest, meaning the employee's ability to control the amount of compensation.
  • Internal consistency of compensation arrangements among employees.
  • The court also articulated the independent investor concept. "If the bulk of the corporation's earnings are being paid out in the form of compensation, so that the corporate profits do not represent a reasonable return on the shareholder's equity, then an independent shareholder would probably not approve." (Elliotts Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983))
• The independent investor test under Exacto Spring.
  • Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999). Judge Posner criticized the multi-factor approach as "nondirective" and observed that it "invites the Tax Court to set itself up as a super-personnel department." (Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999))
  • Under the independent investor test, if a hypothetical independent investor would be satisfied with the company's return after compensating the shareholder-employee, the compensation is presumptively reasonable. (Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999))
  • In Exacto Spring, a 20% return on equity satisfied the independent investor test and supported the compensation as reasonable. (Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999))
• Compensation in prior years bears on the current-year analysis.
  • A history of unreasonably low compensation in prior years followed by a large catch-up payment may still be challenged. (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987))
  • Courts look at whether the cumulative compensation over a multi-year period is reasonable in light of the services rendered. (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987))
  • CAUTION. Do not assume a written employment agreement or board resolution insulates the compensation from challenge. The IRS routinely examines the economic substance behind formal documentation. (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987))
• TRAP. The constructive dividend recharacterization applies only to the shareholder-employee.
  • A non-shareholder employee may still face unreasonable compensation disallowance under § 162(a)(1), but the excessive amount does not convert to dividend income in their hands. The disallowance simply reduces the corporate deduction with no offsetting income to the employee. (Treas. Reg. § 1.162-7(a))
  • A non-shareholder employee may receive compensation that the corporation would not otherwise pay without dividend consequences, though the excessive amount may still be nondeductible under § 162(a)(1) as unreasonable. (Treas. Reg. § 1.162-7(a))

Step 14. Personal Use of Corporate Property, Bargain Purchases, and Related Benefits

• Rent-free or below-market use of corporate property by a shareholder.
  • The shareholder's personal use of corporate property without payment of fair rental value constitutes a constructive dividend to the extent of the fair rental value of the use. (Crosby v. United States, No. 73-2928 (5th Cir. 1974) (per curiam) (Commissioner determined that taxpayers received constructive dividend income equal to the fair rental value of corporate property they used personally). Falsetti v. Commissioner, 85 T.C. 332, 356 (1985) (shareholder living rent-free in corporation-owned house received constructive distribution equal to rental value))
  • The amount of the constructive dividend equals the fair rental value of the property less any reimbursement actually made by the shareholder. (Ireland v. United States, 621 F.2d 731 (5th Cir. 1980))
  • This includes corporate residences, vehicles, aircraft, boats, and other tangible property used for personal purposes. (Crosby v. United States, No. 73-2928 (5th Cir. 1974) (per curiam) (Commissioner determined that taxpayers received constructive dividend income equal to the fair rental value of corporate property they used personally). Falsetti v. Commissioner, 85 T.C. 332, 356 (1985) (shareholder living rent-free in corporation-owned house received constructive distribution equal to rental value))
• Bargain purchases and below-market transfers of corporate property to shareholders.
  • A sale of corporate property to a shareholder at less than FMV results in a constructive dividend equal to the difference between the property's FMV and the price paid. (Noble v. Commissioner, T.C. Memo. 1965-84, aff'd, 368 F.2d 439 (9th Cir. 1966))
  • Capital improvements to shareholder property paid for by the corporation can constitute constructive dividends to the extent they exceed normal tenant improvements or confer a personal benefit on the shareholder. (Jaeger Motor Car Co., T.C. Memo. 1958-223, aff'd, 284 F.2d 127 (7th Cir. 1960))
• Corporate payment of shareholder personal expenses.
  • Payments by the corporation to third parties for the shareholder's personal benefit are constructive dividends to the shareholder. (Noble v. Commissioner, T.C. Memo. 1965-84, aff'd, 368 F.2d 439 (9th Cir. 1966))
  • In Noble, corporate payments for repairs and painting of the shareholders' personal residences, as well as personal travel expenses, were held to be constructive dividends even though the payments went directly to third-party vendors. (Noble v. Commissioner, T.C. Memo. 1965-84, aff'd, 368 F.2d 439 (9th Cir. 1966))
  • The key inquiry is whether the expenditure primarily conferred a personal benefit on the shareholder rather than serving a legitimate corporate purpose. (Palo Alto Town & Country Village, Inc. v. Commissioner, 565 F.2d 1388 (9th Cir. 1977))
  • TRAP. A disallowed corporate deduction does NOT automatically become a constructive dividend. The IRS must separately prove that the shareholder received a personal economic benefit. Each expenditure must be analyzed item by item. (Palo Alto Town & Country Village, Inc. v. Commissioner, 565 F.2d 1388 (9th Cir. 1977))
• The primary beneficiary test.
  • Taxability depends on whether the shareholder or the corporation was the primary beneficiary of the expenditure or benefit. (United States v. Gotcher, 401 F.2d 118 (5th Cir. 1968))
  • In Gotcher, the court held that Mr. Gotcher's all-expenses-paid trip to Germany to tour Volkswagen facilities was not taxable income because the trip primarily benefited Volkswagen's business interests. However, Mrs. Gotcher's trip on the same journey WAS taxable because she had no business purpose and the trip primarily conferred a personal benefit on her. (United States v. Gotcher, 401 F.2d 118 (5th Cir. 1968))
• The fair market value of fringe benefits.
  • The FMV of a fringe benefit equals the amount a hypothetical person would pay a hypothetical third party for the same benefit in an arm's-length transaction. (Treas. Reg. § 1.61-21(b)(2))
  • This objective standard prevents manipulation through artificial valuations between the corporation and the shareholder. (Treas. Reg. § 1.61-21(b)(2))
  • CAUTION. Corporate aircraft and vehicle usage require particular attention. Personal use of corporate aircraft by a shareholder produces a constructive dividend measured by the fair market value of the charter rate for comparable flights, not the marginal cost to the corporation. (Treas. Reg. § 1.61-21(b)(2))
• Corporate guarantees of shareholder debt.
  • A corporate guarantee of shareholder debt may constitute a constructive dividend if the corporation effectively assumes a liability that benefits the shareholder personally. (Wortham Machinery Co. v. United States, 521 F.2d 160 (10th Cir. 1975))
  • The removal of a shareholder's secondary liability through corporate payment on a guaranteed loan constitutes a constructive dividend to the shareholder. (Wilkof, T.C. Memo. 1978-496)
  • The constructive dividend amount equals the economic benefit conferred, which is typically the principal amount satisfied by the corporation. (Wilkof, T.C. Memo. 1978-496)
• Related-party payments to family members of shareholders.
  • Excessive payments by the corporation to a family member of a controlling shareholder may be treated as constructive dividends to the shareholder rather than deductible compensation. (Snyder, T.C. Memo. 1983-692)
  • The analysis applies the same reasonable compensation standard from Step 13. If the family member's compensation exceeds what would be paid to an unrelated person for comparable services, the excess is a constructive dividend to the controlling shareholder. (Snyder, T.C. Memo. 1983-692)
• Below-market employee stock purchases.
  • A bargain purchase of employer stock through below-market options or discounted prices produces taxable income to the employee. (LoBue v. Commissioner, 351 U.S. 243 (1956))
  • The Supreme Court held that when a transfer is in reality compensation despite being given the form of a purchase, the bargain element is taxable. (LoBue v. Commissioner, 351 U.S. 243 (1956))
  • The character of the income depends on the form of the transaction. Below-market stock options typically generate compensation income under § 83 rather than constructive dividend income under § 301. (LoBue v. Commissioner, 351 U.S. 243 (1956)) (§ 83)

Step 15. Shareholder Loans and Advances

"Whether withdrawals are loans or dividend distributions is a question of fact ... depends on the intent of the parties existing at the time the withdrawals were made." (Dean v. Commissioner, 57 T.C. 32, 44 (1971))

• The intent of the parties governs characterization.
  • Every advance from a corporation to a shareholder must be analyzed for genuine debt status. Courts look past the label the parties attach to the transaction. The controlling question is whether the parties intended to create a bona fide debtor-creditor relationship at the time the funds left the corporation. (Dean v. Commissioner, 57 T.C. 32 (1971))
  • Dean v. Commissioner, 57 T.C. 32 (1971). The Tax Court held that open account advances to a shareholder without notes, security, interest, or any repayment schedule were constructive dividends. "Whether withdrawals are loans or dividend distributions is a question of fact ... depends on the intent of the parties existing at the time the withdrawals were made." (Dean v. Commissioner, 57 T.C. 32 (1971))
• Nine factors distinguish bona fide debt from constructive dividend.
  • No single factor is dispositive. Courts weigh all nine factors together based on the particular circumstances. The presence of a note, interest, and a repayment schedule are the strongest indicators of bona fide debt. The absence of all three is nearly fatal to debt characterization. (Dean v. Commissioner, 57 T.C. 32 (1971)) (Jasionowski v. Commissioner, 66 T.C. 312 (1976))
  • Courts routinely examine the following factors. No single factor is dispositive. All nine should be reviewed in every case. (Dean v. Commissioner, 57 T.C. 32 (1971)) (Jasionowski v. Commissioner, 66 T.C. 312 (1976)) (Alterman Foods, Inc. v. United States, 35 Fed. Cl. 222 (1996), aff'd, 119 F.3d 925 (Fed. Cir. 1997))
  • Promissory note. A formal written note executed at the time of the advance is strong evidence of debt intent. Oral understandings or after-the-fact paper do not. (Jasionowski v. Commissioner, 66 T.C. 312 (1976))
  • Interest rate. Interest must be charged at or above the applicable federal rate (AFR). Below-market interest signals disguised equity or a gift of the use of money. (Dickman v. Commissioner, 465 U.S. 330 (1984))
  • Fixed maturity date. A definite date for repayment supports debt characterization. Open-ended or demand advances without maturity dates weigh toward dividend treatment. (Dean v. Commissioner, 57 T.C. 32 (1971))
  • Repayment schedule. Regular amortization or periodic payments of principal demonstrate debt intent. Haphazard or nonexistent repayment schedules suggest dividends. (Jasionowski v. Commissioner, 66 T.C. 312 (1976))
  • Security or collateral. Advances secured by assets or personal guarantees of the shareholder support debt status. Unsecured advances to controlling shareholders are suspect. (Alterman Foods, Inc. v. United States, 35 Fed. Cl. 222 (1996), aff'd, 119 F.3d 925 (Fed. Cir. 1997))
  • Books and records treatment. Recording the advance as a loan receivable on the corporate balance sheet supports debt characterization. Booking as an equity draw or distribution does not. (Dean v. Commissioner, 57 T.C. 32 (1971))
  • Ability to repay. The shareholder must demonstrate a realistic ability to repay from sources other than continued corporate distributions. Advances beyond any reasonable expectation of repayment are dividends. (Jasionowski v. Commissioner, 66 T.C. 312 (1976))
  • Proportion to ownership. Advances made in exact proportion to stock ownership resemble dividends. Advances unrelated to ownership percentages support debt treatment.
  • Valid business purpose. The advance must serve a corporate business purpose, not merely benefit the shareholder personally. (Rapid Electric Co. v. Commissioner, 61 T.C. 232 (1973))
• The Rapid Electric two-part test.
  • The Rapid Electric test is particularly important in intercorporate advance situations. A parent corporation may advance funds to a subsidiary with a valid business purpose without triggering constructive dividend treatment, provided the advance serves a genuine corporate objective and not merely the shareholder's personal benefit. (Rapid Electric Co. v. Commissioner, 61 T.C. 232 (1973))
  • Rapid Electric Co. v. Commissioner, 61 T.C. 232 (1973). The Tax Court held that intercorporate advances with a valid business purpose do not create constructive dividends. The court applied a two-part test. (1) Did the funds leave the transferor's control? (2) Was the transfer designed primarily to benefit the shareholder? (Rapid Electric Co. v. Commissioner, 61 T.C. 232 (1973))
• § 7872 imputes income on below-market shareholder loans.
  • Congress enacted § 7872 in response to Dickman v. Commissioner, 465 U.S. 330 (1984). The statute recharacterizes below-market loans between corporations and their shareholders to prevent income shifting through interest-free or below-market advances. (§ 7872) (Dickman v. Commissioner, 465 U.S. 330 (1984))
  • Demand loans. For a demand loan outstanding at any time during the calendar year, the forgone interest is treated as transferred from the corporation to the shareholder as a constructive dividend. The shareholder must include the imputed interest in gross income. The corporation treats the same amount as interest income and may deduct a matching interest payment deemed made back to the corporation. (§ 7872(b)(1))
  • Term loans. For a below-market term loan, the lender is treated as having transferred the excess of the loan amount over the present value of all payments due as original issue discount (OID). The OID is treated as a constructive dividend to the shareholder. The OID is includible in the shareholder's income over the loan term under the constant yield method. (§ 7872(b)(2))
  • The AFR is set monthly by the IRS under § 1274(d). The rate for demand loans is the short-term AFR in effect for each calendar semester. The rate for term loans is the AFR in effect on the date the loan is made. (Rev. Rul. 85-163, 1985-2 C.B. 207 (establishing AFR rates for below-market loans))
• TRAP. Corporate payments disguised as compensation or commissions can be double-taxed constructive dividends.
  • The corporation may also face accuracy-related penalties under § 6662 and potential criminal referral in egregious cases. The shareholder may be liable for fraud penalties under § 6663 if the understatement was due to intentional evasion. (§ 6662) (§ 6663)
  • The IRS may recharacterize excessive salaries, bonuses, or commissions paid to shareholder-employees as constructive dividends. The amount recharacterized is nondeductible by the corporation. The shareholder includes it in income. This produces double tax at the corporate level. (United States v. Ragen, 314 U.S. 513 (1942) ("sluicing off" corporate income disguised as commissions and salaries held constructive dividends plus criminal tax evasion)) (Combs v. Commissioner, T.C. Memo. 2019-96 (taxpayer sole owner of corporation paid personal expenses from corporate funds) (held constructive dividends taxable to shareholder))

Step 16. Documentation and Reporting Obligations

"Every person who makes payments of dividends aggregating $10 or more to any other person during any calendar year shall make a return according to the forms or regulations prescribed by the Secretary." (§ 6042(a)(1))

• Form 1099-DIV is required for dividends of $10 or more.
  • The corporation must file Form 1099-DIV for each shareholder receiving $10 or more in dividends during the calendar year. This includes both cash dividends and the FMV of property distributions. It also includes constructive dividends once the amount is determined. (§ 6042(a)(1)) (Treas. Reg. § 1.6042-2(a)(1))
  • Box 1a reports ordinary dividends includible in gross income under § 301(c)(1). Box 1b reports the qualified dividend portion eligible for reduced rates under § 1(h)(11). Box 2a reports capital gain distributions under § 852(b)(3) or § 857(b)(3). Box 3 reports nondividend distributions (return of capital) under § 301(c)(2) to the extent of shareholder basis. (Form 1099-DIV instructions, IRS Pub. 1179)
  • The form must be furnished to the recipient by January 31 of the following year. The filing deadline with the IRS is February 28 if filed on paper or March 31 if filed electronically. (§ 6042(a)) (Treas. Reg. § 1.6042-2(a)(1))
  • CAUTION. A shareholder must report constructive dividend income regardless of whether the corporation issues Form 1099-DIV. The absence of a 1099-DIV does not eliminate income inclusion. The corporation may still face penalties for failing to issue the form. (Combs v. Commissioner, T.C. Memo. 2019-96 (taxpayer sole owner of corporation paid personal expenses from corporate funds) (held constructive dividends taxable to shareholder))
• Penalties under §§ 6721 and 6722 apply to late or missing information returns.
  • $60 per form if filed within 30 days of the due date. (§ 6721(a)(1))
  • $130 per form if filed after 30 days but on or before August 1. (§ 6721(a)(2))
  • $340 per form if filed after August 1. (§ 6721(a)(3))
  • $680 or more per form for intentional disregard. Reasonable cause does not apply to intentional disregard penalties. (§ 6721(e))
  • The same tiered penalties apply under § 6722 for failure to furnish correct payee statements. (§ 6722)
• Form 5452 supports nondividend distribution treatment.
  • A corporation that makes distributions exceeding current E&P must attach Form 5452 to its corporate return. The form reports nondividend distributions and provides the IRS with a roadmap of the corporation's E&P and distribution history. (Rev. Proc. 75-17, 1975-1 C.B. 677)
  • The corporation must provide a current-year E&P computation. This includes taxable income adjusted by the items listed in § 312 and the regulations thereunder. (Rev. Proc. 75-17, 1975-1 C.B. 677)
  • The corporation must provide a year-by-year accumulated E&P schedule. This traces the E&P account from inception or the earliest available year through the current tax year. (Rev. Proc. 75-17, 1975-1 C.B. 677)
  • The corporation must attach a tax basis balance sheet. The balance sheet demonstrates that distributions did not exceed the shareholder's aggregate stock basis when claiming return-of-capital treatment under § 301(c)(2). (Rev. Proc. 75-17, 1975-1 C.B. 677)
• Corporate minutes and board resolutions are essential.
  • Board resolutions should state the amount of the distribution, its character (dividend, return of capital, or loan), and the board's determination of available E&P. Resolutions for shareholder loans should reference the note, interest rate, maturity, and repayment terms. (Treas. Reg. § 1.316-1(b))
  • E&P computation worksheets should be prepared contemporaneously and retained in the corporate records. These worksheets support the dividend-or-return-of-capital characterization. They are critical if the IRS challenges the distribution's character. (Rev. Proc. 75-17, 1975-1 C.B. 677)
  • For property distributions, the board should document the FMV of the distributed property and the method of valuation. FMV determines the amount of the distribution under § 301(b)(1). Under § 311(b), the corporation recognizes gain as if it sold the property for FMV. Accurate documentation prevents disputes over both the distribution amount and corporate gain. (§ 301(b)(1)) (§ 311(b))
• TRAP. S corporations with accumulated E&P must track AAA and E&P separately.
  • § 1371(a) applies most subchapter C rules including §§ 301 and 311 to S corporations. An S corporation with accumulated E&P from a prior C corporation year must maintain two separate accounts. The accumulated adjustments account ("AAA") tracks S corporation earnings. Accumulated E&P tracks pre-conversion C corporation earnings. (§ 1368(e)(1)) (§ 1371(a))
  • Distributions are sourced in a specific order. First from AAA (tax-free to basis). Then from accumulated E&P (taxable dividends). Then from remaining stock basis (tax-free return of capital). Any excess is capital gain. (§ 1368(c))
  • CAUTION. S corporation shareholders receiving distributions from accumulated E&P must receive Form 1099-DIV. Distributions from AAA are reported on Schedule K-1 (Form 1120-S) and are generally not taxable to the extent of stock basis. Mixing these two reporting streams is a common error. (§ 1368(c)) (§ 1368(e)(1))