As mentioned in the article on Choice of Entity, corporations (other than S corporations) are subject to two layers of federal taxation. After the corporation pays taxes on its annual earnings, it may choose to distribute earnings to the shareholders. Dividends can take the form of cash or other property. Note that not all dividend distribution would be considered from a tax perspective. Instead, distributions are only considered dividends if it is drawn from current year’s accumulated years’ earnings and profits (E&P). It is also important to note that E&P for tax purposes is not the same as retained earnings for accounting purposes. To the extent that the dividend distribution exceeds the E&P, they would be considered return of capital and then capital gains to the shareholders. Correctly Calculating Earnings and Profits is therefore an important step to make before making distributions to shareholders.
The distinction between cash distributions and other property has important tax consequences for corporations. When a corporation decides to distribute cash to shareholders or when it redeems stock in exchange for cash payments, it does not recognize a gain or a loss.[1] This article will explain the different dividend distribution that corporations typically distribute and the resulting tax consequences. The types of dividends discussed in this article include in-kind dividends, qualified dividends, and constructive dividends. Deductions on dividends received will also be briefly explained. For a more basic introduction to distributions, read The ABC’s of Distributions.
Types of Dividend Distributions
In-Kind Dividends
If the property being distributed is appreciated, the corporation recognizes a gain.[2] For federal tax purposes, the gain is treated as if the corporation had sold the property at fair market value to the shareholder. The taxation of the gain depends on the nature of the assets distributed. Ordinary income, inventory, and unrealized receivables are among assets taxed at the less preferable income tax rate. A gain from capital assets and certain property used in a business is subject to the more desirable capital gains tax.[3] It is therefore to the corporation’s benefit to distribute capital assets rather than ordinary income or inventory. However, there are situations in which a corporation can avoid a gain and its subsequent taxation when distributing appreciated property. The following example describes a situation in which a corporation successfully avoided corporate level gain following a nonliquidating in-kind distribution of property.
Example: Averting
Corporate Level Gain
Claudia, Jed, and Toby each own 5,000 shares of a real estate development company called “WH” Corporation. Toby has a disagreement with Claudia and Jed. Toby now wants the corporation to redeem his stock for $80,000, and his tax basis is $75,000. Toby is unrelated to all of the other shareholders. “WH” Corporation cannot afford to redeem Toby via cash, since its existing cash balance of $100,000 should be used primarily to pay outstanding debts. The remaining shareholders of “WH” Corporation float the idea of distributing a tract of land to Toby instead of a payment in cash. Toby agrees to this plan, since he realizes that he can sell the land immediately. “WH” Corporation has two tracts of land available for distribution: Tract Y and Tract Z.
| Exhibit A: Tracts of Land Available for Distribution | ||||
| Basis | Fair Market Value | Debt | Net Equity | |
| Tract Y | $800,000 | $855,000 | $790,000 | $65,000 |
| Tract Z | $400,000 | $400,000 | $325,000 | $75,000 |
If “WH” Corporation distributed Tract Y to Toby, then they would recognize a gain of $55,000. But if they distribute Tract Z to Toby, then “WH” Corporation will not recognize a gain, since the property neither appreciated nor depreciated. Once Toby sells off Tract Z, he will be left with $75,000 from the sale. To give Toby the full $80,000 that he requested for his stock, “WH” Corporation could give Toby $5,000 in cash and Tract Z with a net equity of $75,000. Remember that cash dividends do not represent any gain or loss for the distributing corporation. So, “WH” Corporation would not recognize any corporate-level gain for the distribution of $5,000 + Tract Z to Toby.
Unfortunately, distributions of depreciated property are another story entirely. A corporation is unable to recognize a tax loss on a nonliquidating distribution of depreciated property. The exception to this rule is when a company distributes depreciated property in the process of complete liquidation.[4]
Qualified
Dividends
A qualified dividend paid either by a domestic U.S. corporation or a qualified foreign corporation to individual shareholders is eligible for long-term capital gains rates, which are lower than the income tax rates on dividends. While ordinary, or “unqualified” dividends are taxed anywhere from 10%- 37%, qualified dividends are taxed at 20%, 15%, or 0% based on the shareholder’s income tax bracket.[5] Whether a dividend can become qualified is determined on an individual shareholder basis, and depends on certain stock holding period requirements. Corporate shareholders, however, are not eligible for the qualified dividend rate.
Dividends
Received Deduction
Although corporate shareholders are ineligible for the qualified dividend rates, they do receive a “dividends received deduction.” If a corporation receives dividends from related entities, the corporation can then deduct from 50% up to 100% of the dividend received from its income tax. The relevant percentage of deduction depends on how much ownership the receiving corporation has in the company paying the dividend.
Constructive
Dividends
A constructive dividend is a payment, reward, or other economic benefit allocated to a shareholder without any expectation of repayment.[6] It is important to note that the recipient in this situation is a shareholder; constructive dividends do not apply to employees or others in a non-shareholding capacity. A few examples of constructive dividends include:
- Payment of personal expenses of shareholders, i.e. travel or food
- Loans with below market interest rates or loans that are interest free
- The corporation provides excessive compensation to shareholders or their family members
Corporations often attempt to classify a payment to a shareholder or employee as compensation rather than a dividend based on a section of the tax code that allows companies to deduct all normal and necessary business expenses.[7] The IRS may then retroactively deny the deduction or a portion of it, and the corporation’s proposed deduction is denied. The compensation received by the shareholder is then taxed as a dividend, and the shareholder is held liable for these taxes based on their marginal income tax bracket, which is why it is important to consult a knowledgeable tax adviser before distributing dividends.
Distributions on S corporations
As mentioned in the article on Choice of Entity, S corporations are not subject to corporate taxes as an entity, rather they “pass through” the taxes to their shareholders. S corporations do not typically have dividend distribution, since they do not generate earnings and profits. A notable exception to this rule is when an S corporation used to be a C corporation or merged with one. As a result, the S corporation now has accumulated earnings and profits, and may decide to pay dividends to shareholders.
Conclusion
There are three main types of dividend distributions that corporations give and receive: in-kind dividends, qualified dividends, and constructive dividends. These should be kept in mind when approaching mergers and acquisitions. The different types of dividends impact a range of variables from stock valuations to the amount of taxes that a company pays. Considering future exit strategies when determining which dividend distribution is an important decision and can have far-reaching consequences. Conversely, buyers should be aware of increased responsibilities to shareholders.
[1] 26 U.S. Code §311(a)
[2] 26 U.S. Code § 311(b)(1)
[3] 26 U.S. Code § 1231 (a)
[4] 26 U.S. Code §311(a)
[5] IR-2019-180
[6] Truesdell v. Commissioner, 89 T.C. 1280 (1987)
[7] 26 U.S. Code §162 (a)