Distributions from the Corporation to its Shareholders

IntroductionCorporations are organized for many tax and nontax reasons. Ultimately, however, a major objective of shareholder-owners is to derive benefits from their interests in a corporation. Distributions can be made as (1) salaries, interest, rents, and similar payments to the shareholders (not in their shareholder capacity though), particularly with respect to closely held corporations, or (2) corporate assets (including cash) to the shareholders as the owners of the corporation. Most of these latter corporate distributions will constitute dividends, treated as sourced from corporate profits, but they can also constitute a return of the capital invested by the shareholders in the corporation. In the United States both (1) the corporation is taxed on its profits and (2) the owner-shareholders are taxed upon the receipt of distributions of profits from the corporation.

Shareholder distributions are usually made in the ordinary course of a corporation's activities. Dividend distributions can occur in other contexts, including through stock redemptions (discussed in Chapter 9 ), corporate divisions (examined in Chapter 11 ), and corporate tax-free reorganizations (discussed in Chapter 12 ). Most corporate dividend distributions are made in the form of cash (i.e., in U.S. dollars) that are taxable to the shareholders under IRC §   301(c)(1) . These “dividends,” as defined by IRC §   316 , are deemed sourced from corporate earnings and profits (E&P). The concept of E&P is identified, and somewhat defined, in IRC §   312 . E&P is a federal tax concept and is not based on “retained earnings,” “earned surplus,” or similar concepts derived from state business corporation statutes or financial accounting rules.

These common corporate distributions ordinarily generate no special federal income tax issues. For federal income tax purposes, the amount of the dividend distribution received by the shareholder is included in the recipient's gross income (see IRC §   61(a)(7) ). The distribution reduces the E&P account of the corporation.

Most of this chapter deals with some of the more complex approaches to dividends, including (1) distributions in kind by a corporation, particularly of appreciated property, and (2) distributions of a corporation's own debt, stock, and rights to acquire its stock. Important federal (and state) income tax events may occur to both (1) the corporation upon the distribution of these items and (2) the shareholder upon the receipt of that distribution. At the end of this chapter, the special treatment of preferred stock “bailouts” is examined.

Dividend Distribution Alternatives

GenerallyMany options exist for making dividend distributions from a corporation. For example, the corporation can distribute (1) cash, (2) appreciated (or depreciated) property, (3) debt instruments issued by the corporation, (4) its own stock (including both common and preferred stock), and (5) rights to acquire either property held by the corporation or stock of the corporation.

Cash

Most corporate dividends are cash distributions made directly to the shareholders or to their agents (e.g., into their bank accounts or brokerage accounts). A check (or more often, a direct deposit) is received by the shareholder either (1) from a dividend disbursing agent (often acting for a publicly listed corporation) or (2) directly from the corporation. The payment is presumed to be sourced from the E&P of the corporation, thereby constituting an ordinary dividend for federal income tax purposes. For a more detailed discussion of E&P, see ¶   8.03 .

Certain variations can occur in the context of cash distributions, however. For example, the corporation may wish to complete the distribution for the benefit of the shareholders, but may wish the cash amount to be held by one central agent (e.g., a trustee), pending the resolution of some controversy with which the corporation is involved. Alternatively, the cash dividend might be maintained by one recipient as an agent for the shareholders to enable all the shareholders, acting together, to invest these proceeds in a new investment outside the ambit of the corporation. In this situation, the dividend could be paid to a trustee (or other agent) delegated to act as an agent on behalf of all shareholders.

To preserve cash (and for other reasons), a corporation may allow its shareholders (on an individual, elective basis) to receive the dividend in the form of additional shares of the corporation rather than cash. This is known as a dividend reinvestment plan. Under such a plan, the shareholder can often avoid brokerage commissions and related transaction costs with respect to the acquisition of these shares.

PropertyA corporation may distribute property (other than cash) as a dividend to shareholders. This property could consist of (1) the stock of a publicly traded corporation, (2) debt instruments of other obligors, (3) various types of intangible property, and (4) real estate. In a closely held corporation situation, this property might be easily divided and distributed to shareholders as tenants in common. When a larger shareholder group exists, this property might be distributed to an agent, to be held proportionately for all the shareholders and thereafter to be managed as a trust or a partnership for the shareholders.

Promissory NotesTo conserve its cash (and for other reasons), the corporation may distribute its own promissory notes to its shareholders. This distribution will be treated as a dividend to the extent of the fair market value of the notes (assuming adequate corporate E&P). The corporation will reduce its E&P by the fair market amount of the notes distribution even though no cash or other property has been distributed. See ¶   8.07 for a more detailed discussion of distributions of corporate debt obligations.

StockA corporation can distribute its own stock of the same class as that already held by the shareholders. This distribution preserves cash for the corporation because it is merely distributing share certificates representing ownership in the corporation.

In a pro rata distribution, the receipt of these shares will not be taxable to the shareholders. In a variety of other situations (involving the applicability of the various exceptions to nontaxable treatment as prescribed in IRC §   305(b) ), however, dividend treatment will occur when the distribution produces ownership disproportionality after the distribution.

Dividend Distributions Must Be Sourced From E&P

A dividend distribution must come from a corporation's E&P (as defined for federal income tax purposes). E&P are determined by reference to the corporation's taxable income (for federal income tax purposes), with various modifications being made to this amount. These adjustments are necessary to conform the dividend amount to the cash (and other property) that is actually available for distribution to the shareholders as corporate profits.

Under a “nimble dividend” rule, E&P can be determined by reference to either (1) the current year's E&P (without regard to any accumulated deficits in prior years) or (2) accumulated E&P. If current earnings do not exist, the categorization of the distribution as being a dividend will be made by reference to accumulated (or historical) E&P.

Notwithstanding the requirement that a dividend distribution must come from a corporation's E&P, an individual shareholder will want, if possible, the distribution not to be sourced from E&P, because then the individual would be treated as receiving (1) a return of invested capital, to the extent of the shareholder's tax basis for the shares held, and (2) thereafter, capital gain. See IRC §§   301(c)(2) , 301(c)(3) . This is particularly significant during periods when the tax rate for capital gains distributions is substantially lower than the tax rate imposed on dividends received by individuals. However, if the shareholder is another corporation, the recipient ordinarily will want the distribution to be sourced from the distributing corporation's E&P, thereby allowing the recipient to take advantage of the dividends received deduction.

Capital Gains Tax RateFor individuals the tax rate applicable to dividends is the same as that applicable to capital gains, but for corporations the tax rate is the same as that applicable to a corporation's ordinary income. As enacted in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA ), “qualified dividend income” received by an individual from domestic corporations is taxed at the same rates as those that apply to net capital gain. See IRC §   1(h)(11) . Thus, these dividends are taxed at the rate of 15 percent (and, in some situations, at a lower 5 percent rate). As described in ¶   8.02 , the term “qualified dividend income” means dividends received during the taxable year from (1) a domestic corporation and (2) qualified foreign corporations. IRC §   1(h)(11)(B)( i) .

Distributions of Property

Taxation to Distributor CorporationThe distribution of appreciated property (i.e., other than U.S. dollars) by a corporation will ordinarily trigger the requirement that it recognize gain (assuming appreciation) to the extent of the difference between (1) its tax basis for the distributed asset and (2) the asset's fair market value. This gain will, in turn, be added to the corporation's E&P. The dividend distribution of depreciated property by a corporation will not enable it to recognize any accrued loss for federal income tax purposes. The E&P of the corporation will be debited by the fair market value of the distributed property, that amount being the dividend received by the shareholder.

Taxation to Distributee ShareholderThe receipt of appreciated property will constitute a dividend to the shareholder in an amount equivalent to the fair market value of the property (assuming adequate E&P). The shareholder will then take a fair market value basis in the received property.

The receipt of depreciated property will also constitute a dividend to the shareholder to the extent of the fair market value of the property (assuming adequate E&P). The shareholder will take a fair market value basis for the depreciated property. This means that the differential between the higher tax basis to the corporation and the lower fair market value will be lost as a deduction to both the corporation and the shareholder. For this reason, the corporation should ordinarily sell the depreciated property first, thereby realizing a loss for tax purposes, and then distribute the proceeds. Only in unique situations, for example, where the corporation may want the property to be maintained within a small shareholder group, might the decision be made to forgo the availability of this loss deduction.

Distributions of Encumbered PropertyA corporation may distribute property encumbered by debt to shareholders as a dividend (again assuming adequate E&P). The reduction to the corporation's E&P will be for an amount equivalent to the net value of the property distributed. This will also be the amount of the dividend received by the shareholder. However, the shareholder's tax basis in the property received will include the amount of the debt (similar to the inclusion in tax basis of other purchase money debt).

Cash Dividends

GenerallyCorporations usually pay dividends in the form of cash and, for U.S. taxpayers, the cash is usually in U.S. dollars. The distribution is ordinarily made by check, which is sent to the shareholders, drawn on the corporation's bank account or through electronic funds transfers, and credited to the shareholder's account, including when the shares (often of a publicly traded corporation) are held in street name in a brokerage or similar account. Of course, the cash could also be in the form of Euros, U.K. pounds, or some other foreign currency.

Corporate Declaration of Cash DividendFor a corporation to be eligible to declare a dividend, it must comply with applicable state corporation laws. This necessitates that the payment be made from permitted corporate resources, as identified in the provisions of the locally applicable state business corporation act. One important objective of this limitation is to preclude disbursements being made from the corporation to the detriment of corporation's creditors.

The ABA Section of Business Law's Model Business Corporation Act (as revised through June 2005), § 6.40(a), provides that a board of directors may authorize, and the corporation may make, distributions to its shareholders subject to any restriction by the articles of incorporation and the limitation in § 6.40(c) of that Act. A “distribution” is defined (in Act § 1.40) as a direct or indirect transfer of money or other property (except its own shares) or incurrence of indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its shares. A distribution may be in the form of a declaration or payment of a dividend; a purchase, redemption, or other acquisition of shares; a distribution of indebtedness; or otherwise.

Section 6.40(c) of this Act provides that no distribution may be made if, after giving it effect, (1) the corporation would not be able to pay its debts as they become due in the usual course of business or (2) the corporation's total assets would be less than the sum of its total liabilities, plus (unless the articles of incorporation permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of those shareholders whose preferential rights are superior to those receiving the distribution. Section 6.40(d) of the Act specifies that a corporation's board of

directors may base a determination that a distribution is not prohibited either (1) on financial statements prepared on the basis of accounting practices and principles that are reasonable under the circumstances or (2) on a fair valuation or other method that is reasonable under the circumstances. Section 8.33 of the Act provides that a director who votes for or assents to a distribution in excess of what may be authorized and made pursuant to Act § 6.40(a) is personally liable to the corporation for the amount of the distribution that exceeds what could have been distributed without violating Act § 6.40(a), if the party asserting liability establishes that, when taking the action, the director did not comply with Act § 8.30 (relating to standards of conduct for directors).

Individuals Taxed at Capital Gains Tax Rate

Applicable Income Tax RateThe dividends received by individuals are taxed at the capital gains rate, but the dividends received by corporations are taxed at the same rate applicable to a corporation's ordinary income. As enacted in JGTRRA , “qualified dividend income” received by an individual from domestic corporations is taxed at the same rates that apply to net capital gain. See IRC §   1(h)(11) . Thus, qualified dividends are taxed at the maximum rate of 15 percent (and, in

Defining “Qualified Dividend Income”The term “qualified dividend income” means dividends received during the taxable year from (1) domestic corporations and (2) qualified foreign corporations. IRC §   1(h)(11)(B)( i) . A qualified foreign corporation is any foreign corporation (1) incorporated in a U.S. possession or (2) eligible for the benefits of a comprehensive income tax treaty with the United States that the Secretary determines is satisfactory for this purpose and that includes an exchange of information provision. IRC §   1(h)(11)(C)( i) . In Notice 2006-101, 2006-47 IRB 930 , which supersedes Notice 2003-69, 2003-2 CB 851 , the IRS lists treaties that meet the requirements of this provision and treaties that do not meet the requirements of IRC §   1(h)(11)(C)( i)(II) . The tax treaties with Bermuda and the Netherlands Antilles are not comprehensive income tax treaties under IRC §   1(h)(11) . The U.S.-U.S.S.R. income tax treaty, which was signed on June 20, 1973, and currently applies to certain former Soviet Republics, does not include an information exchange program.

The Treasury and the IRS intend to update this list as needed. Situations that may result in changes to the list include the entry into force of new income tax treaties and the amendment or renegotiation of existing tax treaties. Furthermore, the Treasury and the IRS continue to study the operation of each U.S. income tax treaty, including the implications of any change in the domestic laws of the treaty partner, to ensure that the treaty accomplishes its intended objectives and continues to be satisfactory for purposes of IRC §   1(h)(11)(C)( i) . It is anticipated that any change to the list of income tax treaties that meets the requirements of IRC §   1(h)(11) (C)(i)(II) will apply only to dividends paid after the date of publication of the revised list.

Defining “Qualified Foreign Corporation”A foreign corporation not otherwise treated as a “qualified foreign corporation” shall be so treated with respect to any dividend paid by that corporation if the stock with respect to which such dividend is paid is “readily tradable on an established securities market in the United States.” In Notice 2003-71, 2003-2 CB 922 , the IRS identified stock that is considered readily tradable on an established U.S. securities market for purposes of IRC §   1(h)(11)(C)(ii) . Common or ordinary stock, or an American depositary receipt in respect of such stock, is considered readily tradable on an established U.S. securities market if it is listed on a national securities exchange that is registered under § 6 of the Securities Exchange Act of 1934 (15 USC § 78f) or on

the Nasdaq Stock Market. As stated in the Security and Exchange Commission's (SEC's) Annual Report for 2002, registered national exchanges as of September 30, 2002, include the following:

1. The American Stock Exchange; 2. The Boston Stock Exchange; 3. The Cincinnati Stock Exchange; 4. The Chicago Stock Exchange; 5. The New York Stock Exchange; 6. The Philadelphia Stock Exchange; and 7. The Pacific Exchange, Inc.

Notice 2003-71 indicated that the Treasury and the IRS are considering the future treatment of dividends with respect to stock listed on the OTC Bulletin Board and on the electronic pink sheets. Specifically, the Treasury and the IRS are considering whether and to what extent stock listed on the OTC Bulletin Board and on the electronic pink sheets should be conditioned on the satisfaction of parameters regarding the following:

1. Minimum trading volume; 2. Minimum number of market makers; 3. Maintenance and publication of historical trade or quotation data; 4. Issuer reporting requirements under SEC or exchange rules; or 5. Issuer disclosure or determinations regarding passive foreign investment company (PFIC), foreign investment company (FIC), or foreign personal holding company (FPHC) status.

Notice 2003-79, 2003-2 CB 1206 , §   5 , states that the IRS intends to issue regulations, for years after 2003, that provide procedures for a foreign corporation to certify that it is a qualified foreign corporation for purposes of IRC §   1(h)(11)(C) . Temporary rules provided in Notice 2003-79 were subsequently extended by Notice 2004-71, 2004-2 CB 793 , and by Notice 2006-3, 2006-1 CB 306 . The regulations are also to provide the following:

1. Procedures for certifying that a security that is not a common or ordinary share is equity rather than debt; 2. That a foreign company is entitled to benefits under a comprehensive income tax treaty where a security is not readily tradable on a recognized U.S. stock exchange; 3. That the foreign corporation is not a PFIC in the taxable year in which a dividend is paid, or in the preceding taxable year; and 4. The meaning of the requirement in the legislative history that to qualify under a treaty for purposes of IRC §   1(h)(11) “substantially all of [the foreign corporation's] income in the taxable year in which the dividend is paid” must qualify for treaty benefits.

Notice 2004-70, 2004-2 CB 724 , provides guidance regarding the extent to which distributions, inclusions, and other amounts received by, or included in the income of, individual shareholders as ordinary income from foreign corporations subject to certain antideferral regimes may be treated as qualified dividend income for purposes of IRC §   1(h)(11) . This notice stipulates that distributions of previously nontaxed E&P from a controlled foreign corporation (CFC) to an individual are qualified dividend income and, therefore, are eligible for the reduced tax rates applicable to certain capital gains under IRC §   1(h)(1) , provided the CFC is a qualified foreign corporation. This notice also provides that IRC §   951(a)(1) inclusions from a CFC and deemed or actual distributions from an FPHC (now repealed), an FIC (also now repealed), or a PFIC are not qualified dividend income under IRC §   1(h)(11)(B)( i)(II) and, therefore, are not eligible for the reduced tax rates applicable to certain capital gains under IRC §   1(h)(1) . In addition, this notice provides that, for purposes of IRC §   1(h)(11) , the determination of whether a foreign corporation is a PFIC is made on a shareholder-by-shareholder basis. Accordingly, distributions of previously nontaxed E&P received by an individual from a CFC that would be a PFIC with respect to that individual but for the application of IRC §   1297(e) are qualified dividend income if the CFC is a qualified foreign corporation.

Notice 2006-3, 2006-1 CB 306 (a sequel to Notice 2003-79 and Notice 2004-71 ) deals with information reporting regarding distributions of securities issued by foreign corporations. In Notice 2006-3 , the IRS extended the simplified procedures provided in Notice 2003-79 and Notice 2004-71 to 2005 and future years. A person filling out IRS Form 1099-DIV, concerning a distribution with respect to a security issued by a foreign corporation, can report that distribution as a “qualified dividend” if the following conditions are satisfied:

1. Either the security with respect to which the distribution is made is a common or an ordinary share, or a public SEC filing contains a statement that the security will be, should be, or more likely than not will be treated as equity rather than debt for U.S. federal income tax purposes; and 2. Either a. The security is considered “readily tradable on an established securities market in the United States”; b. The foreign corporation is organized in a possession of the United States; or c. The foreign corporation is organized in a country whose income tax treaty with the United States is comprehensive, is satisfactory to the Secretary for purposes of IRC §   1(h)(11) , and includes an exchange of information program, and if the relevant treaty contains a limitation on benefits provision, the corporation's common or ordinary stock is listed on an exchange covered by that provision's public trading test, unless the person required to file an information return knows or has reason to know that the corporation is not eligible for benefits under that treaty; and3. The person required to file the IRS Form 1099-DIV does not know or have reason to know that the foreign corporation is or expects to be, in the taxable year of the corporation in which the dividend was paid, or was, in the preceding taxable year, a “foreign person holding company” (as defined in IRC § 552 ), a “foreign investment company” (as defined in IRC § 1246(b) ), or a “passive foreign investment company” (as defined in IRC §   1297 ); and 4. The person required to make a return (under IRC §   6042 ) determines that the owner of the distribution has satisfied the holding period requirement (under IRC §   1(h)(11) ) or it is impractical for such person to make such determination.

The IRS also indicated that it will exercise its authority under IRC §   6724(a) to waive penalties under IRC §§   6721 and 6722 with respect to the reporting of payments if persons required to file IRS Form 1099-DIV make a good faith effort to report payments consistent with the rules summarized above.

Identifying “Dividends” and “Earnings and Profits”

The Federal Income Tax Concept of “Dividends”“Dividends” received from corporations are included in the recipient's gross income for federal income tax purposes. IRC §   61(a)(7) . A corporate distribution is a “dividend” if made from (1) E&P accumulated after February 28, 1913, or (2) E&P of the current tax year (i.e., sourced from E&P derived during that year). IRC §   316 . Thus, E&P is relevant at the shareholder level for determining the federal income tax status of corporate dividends to its shareholders. The distribution of a dividend is a corporate disbursement made to a shareholder “with respect to its stock.” The balance (if any) of any corporate distribution to the shareholders (as shareholders) that exceeds the allocable E&P is a return of capital (under IRC §   301(c)(2) ) and, thereafter, taxable gain (under IRC §   301(c)(3) ).

The concept of a “dividend” (defined by IRC §   316 ) for federal income tax purposes is not synonymous with the term “dividend” under applicable state law. Under most business corporation acts enacted by states, a corporation is not permitted to pay dividends that might harm creditors of the corporation or otherwise impair the capital of the corporation. See, e.g., the

ABA Section of Business Law's Model Business Corporation Act (as revised through June 2005), § 6.40(c).

IRC §   316(a) provides an irrebuttable presumption that, for federal income tax purposes, every distribution is from E&P to the extent a company has E&P. Furthermore, every distribution is presumed to come from the most recently accumulated E&P. IRC §   316(a)(2) provides that the E&P for the current year is determined as of the close of the year without reduction by reason of any distributions during the year. This means that a distribution will be a dividend if the corporation has E&P at the end of the current tax year, even though it had none earlier in the year when the distribution actually occurred. Alternatively, a distribution that appeared to be a “dividend” when made may ultimately be a return of capital because the corporation has no E&P at the end of the year or for prior years. Consequently, only to the extent of E&P will the corporate distribution constitute a dividend for federal tax purposes. IRC §   301(c)(1) .

Defining “Earnings and Profits”The term “earnings and profits” is identified in IRC §   312 , but it only furnishes limited guidance as to the scope of the concept of E&P for federal tax purposes. The IRC §   312 regulations provide greater elaboration of the term. In essence, significant adjustments must be made to a corporation's “taxable income” amount (as determined for federal income tax purposes) in determining the E&P account. The fundamental objective is to identify that economic amount which represents the net profits of the enterprise that can be distributed to the shareholders without it being a distribution of their contributed capital.

To determine E&P, the following adjustments must be made to a corporation's taxable income:

1. Certain items that are excluded from taxable income are included in computing E&P. For example, proceeds of life insurance excluded under IRC §   101 from gross income for federal income tax purposes and interest on state and local government obligations excluded under IRC §   103 must be included in E&P. These items constitute positive cash balances (i.e., profits) to the corporation although not included in gross income for federal income tax purposes. 2. Certain items that are deducted in computing taxable income may not be deducted in computing E&P. For example, the dividends received from another corporation must be fully included by the recipient corporation in its E&P without regard to the dividends received deduction, which is available under IRC §   243 in determining the corporation's taxable income. The dividends received deduction does not represent a cash cost to the recipient corporation. 3. Timing differences must be considered, both as to deferred income and accelerated deductions. For example, income from installment sales must be included in E&P without the benefit of the income tax deferral available under the IRC §   453 installment sales provision. Straight-line depreciation must be used in computing E&P even though more rapid depreciation or amortization methods are often available for computing taxable income. In Rev. Proc. 2009-37, 2009-36 IRB 309 , the IRS indicated that regulations are to be issued regarding the computation of a corporation's earnings and profits with respect to cancellation of debt (COD) income and original issue discount (OID) deductions that are deferred under IRC §   108( i) . These regulations generally will provide that deferred COD income increases earnings and profits in the taxable year that it is realized and not in the taxable year or years that the deferred COD income is includable in gross income. OID deductions deferred under IRC §   108( i) generally will decrease earnings and profits in the taxable year or years in which the deduction would be allowed without regard to IRC §   108( i) . IRC §   108( i) was added to the Code by §   1231 of the American Recovery and Reinvestment Tax Act of 2009, Pub. L. No. 111-5, 123 Stat. 338 . In general, IRC §   108( i) provides that, at the election of a taxpayer, COD income realized in connection with a reacquisition after December

31, 2008, and before January 1, 2011, of an applicable debt instrument is includable in gross income ratably over a five-taxable-year inclusion period, beginning with the taxpayer's fourth or fifth taxable year following the taxable year of the reacquisition. Generally, if a taxpayer makes an IRC §   108( i) election and reacquires (or is treated as reacquiring) the applicable debt instrument generating the COD income for a new debt instrument with OID, then interest deductions for this OID also are deferred, as provided in IRC §   108( i)(2) . 4. Certain items not deducted in computing taxable income can be deducted in computing E&P. For example, federal income taxes paid are not available for making distributions to shareholders and, therefore, must reduce E&P. In Rev. Rul. 2009-25, 2009-38 IRB 365 , the IRS ruled that an interest expense disallowed under IRC §   264(a)(4) reduced earnings and profits for the taxable year in which that interest would have been allowed as a deduction, but for the specific disallowance provision. Under this provision, an interest expense deduction is not allowed for interest paid or accrued on any indebtedness concerning a life insurance policy.

This process of determining the appropriate amount of E&P can occur well after the year during which the taxable income was reported. No “statute of limitations” applies to foreclose an analysis of E&P attributable to prior years, so, theoretically, this analysis could go back to the beginning of the corporation's existence.

The accounting treatment of a specific item may also control the timing for the inclusion of that item in earnings and profits. In Priv. Ltr. Rul. 200817029 , the IRS noted that a taxpayer was permitted (consistent with Rev. Proc. 2004-34, 2004-1 CB 991 ) to recognize as income certain intellectual property licensing fees over a specified period, rather than in the year of receipt. This was considered a proper method of accounting and, as such, enabled the deferral of inclusion of the income items in the earnings and profits account until included in gross income. See also Priv. Ltr. Rul. 200817029 , which provides a discussion of the tax accounting rules permitting the inclusion of advance payments in gross income to be postponed until a subsequent year.

Determining the Source of Corporate DistributionsRev. Proc. 75-17, 1975-1 CB 677 , specifies the requirements for correctly determining the source of corporate distributions. Taxpayers should analyze their capital stock, paid-in surplus, and capital surplus accounts. Special computations are required for each year for which a consolidated return was filed, including an identification of intercompany profits and losses that were eliminated from consolidated taxable income. Rev. Proc. 75-17 includes exhibits showing (1) a year-by-year analysis of E&P, (2) a summary of year-by-year differences in surplus and E&P, and (3) a corporate balance sheet. For modified E&P computations for purposes of the alternative minimum tax (i.e., to determine “adjusted current earnings”), see IRC §   56(g)(4) .

The IRS periodically refines the definition of “earnings and profits” through published rulings. See, e.g., Rev. Rul. 2001-1, 2001-1 CB 726 , where the IRS ruled that, if a corporation transfers stock upon the exercise of an option that was granted in connection with the performance of services and to which IRC §   421 does not apply (i.e., a nonstatutory stock option), and the option did not have a readily ascertainable fair market value at the time of grant, the E&P of the service recipient is reduced by the amount of the deduction allowed to it under IRC §§   83(h) and 162 by reason of such exercise.

Impact of Corporate Adjustments on E&P

The adjustments to a corporation's E&P are not limited to the inclusion of taxable income, as adjusted, and a reduction by ordinary dividend distributions. During its history, a corporation may be involved in various transactions that may impact its E&P, such as:

1. Distributions of property in kind, which may cause gain recognition for the property that is includable in E&P (less applicable income tax liabilities); 2. Distributions of stock to its shareholders, which might constitute a taxable dividend necessitating an adjustment of E&P; 3. Distributions in partial liquidation, or in redemption of a portion of its stock, whether treated as a dividend or as a capital distribution, which will necessitate adjustments to E&P; or 4. Mergers, consolidations, complete liquidations, spin-offs, and other transactions where one corporation succeeds to the property and tax attributes of another corporation, which will necessitate adjustments to E&P.

IRS Reporting RequirementsA corporation must annually report to the IRS, on IRS Form 1099-DIV (see Form 9.1(d) ), the dividends paid to its shareholders. See IRC §   6042 . A corporation should make sure it has sufficient E&P to cause distributions to be treated as dividends for federal income tax purposes. On IRS Form 1099-DIV separate blocks are provided to identify dividend and nondividend distributions. A payment must be reported as a dividend if the payor cannot determine whether it should be classified otherwise.

Constructive Dividends

Identification of Possible “Disguised Dividends”Dividend treatment is not applicable to a payment by a corporation to a shareholder “unless the amount is paid to the shareholder in his capacity as such.” Reg. §   1.301-1(c) . Thus, payments to shareholders, for services or property received by the corporation from the shareholders, will not constitute dividends. The objective of such payments, of course, may be to direct the maximum amount from the corporation into the hands of the shareholders in a form that is deductible under IRC §   162 , or is otherwise available as a deduction to the corporation if it is a C corporation. Consequently, the IRS closely monitors corporate payments to shareholders to determine whether they constitute “disguised dividends.” If the IRS determines a “disguised dividend” exists, it will pursue the matter even though no formal dividend has been declared or other corporate action has been undertaken concerning a dividend distribution.

Usually, constructive dividends apply to closely held corporations. With respect to publicly held corporations, the officers and directors have fiduciary responsibilities to all of the shareholders and, under applicable securities laws, must disclose dividend arrangements. Consequently, publicly held corporations often seek to avoid situations that might lead to IRS or shareholder challenges of excessive payments to corporate officers. See generally Bittker & Eustice, ¶   8.05 .

The IRS may be less motivated to pursue an apparent constructive dividend if the revenue to be generated by an audit is limited, such as a situation involving an individual shareholder who would be treated as receiving a dividend subject to a maximum 15 percent income tax rate, rather than a maximum 35 percent tax rate if receiving compensation, interest, or rent from a closely held corporation. Of course, the corporation would not receive a deduction for the dividend paid, but would ordinarily receive a deduction for the compensation, interest, or rent paid. In addition, it is less appealing for the government to pursue apparent constructive dividends at a time when the dividend tax rate to individuals is the same as the capital gains tax rate. Similarly, if the dividend is deemed paid to another corporation, the availability of the 70 percent (or greater) dividends received deduction to the recipient would significantly reduce the tax deficiency amount obtainable from the shareholder.

In Priv. Ltr. Rul. 200935009 , the IRS determined that where a parent corporation of a consolidated return group that sponsors a stock-based compensation plan, including restricted stock unit awards, transferred its stock to employees of subsidiaries who held these awards, the reimbursements to the parent by the subsidiaries for the fair market value of these stock awards would not constitute a dividend distribution by the subsidiaries (within the meaning of IRC §   301 ).

LitigationBecause constructive dividends are laden with individual facts and circumstances, litigation occurs at regular intervals. The challenge for taxpayers is to frame the relevant facts in the best possible light for themselves. Often, taxpayers can be successful in frustrating IRS challenges only through litigation. Various Tax Court decisions have found constructive dividends not to be present. See, e.g., Jones v. Comm'r, TC Memo. 1997-400 (amounts not constructive dividends because paid to shareholder in his capacity as president and director, and not used for personal benefit); Martin v. Comm'r, TC Memo. 1997-492 (50 percent shareholder did not receive constructive dividend as a result of lending corporate funds to friend; no showing that shareholder received any benefit therefrom); Eugene D. Lanier, Inc. v. Comm'r, TC Memo. 1998-7 (married taxpayers did not receive constructive dividend as a result of their wholly owned corporation's transfer of money to their son's election committee; amount transferred satisfied obligations that were the liability of the committee and that were not guaranteed by candidate); Ciaravella v. Comm'r, TC Memo. 1998-31 (amounts paid for advertising expenses incurred in an individual shareholder's car-racing business did not result in constructive dividend, since such business benefited the corporation, which leased and sold jet aircraft); Asher v. Comm'r, TC Memo. 1998-219 (construction of loft used by shareholder as office space did not, despite existence of personal amenities, result in constructive dividend).

In AJF Transp. Consultants, Inc. v. Comm'r, TC Memo. 1999-16 , however, fuel reimbursement checks cashed by a transportation company's sole shareholder were included in that shareholder's gross income as constructive dividends. In Spera v. Comm'r, TC Memo. 1998-22 , the taxpayer was not able to defeat constructive dividend treatment by characterizing a portion of the dividends as a nontaxable return of basis in a loan made to the corporation. Similarly, see Priv. Ltr. Rul. 200215036 , where discounts provided to shareholders on food and beverage purchases, golf membership dues, and cart rental and range fees were treated as constructive dividends. The IRS noted that if a corporation transfers property to a shareholder for an amount less than its fair market value, the excess value constitutes a distribution of property and, to the extent the distribution is derived from the corporation's E&P, constitutes a dividend.

In Hood v. Comm'r, 115 TC 172 (2000) , the Tax Court held that legal fees paid by a successor corporation to defend a sole shareholder against criminal tax charges connected with a sole proprietorship were not deductible by the corporation and constituted constructive dividend income to the shareholder.

The IRS has been successful in asserting that extraordinary compensation amounts might constitute a dividend distribution, rather than deductible compensation. See, e.g., Pediatric Surgical Assocs. PC v. Comm'r, TC Memo. 2001-81 , where the Tax Court agreed with the IRS that a portion of bonuses paid to shareholder surgeons who worked for a surgical corporation was nondeductible, a disguised dividend, and not compensation paid to the corporate officers.

In Notice 2000-60, 2000-2 CB 568 , the IRS issued a warning about a constructive dividend–type transaction that will be treated as a tax shelter “listed transaction.” Notice 2000-60 describes a situation where a subsidiary (S) uses cash to purchase stock of its parent (P) from P's shareholders. From time to time, S transfers P shares to P employees in satisfaction of P's stock-based employee compensation obligations (e.g., upon the exercise by an employee of a nonstatutory option to purchase P stock). In a few years, S will sell any remaining P stock, and then S will liquidate or P will sell its S stock. When S liquidates or P sells its S stock, P claims a capital loss under IRC §   331 or IRC §   1001 because S has already transferred most of its P stock to the P employees, which has substantially reduced the value of S without a corresponding downward adjustment in P's basis in its S stock. Because S claims to have shifted all of its basis in the P stock to S's shares of P stock remaining after the transfers to the P employees, S also reports a capital loss on the sale of its remaining P stock immediately before S's liquidation or sale. The IRS indicated that to permit a controlled subsidiary to avoid distribution treatment for transfers made on behalf of a parent corporation merely by purchasing some shares of the parent corporation's stock would contravene the framework governing the treatment of such distributions under IRC §   301 . The transfers by S to P's employees are properly characterized as distributions by S to P with respect to P's stock, subject to the rules of IRC §§   301 and 311 , followed by compensatory transfers by P to P's employees. Alternatively, the IRS indicated that it may disregard the described steps and treat the transaction as a redemption by P . Notice 2000-60 is mentioned in Notice 2004-67, 2004-2 CB 600 , where the IRS again identified and reaffirmed “listed transactions” for which corporate taxpayers may need to disclose their participation (as prescribed in Temp. Reg. § 1.6011-4T ). Notice 2004-67, 2004-2 CB 600 , was updated by Notice 2009-59, 2009-31 IRB 170 , which reaffirmed that this issue is a “listed transaction.”

Corporate Payments to Third Parties

Related Family Members as RecipientsThe IRS may challenge not only arrangements between shareholders and their closely held corporations but also payments made by the corporation to third parties, particularly relatives of shareholders of closely held corporations. The corporation could pay compensation to the relative and a determination would then be required concerning whether that compensation is excessive. If so, the IRS might assert that the excessive amount was paid (in the form of a dividend) to the shareholder who thereafter transferred that excess to the actual recipient, whether in the form of a gift, a loan, or compensation, or for some other purpose.

Triangular DistributionsTransactions between two corporations under common control can be treated as constructive distributions to the controlling shareholder of these corporations. This result can occur even though no funds (or other benefits) actually pass through the hands of the common owner. See, e.g., Rev. Rul. 78-83, 1978-1 CB 79 , where a diversion of income from one subsidiary to another subsidiary was held to be a constructive dividend distribution to the parent corporation and, subsequently, a capital contribution by the parent corporation to the recipient corporation. Of course, the common owner would be entitled to a dividends received deduction and, by reason of the “capital contribution” treatment, would obtain tax basis for the shares of the recipient subsidiary corporation.

Subsequent AdjustmentsIf constructive dividend treatment is successfully applied by the IRS, certain “correlative adjustments” must also be made. For example, the E&P of the “distributing” corporation will be reduced by the amount ultimately determined to be a dividend distribution. In the process of making this adjustment, the parties may ascertain that the E&P of the corporation is inadequate for the “constructive dividend” to constitute an actual distribution of a dividend. Under these circumstances, the distributions would be treated under IRC §   301(c) as a recovery of tax basis in the shares held by the distributee and, thereafter, a capital gains distribution. Of course, the burden to prove the absence of E&P will be on the corporation and the shareholder. See, e.g., Reg. §   1.162-8 , second sentence, which specifies that in the case of excessive compensation payments made by a corporation, if such payments correspond or bear a close relationship to stockholders and are found to be a distribution of E&P, the excessive payments will be treated as a dividend. However, the assumption in this rule must be that adequate E&P exist.

The IRS's assertion of a constructive dividend can be negated if a shareholder can reverse a distribution. Shareholders usually cannot deduct a repayment merely because the original payment was improper. However, under the “Oswald” approach, an agreement between the corporation and the shareholder can be implemented prior to the distribution to mandate a repayment to the corporation if the transaction is unraveled for federal tax purposes. Of course, the agreement must be in existence at the time of the original transaction. Furthermore, during an audit examination, the IRS representative may request information concerning the existence of any such arrangement, and may then argue that the taxpayer knew the arrangement was not bona fide from its inception. See Oswald v. Comm'r, 49 TC 645 (1968) , acq. 1968-2 CB 2; Rev. Rul. 69-115, 1969-2 CB 50 ; and ¶   5.04[3] and Form 5.04(a) .

Nondividend Distributions and Extraordinary Dividends

Corporate Distributions Subject to Special TreatmentSome corporate distributions to shareholders may be subject to special rules either because (1) they do not constitute “dividends” (as defined for federal income tax purposes) or (2) their amounts cause them to be categorized as “extraordinary dividends.” In these circumstances, special federal income tax treatment will be applicable, including tax reporting requirements.

Nondividend DistributionsIf a corporation has neither accumulated nor current E&P, a distribution to its shareholders (as shareholders) will not be a “dividend” includable in their gross income under IRC §   61(a)(7) . This assumes that the distribution itself (e.g., of appreciated property) will not trigger gain that will generate current E&P. As specified in IRC §   311(b) , the distribution of appreciated property will cause gain recognition of that appreciation to the corporation, and that gain (after applicable income tax) is includable in E&P. This treatment results because of the repeal of the General Utilities doctrine in the Tax Reform Act of 1986. Of course, the risk of increasing E&P does not exist if cash (at least in the form of U.S., not foreign, money) is being distributed. Furthermore, if gain is realized on a property distribution, E&P may still not result if the gain would be absorbed by, and be less than the net operating loss accumulated for, that year.

Under IRC §   301(c)(2) , a nondividend distribution is applied against, and reduces the adjusted basis of, the shareholder's stock. If the distribution is greater than the adjusted basis of the stock, the excess is subject to IRC §   301(c)(3) and will be treated as gain from the sale or exchange of property (and, therefore, capital gain, assuming the stock is a capital asset).

Of course, to have nondividend treatment, the absence of E&P must be demonstrated by the recipient or the payor. The principle that unauthorized withdrawals from a corporation would not constitute dividend income if E&P is absent was reaffirmed in US v. D'Agostino, 145 F3d 69 (2d Cir. 1998) (citing DiZenzo v. Comm'r, 348 F2d 122 (2d Cir. 1965) , as earlier authority). However, to enable tax basis recovery, the shareholder's tax basis must itself be adequately demonstrated. In Hawthorne v. Comm'r, TC Memo. 1999-31 , cash distributions were held to constitute gains from the sale or exchange of property (IRC §   301(c)(3)(A) ) where the shareholder failed to establish the basis in the shares.

Aggregating Share Basis in Determining Stock GainWhen receiving nondividend distributions, a question arises concerning how the shareholder must determine gain when holding multiple blocks of the corporation's stock. For example, the shareholder may hold both high- and low-basis shares. If so, is the shareholder (1) entitled to first recover his or her aggregate basis for all shares held or (2) must the distribution be allocated on a share-by-share basis in determining gain? If the distribution is treated as made on a share-by-share basis, the shareholder may be treated as recognizing gain on the low-basis shares, even though the tax basis attributable to the high-basis shares has not been completely recovered.

Bittker & Eustice, ¶   8.02[5] , observes that when a stock redemption is treated as a sale under IRC §   302(a) , or when corporate assets are distributed in complete liquidation, the shareholders generally compute gain or loss on a share-by-share basis, “and the same approach presumably should be applied to the computation of shareholder gain under §§   302(c)(2) and 301(c)(3) .” However, Bittker & Eustice also recognize that there is an argument for aggregate treatment under IRC §   301(c)(2) , noting Fink v. Comm'r, 483 US 89 (1987) , where the court applied the aggregate method in a case involving a capital contribution of stock to the corporation.

Extraordinary DividendsBecause a corporate shareholder is taxed on a reduced basis upon the receipt of a dividend (by reason of the dividends received deduction, discussed at ¶   5.08 ), this shareholder may desire to receive significant dividends (as defined for federal income tax purposes), rather than capital distributions (which, after basis recovery, would produce fully taxed capital gain). This is often referred to as dividend stripping, and it used to arise in situations where (1) stock would be acquired shortly before its ex-dividend date, (2) a dividend was then received that was eligible for the 70 percent dividends received deduction, and (3) the stock would then be sold (after satisfying the IRC §   246(c) holding period requirement for the dividends received deduction). A corporation would end up with (1) dividend income taxable at a low effective tax rate because of the dividends received deduction and (2) a short-term capital loss on the sale of stock, which often was used to offset previously realized unrelated capital gain.

To avoid the possible exploitation of this opportunity, a special rule under IRC §   1059 provides, in certain situations, for a tax basis reduction for the amount of a dividend that was not eligible for the dividends received deduction. A shareholder must reduce its basis for stock it owns to the extent of the nontaxed portion of any “extraordinary dividend.” An extraordinary dividend is received when it equals or exceeds a prescribed threshold percentage of the basis of the underlying stock, unless the stock was held for more than two years before the dividend announcement date or unless certain other conditions are satisfied. This percentage is 5 percent for preferred stock and 10 percent for other stock (i.e., common stock), as received during a specified period. See ¶   5.08[7] .

The shareholder has the option to show the fair market value of its stock in the corporation as of the day before the ex-dividend date, and to use that amount, rather than its adjusted stock basis, in calculating the 5 percent or 10 percent thresholds. See Rev. Proc. 87-33, 1987-2 CB 402 , which provides guidance to taxpayers on how to make a special election available under IRC §   1059(c)(4) to substitute, in certain situations, the fair market value for the taxpayer's basis.

Distributions of Property to Shareholders

Making Appreciated Property DistributionsRather than distributing cash to the shareholders (or to a trust for the shareholders), a corporation might distribute property that has appreciated in fair market value in the hands of the corporation. This appreciated property might include government bonds, corporate bonds, corporate stock, real property, inventory, and a variety of other properties, both tangible and intangible.

Proportionate interests in the property could be distributed directly to the shareholders. To facilitate distributions to a large or dispersed group of shareholders, property might be transferred to a trust or other arrangement where the property can be held (in noncorporate form) on behalf of the shareholders. This situation does not arise, obviously, where the corporation has only one shareholder to whom the property is transferred in a dividend.

Federal Income Tax Consequences to the Distributing Corporation on Appreciated Property Distributions

Gain But Not Loss Recognized on DistributionA corporation is required to recognize the gain realized on a dividend distribution of appreciated property to its shareholders. IRC §   311(b) . The tax rate on recognized gain could be 35 percent, because ordinary income and capital gain are subject to the same rate at the corporate level. Loss, however, is not recognized by the corporation on an appreciated property distribution. IRC §   311(a) .

The income tax impact of gain recognition may be lessened if the corporation has a loss carryover that can diminish the gain realized on the distribution. In the closely held corporate context, a high income–producing asset may be distributed to the shareholders, because the effective income tax rates applicable to shareholders may be lower than those applicable to the corporation. The issue of gain recognition might also be solved through an S corporation election, but the election may not be available in all situations. See Chapter 6 .

Alternatively, the corporation may be uncertain about the value of the property. If no loss carryover is available, the corporation will want to take the position that the property's fair market value is low. If a loss carryover is available, the corporation may want to take the position that the property's fair market value is high. Either way the IRS could attempt to challenge the valuation.

Corporation's E&P ReductionWhen gain is recognized on an appreciated property distribution, a corporation's E&P will be adjusted to reflect this gain. IRC §   312(b)(1) . Furthermore, as a result of this distribution, E&P will be reduced by an amount equal to the fair market value of the distributed property. IRC §   312(b) (2) . The E&P reduction for the distribution will be for the net value of the property. For example,

if the distributed property is subject to debt, the net equity value will be reduced by the debt, and this will be the amount of the dividend distribution. If, however, depreciated property is distributed, the reduction in E&P will be to the extent of the corporation's tax basis for the distributed property. IRC §   312(a)(3) .

Valuation of Distributed PropertyThe IRS may challenge the actual value of the property distributed for purposes of determining the amount of gain to the corporation on the distribution. See Tech. Adv. Mem. 200443032 , where the corporation transferred various business assets into several limited partnerships and, thereafter, distributed the partnership interests to the shareholders. The corporation asserted that the value upon the distribution was to be determined by reference to the value of the several limited partnership interests, taking into account minority interest positions and the lack of marketability of the partnership interests, rather than the operational assets themselves. The IRS concluded that the value of the distribution was to be determined by reference to the value of the operational assets being distributed, even though directly held by several partnerships. Consequently, from the IRS's perspective, the value of the dividend distribution cannot be suppressed by first infusing the operational assets into a limited partnership, with the partnership interests constituting the assets subsequently being distributed by the corporation.

Federal Income Tax Consequences to Recipient Shareholder of Appreciated Property DistributionsShareholders are required to report the entire net value of property received as a dividend, assuming that the distributing corporation has adequate E&P. The dividend realized by the shareholders will be in an amount equivalent to the net fair market value of the property received. If the property received is subject to debt, the amount of the dividend would be the fair market value of the property, reduced by the liability attached to the distributed property.

Because the distribution is includable in gross income, the recipient shareholders receive a fair market value basis for the property interest received. IRC §   301(d) specifies that the tax basis for the property in the hands of the shareholders will be the fair market value of the property at the time the property is received. If the property is subject to debt when received as a dividend, the shareholder will be treated as purchasing that property for its fair market value (excluding the impact of the debt). This is consistent with the long-established doctrine from Crane v. Comm'r, 331 US 1 (1947) , which specified that acquisition indebtedness is includable in basis for the acquired property.

Assignment of Income RiskThe corporation may distribute property as a dividend when, in fact, it really is an “assignment of income” to be realized by the corporation. For tax planning purposes, the corporation and shareholders would want to distribute this type of asset before the IRS could assert that it had been transformed into income and treated as already economically realized by the corporation.

Distribution of Corporation's Own Obligations

FormatIn lieu of distributing cash or other property, a corporation may distribute it own debt obligations to its shareholders. Such a distribution is ordinarily (but not necessarily) evidenced by promissory

notes, bonds, debentures, or other forms of securities issued by the corporation. See Chapter 4 for various examples of forms of promissory notes, bonds, and debentures. The assumption in this context is that the corporation is actually distributing a debt obligation, rather than only having declared a future dividend, in which event the future payment will constitute the corporate distribution.

Federal Income Tax Consequences to Distributor

No Gain RecognitionThe corporation does not recognize gain on the distribution of its own obligations. IRC §   311(b)(1) (A) . This is consistent with the general rule that the issuance of a debt instrument is not an income realization event to the debtor.

E&P AdjustmentsThe corporation's E&P is reduced by the principal amount of the distributed obligations, rather than by their fair market value. See IRC §   312(a)(2) . However, if obligations distributed by the corporation have OID, E&P is decreased by the aggregate issue price of the obligations. The issue price is the obligations' fair market value if they are publicly traded and bear “adequate stated interest.” See IRC §   312(o) . If the obligations are not publicly traded but bear adequate stated interest, their “issue price” is the stated redemption price at maturity. See IRC §   1273(b)(4) .

The E&P gain recognition rules under IRC §   312(b) , relating to the corporate distribution of appreciated property, do not apply to a corporation's distribution of its own obligations. Accordingly, the corporation's E&P will not be increased by the distribution. Absent such an exception, the distribution of the corporation's obligations, deemed to have a zero tax basis in the hands of the corporation, would cause the entire value of the obligations to be added to the corporation's E&P.

Federal Income Tax Consequences to ShareholderUnder IRC §   301(b)(1) , the distribution of a corporation's own debt obligations is a distribution of “property” to a shareholder. A dividend will be received by the shareholder to the extent of the fair market value of the obligations received, assuming the corporation has adequate E&P. In the unlikely event that the debt obligations cannot be reasonably valued as of the time of their distribution, “open transaction” treatment would be applied.

The federal income tax basis for the distributed obligations in the hands of the shareholders is the fair market value of the obligations when distributed (being the same amount as the dividend distribution). IRC §   301(d) . Any payments on the note in excess of its basis would be treated as a sale or exchange of the note eligible for capital gains treatment. See IRC §   1271(a)(1) .

Distribution of Corporation's Common Stock

Possible Stock Dividend AlternativesTo conserve its cash, a corporation may distribute dividends in the form of its own stock, rather than in cash, property, or debt. Furthermore, a corporation may distribute its own stock to reduce the value per share of its outstanding stock, thereby making the trading value of those shares

more attractive, particularly to individual investors. A variety of stock distribution alternatives might be considered by the corporation, including the following:

1. Common stock on common stock of the same class as the outstanding stock on which the stock dividend is paid; 2. Common stock on common stock that is of a different category (e.g., nonvoting common distributed with respect to the holdings of voting common stock); 3. Common stock on preferred stock; 4. Preferred stock on common stock; 5. Preferred stock on preferred stock in the same class as the outstanding stock on which it is paid; and 6. Preferred stock of a different class on the outstanding preferred.

Corporate AuthorizationA corporation must authorize the distribution of its own shares as a dividend. The procedures for authorizing the distribution is governed by the business corporation laws of the state in which the corporation is incorporated. The ABA Section of Business Law's Model Business Corporation Act (as revised through June 2005), § 6.23(a), specifies that, unless the articles of incorporation provide otherwise, shares may be issued pro rata and without consideration to the corporation's shareholders or to the shareholders of one or more classes or series. An issuance of shares under this subsection is a share dividend. Section 6.23(b) provides that shares of one class or series may not be issued as a share dividend in respect of shares of another class or series unless (1) the articles of incorporation so authorize, (2) a majority of the votes entitled to be cast by the class or series to be issued approve the issue, or (3) there are no outstanding shares of the class or series to be issued. Section 6.23(c) specifies that if the board of directors does not fix the record date for determining the shareholders entitled to a share dividend, it is the date on which the board of directors authorizes the share dividend.

The Official Comment to these provisions notes that a share dividend is solely a paper transaction, no assets are received by the corporation for the shares, and any dividend paid in shares does not involve the distribution of property by the corporation to its shareholders. The Official Comment does indicate that share dividends may create problems when a corporation has more than a single class of shares. The requirement that a share dividend be pro rata only applies to shares of the same class or series. If there are two or more classes entitled to receive a share dividend in different proportions, the dividend will have to be allocated appropriately. The Official Comment further observes that the distribution of shares of one class to holders of another class may dilute the equity of the holders of the first class. Therefore, the distribution of shares of one class to the holders of another class is permitted only if one or more of the following conditions are met: (1) the articles of incorporation expressly authorize the transaction; (2) the holders of the class being distributed consent to the distribution; or (3) there are no holders of the class being distributed.

Fractional Share Considerations When Stock Dividend DistributedA stock distribution will often lead to fractional shares for many shareholders. A corporation desiring to avoid the issuance of fractional shares as part of a stock dividend may issue script certificates, which can then be combined and exchanged for whole shares. If the shares of the corporation are publicly traded, the corporation may arrange with a securities broker or dealer to provide a mechanism for shareholders to sell their fractional interests or to purchase enough fractional interests to constitute a whole share. Alternatively, the corporation may simply distribute cash in settlement of all fractional claims. See ABA Section of Business Law's Model Business Corporation Act (as revised through June 2005), § 6.04(a).

The Official Comment to this provision indicates that the corporation may authorize the immediate sale of all fractional share interests, thereby avoiding the expense and delay of script certificates and the inconvenience of recognizing fractional shares. While this procedure denies shareholders the benefit of any subsequent rise in the market, it protects them against any subsequent decline and ensures them of recognition based on market values contemporaneous with the transaction. As noted, because these transactions involve less than one full share for each shareholder, the amount involved in subsequent price changes is usually modest.

Federal Income Tax Consequences to Recipient Shareholder of Stock Dividend Distributions

Tax-Free TreatmentA stock dividend is usually tax-free for federal income tax purposes, but this rule is subject to numerous exceptions. IRC §   305(a) provides that stock dividends are tax-free to the recipient shareholders “except as otherwise provided in this section.”

Exceptions to Tax-Free TreatmentThe exceptions to IRC §   305(a) are specified in IRC §   305(b) , and they are complex. The distribution arrangements discussed immediately below are taxable to a corporation's shareholders.

A distribution where any shareholder may elect to receive the stock dividend in lieu of money or other property.   Under IRC §   305(b)(1) , this taxable treatment applies to all shareholders, even though only some shareholders (or none) may actually make this election. Reg. §   1.305-2(a) provides that under IRC §   305(b)(1) , if any shareholder has the right to an election or option with respect to whether a distribution shall be made either in money or any other property, or in stock or rights to acquire stock of the distributing corporation, then, with respect to all shareholders, the distribution of stock or rights to acquire stock is treated as a distribution of property to which IRC §   301 applies regardless of

1. Whether the distribution is actually made in whole or in part in stock or in stock rights; 2. Whether the election or option is exercised or exercisable before or after the declaration of the distribution; 3. Whether the declaration of the distribution provides that the distribution will be made in one medium, unless the shareholder specifically requests payment in another; 4. Whether the election governing the nature of the distribution is provided in the declaration of the distribution, in the corporate charter, or arises from the circumstances of the distribution; or 5. Whether all or some of the shareholders make the election.

The IRS may consider an informal pattern of granting shareholders' requests to redeem their stock as evidence of an election to take the distribution either in stock or cash. See Rev. Rul. 83-68, 1983-1 CB 75 . See also Priv. Ltr. Rul. 200348020 , where a corporation intended to distribute a combination of stock and cash having a value equaling or exceeding the corporation's E&P. The shareholders would receive a right entitling them to elect to receive 100 percent cash, 100 percent common stock, or a fixed percentage of cash with the remaining percentage to be paid in common stock of the corporation. The IRS determined that all of the cash and stock would be treated as a distribution of property with respect to the corporation's stock to which IRC §   301 would apply, and the distribution would be taxable under IRC §   305(b)(1) to the shareholders as dividends, to the extent of the corporation's E&P.

A distribution that is one of a series of distributions where some shareholders receive cash or property and other shareholders increase their proportionate interests in the corporation's E&P.   Under IRC §   305(b)(2) , if a corporation has two classes of common stock outstanding and cash dividends are paid on one class and stock dividends are paid on the other class, the stock dividends are treated as distributions to which IRC §   301 dividend treatment applies. The regulations imply that, if the distributions occur within thirty-six months of each other, the stock and property distributions contemplated by IRC §   305(b)(2) can be linked together for purposes of applying this provision. Reg. §   1.305-3(b) . The regulations specify that the distribution of cash in lieu of fractional shares to which shareholders would otherwise be entitled shall not be subject to the IRC §   305(b)(2) recognition rule if the purpose of the distribution is to save the corporation the trouble, expense, and inconvenience of issuing and transferring fractional shares, issuing script certificates representing fractional shares, or issuing full shares representing the sum of fractional shares, and is not intended to give the particular group of shareholders an increased interest in the corporation's assets or E&P.

A distribution where some shareholders receive common stock and other shareholders receive preferred stock.   Under IRC §   305(b)(3) , all of the shareholders will be taxable under IRC §   301 on the receipt of their stock, whether they receive common stock or preferred stock. This treatment applies because of the actual increase of the proportionate interest of one shareholder group and, therefore, the decrease in the proportionate interest of another shareholder group.

A stock dividend on preferred stock (other than an increase in the conversion ratio of convertible preferred stock solely to recognize the effect of a stock dividend or stock split with respect to the stock into which such convertible stock is convertible).   Under IRC §   305(b)(4) , this treatment is premised on the analysis that any addition to the stock ownership of a class that has an enhanced future participation in the corporation's equity does so at the expense of the other classes of stock. Thus, this situation can produce a shift in the proportionate ownership of the future increase of the corporation's E&P and equity growth.

Any distribution of a corporation's convertible preferred stock, unless the corporation can establish that it will not result in a disproportionate distribution.   Under IRC §   305(b)(5) , adjustments made for a conversion ratio of convertible preferred stock to avoid a shift in the proportionate interest should alleviate the application of IRC §   305(b)(4) . Reg. §   1.305-6(a)(2) specifies that the distribution of convertible preferred stock is likely to result in a disproportionate distribution when (1) the conversion right must be exercised within a relatively short period after the distribution and, (2) taking into account such factors as the dividend rate, the redemption provision, the marketability of the stock, and the conversion price, it is anticipated that some shareholders will exercise their conversion rights and some will not. However, if the conversion right may be exercised over a period of many years and the dividend rate is consistent with market conditions at the time of distribution, no basis exists for predicting when and to what extent the stock will be converted, and it is therefore unlikely that a disproportionate distribution will exist.

Pursuant to IRC §   305(c) , regulations were issued treating a wide variety of transactions as constructive distributions of stock with respect to the stock of any shareholder whose proportionate interest in the corporation's earnings or assets is increased by the transaction. These transactions include (1) changes in conversion ratios, (2) changes in redemption prices, (3) unreasonable call-premium provisions, (4) dividend-equivalent periodic redemption plans, and (5) similar arrangements. Reg. §   1.305-7 .

Distribution of the Same Class of Common StockUsually, a stock dividend is distributed in a way that does not cause inclusion in gross income (i.e., does not fit within any of the IRC §   305(b) exceptions). This is achieved most easily through a pro rata distribution of common stock by a corporation that has only one class of common stock

outstanding. Under IRC §   305(a) , this standard type of stock dividend continues to enjoy a tax-free character. This has been the situation since Eisner v. Macomber, 252 US 189 (1920) .

Stock SplitSimilar federal income tax treatment is applicable to shareholders receiving stock in a stock split. In a stock split, the shareholder may receive one or two shares for each share presently held, as a opposed to a stock dividend, where the shareholder may receive one share for each ten shares presently held. See ¶   8.10 .

Allocation of Shareholder's Tax Basis When a Tax-Free Stock Dividend OccursStock dividends that are received tax-free under IRC §   305(a) require an allocation of each shareholder's tax basis, pursuant to IRC §   307 , in the original shares among the total shares held after the transaction. This allocation is made in proportion to the fair market values of the old stock and the new stock on the date of distribution. Furthermore, those new shares have a “tacked” holding period under IRC §   1223(4) .

If, however, the stock distribution is taxable, the basis of the distributed stock in the hands of the shareholders is its fair market value, as determined under IRC §   301(d) . The holding period of stock received in such a taxable distribution commences the day after its acquisition. See Rev. Rul. 76-53, 1976-1 CB 87 .

Tax Treatment of Fractional Share Proceeds Received by ShareholdersThe use of cash to eliminate fractional shares will not be treated as a disproportionate distribution under IRC §   305(b)(2) . Reg. §   1.305-3(c) . This assumes that the purpose of the cash distribution is to avoid the expense of issuing fractional shares and that the total cash paid does not exceed 5 percent of the total fair market value of the stock distributed. The treatment by the shareholders of the cash received under these circumstances will be determined under the IRC §   302 stock redemption rules, usually enabling sale or exchange treatment. See the discussion of these rules at Bittker & Eustice, Chapter 9.21 .

Federal Income Tax Consequences to Distributing Corporation of Stock Dividend DistributionsThe corporation that distributes a tax-free stock dividend does not reduce its E&P when making a nontaxable distribution of its stock. IRC §   312(d)(1)(B) . However, taxable stock dividends are treated like distributions by a corporation of its own obligations or analogous to cash dividends. The corporation's charge to E&P for such distributions is the fair market value of the stock. The expenses incurred in issuing a stock dividend cannot be deducted by the corporation under IRC §   162 .

Distribution of Stock Rights by Corporation

Purposes for a Stock Rights Distribution

A corporation may distribute either rights to purchase its shares or warrants to purchase its shares. Ordinarily, the terms “rights” and “warrants” are interchangeable for federal tax purposes.

Often, stock rights are sold on a favorable basis so as to encourage their exercise by the shareholder receiving them. For the corporation, this is an alternative method for raising capital. For the shareholders, stock rights provide an uncomplicated method for further equity investment in the corporation. If the stock rights are sold at a discount, the shareholders may want to exercise those rights to maintain their proportionate future participation in the earnings of the corporation. This will be especially significant when the shareholder group is limited and changes in share percentages can cause significant shifts in shareholder control of the corporation.

Corporate Authorization to Issue Stock RightsA corporation must appropriately authorize the issuance of rights for the purchase of its shares or other securities. The ABA Section of Business Law's Model Business Corporation Act (as revised through June 2005), § 6.24(a), specifies that a corporation may issue rights, options, or warrants for the purchase of its shares or other securities. The board of directors shall determine (1) the terms upon which the rights, options, or warrants are issued and (2) the consideration for which the shares or other securities are to be issued. The authorization by the board of directors for the corporation to issue such rights, options, or warrants also constitutes authorization of the issuance of the shares or other securities for which the rights, options, or warrants are exercisable. Section 6.24(b) provides that the terms and conditions of such rights, options, or warrants may include, without limitation, restrictions or conditions that (1) preclude or limit the exercise, transfer, or receipt of such rights, options, or warrants by any person or persons owning or offering to acquire a specified number or percentage of the outstanding shares or other securities of the corporation, or by any transferee or transferees of any such person or persons, or (2) invalidate or void such rights, options, or warrants held by any such person or persons or any such transferee or transferees.

The Official Comment to the provision above notes that many state business corporation statutes contain stipulations authorizing the creation of rights, options, and warrants. Even though corporations undoubtedly have the inherent power to issue these instruments, specific authorization is needed because of the economic importance of rights, options, and warrants, and because it is necessary to confirm the broad discretion of the board of directors in determining the consideration to be received by the corporation for their issuance. This comment further specifies that the issuance of rights, options, or warrants is a matter of business judgment and that, in appropriate cases, incentive plans may provide for exercise prices that are below the current market prices of the underlying shares or other securities.

The Official Comment observes that § 6.24(a) does not require shareholder approval of rights, options, or warrants, but that prior shareholder approval may be sought as a discretionary matter. Shareholder approval may also be required in order to comply with the rules of national securities markets (see, e.g., N.Y.S.E. Listed Company Manual, § 309.00). In the federal income tax context, shareholder approval for the issuance of stock options will be required for the benefits under stock option plans, such as those under IRC §   422(b)(1) , to be available.

Under § 6.24(a), the board of directors may designate the interests being issued as options, warrants, rights, or by some other name. These interests may be evidenced by certificates, contracts, letter agreement, or in other forms that are appropriate under the circumstances. Rights, options, or warrants may be issued together with, or independently from, the corporation's issuance and sale of its shares or other securities.

Federal Income Tax Consequences to Recipient Shareholder of Stock Rights Distributions

Tax-Free Receipt of Rights by ShareholderA pro rata distribution to shareholders of a “right” to purchase additional shares of the corporation is ordinarily a tax-free event pursuant to IRC §   305 . However, this assumes that the distribution is not subject to one of the exceptions in IRC §   305(b) , where income recognition is required upon distributions in lieu of money, disproportionate distributions, and similar distribution events. Similarly, the exercise of such rights by the shareholders for the purchase of the corporation's shares is also tax-free.

Tax Basis Allocation Between Stock and RightsThe original tax basis for the shares on which the rights are issued is allocated between the stock and the rights if the rights are either exercised or sold. IRC §   307(a) . This allocation of the basis is to be in proportion to the fair market value of the stock and the rights as of the date of the rights distribution. Reg. §   1.307-1(a) . In the case of the exercise of the rights, the tax basis amount allocated to the rights is added to the cost of the stock acquired upon exercising the rights. Reg. §§   1.307-1(a) , 1.307-1(b) . In the situation of a sale of the rights, the amount allocated to the rights is used to determine the shareholder's gain or loss on the sale. If the rights expire, however, no tax basis allocation is permitted. Under such circumstances, no capital loss is incurred by the shareholder and the allocated tax basis reverts to the underlying shares.

Exception to Tax Basis Allocation RuleThis rule of tax basis allocation is subject to an exception. If the fair market value of the stock rights when distributed is less than 15 percent of the fair market value of the old stock at the time of distribution, the basis of the rights will be zero. This rule avoids the necessity of a tax basis adjustment when the value of the distributed rights is small. However, the shareholder may elect to allocate tax basis under the method provided in IRC §   307(a) . This method may be elected if the rights have depreciated in value since issuance and the shareholder wants to generate a loss on their sale, thereby enabling the potential of offsetting other capital gains. If the shareholder sells his or her rights, the holding period of the underlying shares is tacked to the holding period for the rights if the tax basis of the rights “is determined under section 307 .” See IRC §   1223(4) .

Federal Income Tax Consequences to Distributing Corporation of Stock Rights Distributions

Tax-Free Treatment to Distributing CorporationThe distribution of stock rights will not cause income recognition to the corporation. Even though the rights may have some value, and the corporation's tax basis in those rights will be zero, the corporation will recognize no income upon their distribution. See IRC §   311(a)(1) , which specifies that no gain or loss shall be recognized to a corporation on the distribution of its stock or “rights to acquire its stock.”

E&P Adjustment

If the stock rights distribution to shareholders is tax-free, the corporation's E&P will not be reduced by the value of the rights. As noted below, if, however, the distribution of rights is taxable as a dividend, the corporation's E&P will be reduced by a corresponding amount, assuming there is an adequate amount of E&P.

Taxable Distribution of Rights

Receipt by Shareholder of Taxable RightsA distribution of stock rights may be taxable because the shareholders have an option to take property from the corporation rather than stock rights. In this situation, the distribution will be treated (under IRC §   305(b) ) as a distribution of property to which IRC §   301 (i.e., dividend treatment) applies. Consequently, the receipt of these rights will cause ordinary dividend recognition to the shareholders, assuming (1) that the rights can be valued and (2) that the E&P is equal to or greater than the fair market value of the rights. This income tax recognition will establish a cost basis for these rights in the hands of the shareholders.

The shareholder may subsequently sell the rights, exercise the rights, or allow them to lapse. The shareholder's sale of the rights would produce a gain or loss, depending on the tax basis for the rights and the amount received upon the sale. The exercise of the rights would cause the tax basis for the rights to be added to the purchase price for the shares in establishing the total tax basis for those shares in the hands of the shareholder. The lapse of these rights would ordinarily enable a deductible tax loss to the extent of the basis previously established for these rights.

Distribution by the Corporation of Taxable RightsThe distribution of stock rights will not cause income recognition to the corporation even though it may be taxable to the recipient shareholders. See IRC §   311(a)(1) , which specifies that a corporation will recognize no gain or loss upon a distribution of its stock rights. This provision does not limit tax-free treatment to the corporation to only those situations where the shareholder also does not recognize income.

When the stock rights distribution is treated as taxable to the shareholder, the corporation can reduce its E&P by the fair market value of the rights. IRC §   312(d) specifies that a stock or stock rights distribution shall not be considered a distribution of the corporation's E&P if the shareholder recognizes no gain from the receipt of the stock rights or if the distribution was not subject to tax in the hands of the shareholder by reason of IRC §   305(a) . More precisely, Reg. §   1.312-1(d) states that, in the case of a distribution of stock or rights to acquire stock, a portion of which is includable in income by reason of IRC §   305(b) , the E&P shall be reduced by the fair market value of such portion. However, this regulation specifies that no E&P reduction shall be made if a distribution of rights to acquire stock is not includable in income under the provisions of IRC §   305 .

Other Types of Stock Rights DistributionsA corporation may distribute other types of stock rights, such as “poison pill” rights plans and rights included in unbundled stock units. In a poison pill situation, a rights plan may be adopted to allow shareholders of a potential target corporation to acquire the target's stock at a

significant discount upon the occurrence of certain triggering events. The ownership stake of a hostile acquirer is thereby diluted and the hostile acquisition may then become unacceptably expensive. See Rev. Rul. 90-11, 1990-1 CB 10 , indicating that no income tax consequences to the corporation or the shareholders arise merely from a corporation's adoption of such a plan. Since its issuance, this revenue ruling has been cited on numerous occasions in private letter rulings to support that the mere adoption of a poison pill rights plan will not be treated as a sale event. If the rights do actually become available when the identified triggering event occurs, shareholders will probably be taxed under IRC §   305(b)(2) .

See ¶   8.12 for a description of an unbundled stock unit distributed to shareholders. A portion of that unit might include an “option,” which might be considered a stock right for purposes of the discussion herein.

Stock Splits

GenerallyThe objective of a stock split is ordinarily the same as that of a regular stock dividend (i.e., to have a tax-free distribution). In contrast to a stock dividend, a stock split will produce a much larger number of shares outstanding and, thereby, a much greater reduction of the fair market value per share outstanding prior to the time of the stock split.

As identified in the New York Stock Exchange, Listed Company Manual, § 703.02, a stock split is a distribution of 100 percent or more of the outstanding shares of a corporation (as calculated prior to the distribution). A partial stock split is identified as a distribution of 25 percent or more, but less than 100 percent, of the outstanding shares (as calculated prior to the distribution). A “stock dividend” is defined as a distribution of less than 25 percent of the outstanding shares (as calculated prior to the distribution). A stock split requires a transfer from paid-in capital for the par or stated value of the shares issued, but not where there is to be a change in the par or stated value of the shares.

A fractional share distribution is less likely to occur with a stock split than with a stock dividend. In a stock split, the shares distributed may be one or two shares for each share held. If a stock split occurs on the basis of one share for every two shares held, only those shareholders holding an uneven number of shares would need to deal with the fractional share issue.

Corporate Authorization Required for Stock SplitAppropriate corporate authorization for a stock split will be required, often by a vote of a majority of the shareholders. Revised Model Business Corporation Act, Fourth Edition (2008) Revised Model Business Corporation Act, Fourth Edition (2008), § 6.23(a), specifies that, unless the articles of incorporation provide otherwise, shares may be issued pro rata and without consideration to the corporation's shareholders or to the shareholders of one or more classes or series. An issuance of shares under this subsection is identified as a share “dividend.” The Official Comment to this provision further specifies that the par value statutory treatment of share dividend transactions previously distinguished a share “split” from a share “dividend.” In a share “split” the par value of the former shares was divided among the new shares and there was no transfer of surplus into the stated capital account as in the case of a share “dividend.” Because the above-mentioned Act eliminated the concept of par value, the distinction between a “split” and a “dividend” was not retained; accordingly, both types of transactions are referred to simply as share dividends.

Of course, many state business corporation codes retain some form of par value requirements, and this must be taken into consideration. Furthermore, the Official Comment to the ABA Section

of Business Law's Model Business Corporation Act notes that a distinction between “share dividends” and “share splits” continues in other contexts, for example in connection with transactions by publicly held corporations. See NYSE Listed Company Manual, § 703.02(a), for corporations that have optionally retained par value for their shares.

Federal Income Tax Consequences to Recipient of Stock Split DistributionsA stock split is usually treated as tax-free for federal income tax purposes, but this rule is subject to numerous exceptions. Section 305(a) provides that stock dividends, including stock splits, are tax-free to recipients “except as otherwise provided in this section.” See, e.g., Priv. Ltr. Rul. 9709004 , where the IRS ruled that a regulated investment company's stock split would not result in a deemed distribution under IRC §   305(a) . The existence of redemption rights in this investment company before and after the distribution would not cause the distribution to be taxable under IRC §   305(b) or IRC §   305(c) . Under IRC §   311(a) , no gain or loss would be recognized to the investment company upon the distribution of the new shares with respect to the old shares.

Similar to stock dividends, the use of cash to eliminate fractional shares in a stock split ordinarily should not be treated as a disproportionate distribution under IRC §   305(b)(2) . See Reg. §   1.305- 3(c) . This assumes that the purpose of the cash distribution is to avoid the expense of issuing fractional shares and that the total cash paid does not exceed 5 percent of the total fair market value of the distributed stock. The income tax treatment by the shareholders of the cash received under these circumstances will be determined under the IRC §   302 stock redemption rules.

Federal Income Tax Consequences to Distributing Corporation of Stock Split DistributionsThe corporation distributing its shares in a stock split does not recognize gain on the distribution. IRC §   311(a)(1) . Furthermore, the corporation that distributes a tax-free stock dividend does not reduce its E&P account when making a nontaxable distribution of its stock. IRC §   312(d)(1)(B) . The costs of implementing the distribution of stock in a stock split are not deductible under IRC §   162 .

“Reverse Stock Split”In some situations, the value of a corporation's shares may have declined so much that the per-share value is quite small. Corporate shares may become delisted on an exchange if their value dips too low. To increase the value of shares, a corporation may engage in a “reverse stock split.” In a reverse stock split, a corporation can restructure itself so as create a situation where each outstanding share becomes, for example, only one fifth of a share. Stated alternatively, five outstanding shares become one share. This result would occur even if a shareholder does not transmit his or her share certificates to the corporation for new post-reverse stock split shares. For federal income tax purposes, the tax basis for the old shares would be attributed to the new shares (now reduced in number).

Dividend Reinvestment Plan

Objective of a Dividend Reinvestment Plan

As a method of increasing its capital, a corporation may offer to its shareholders an opportunity to reinvest their cash dividends in additional stock of the corporation. Dividend reinvestment under a plan usually continues until the shareholder withdraws from the plan. Such a plan may be made more attractive to the shareholder by offering a price advantage over open market purchases of the stock. This can be accomplished by purchase discounts or by bringing to the attention of the shareholder the brokerage commissions that would be incurred if the shares were purchased through a securities dealer.

Alternative Types of Dividend Reinvestment PlansA dividend reinvestment plan may be administered so that the shares are purchased directly from the corporation with the cash dividends otherwise to be received. In this situation, the net assets of the corporation are not reduced by the amount of the dividend that is otherwise payable in cash. Alternatively, the shares may be purchased in the open market, thereby not increasing the number of outstanding shares of the corporation. This technique would not allow, however, the cash dividend amount to be retained by the corporation, which is often the primary objective.

Taxability of the DistributionIf a corporation pays cash dividends, which the taxpayer can receive and retain at her option, the stock received under a dividend reinvestment plan is not a tax-free distribution of a stock dividend. See IRC §   305(b)(1) . In effect, shareholders participating in a dividend reinvestment plan constructively receive cash dividends and thereafter reinvest them by purchasing additional shares of the corporation.

If the shareholders receive a price reduction under a dividend reinvestment plan, the amount includable in gross income as a dividend under IRC §   301 is the fair market value of the stock that is purchased with the dividend-sourced cash. This amount is equal to the sum of the cash dividend and the price discount. The shareholders do not realize gross income, however, on the value of the brokerage commissions that they would have paid had they purchased the shares on the open market, rather than through the corporation's dividend reinvestment plan.

For the income tax treatment of a dividend reinvestment plan under which the shareholders cannot elect to receive stock or cash dividends, see Rev. Rul. 77-149, 1977-1 CB 82 . In that situation, if the shareholder (or its agent) first receives the cash and then buys the stock, the cash amount is taxed as a dividend. Under the facts in this ruling, a bank received the dividend distribution and then acted on behalf of the shareholder in acquiring shares of the dividend-paying corporation. The dividend status was determined without reference to IRC §   305(b)(1) . Rev. Rul. 77-149 is distinguished in Rev. Rul. 78-375, 1978-2 CB 130 , and Rev. Rul. 79-42, 1979-1 CB 130 . Rev. Rul. 78-375 involved a dividend reinvestment plan where the shareholder could not only elect to receive stock with a greater fair market value than the cash dividend the shareholder might have instead received, but also could purchase through the plan additional stock from the corporation at a discount price less than the fair market value of the stock. In Rev. Rul. 79-42 , a corporation transferred cash dividends to an agent who purchased stock for the shareholders directly from the corporation for 95 percent of the average closing market prices on the dividend payment date. The parties were treated as having received distributions to which IRC §   301 applies, by reason of IRC §   305(b)(1) , with the amount of the dividend being the fair market value of the stock.

Numerous IRS releases (e.g., Publication No. 17, “Your Federal Income Tax”) provide instructions about the tax effects of dividend reinvestment plans. For example, Publication 17 indicates that a member of a dividend reinvestment plan who uses dividends to buy more stock at a price equal to its fair market value must report the dividends deemed received as income. This publication also indicates that if the dividend reinvestment plan permits a shareholder to buy more stock at a

price less than its fair market value, the shareholder must report as income the fair market value of the additional stock on the dividend payment date. Presumably, this income amount is limited to the difference between the purchase price and the fair market value for the stock. Furthermore, the shareholder must report as income any service charge subtracted from the cash dividends before the dividends were used to buy the additional stock. However, the publication notes, the shareholder may be able to deduct this service charge.

The IRS has issued numerous private letter rulings in the dividends reinvestment context. For example, in Priv. Ltr. Rul. 9509039 , the IRS indicated (with only minimal explanation) that the purchase by either shareholders or employees of a corporation's stock at a discount under a stock discount purchase plan was not to be treated as a distribution of the corporation's stock under IRC §   305(b) . Accordingly, the IRS ruled that the purchaser would realize no income as a result of the purchases under the discount purchase program. See also Priv. Ltr. Rul. 9634024 , which involved the utilization by a real estate investment trust (REIT) of a dividend reinvestment plan and the related federal income tax effects. In Priv. Ltr. Rul. 9750033 , a REIT allowed its shareholders (1) to elect to have their dividends reinvested into REIT stock at a discount price (the “Reinvestment Program”), (2) to invest additional funds in exchange for REIT stock at the same discount price (the “Cash Purchase Program”), or (3) to do both. Shareholders who participated solely in the Cash Purchase Program were not treated as having received a distribution of the discount amount of the stock to which IRC §   301 applies by reason of IRC §   305(b) . Therefore, these shareholders were determined not to realize income as a result of these purchases. Shareholders who participated in both the Cash Purchase Program and the Reinvestment Program, however, were treated as having received at the time of the purchase a distribution of the discount amount of the stock to which IRC §   301 applies by reason of IRC §   305(b)(2) . Similarly, see Priv. Ltr. Rul. 200414022 , where the IRS ruled that a shareholder's purchase of stock through a corporation's stock discount purchase program would not be treated as a distribution of corporate stock under IRC §   305(b) and that the shareholder would not recognize income as a result of the purchase. In Priv. Ltr. Rul. 200618008 , the IRS ruled that REIT shareholders who participate in a dividend reinvestment plan are to be treated as receiving an IRC §   301 distribution of property in connection with any cash dividend declared by the REIT. The stock sale would not be treated as an IRC §   301 property distribution.

Tax Basis to Shareholders for Acquired StockThe tax basis to the shareholder for the stock acquired under a dividend reinvestment plan would be its fair market value. See IRC §   301(d) . The holding period for the stock acquired in this transaction would commence as of the time of its acquisition. No “tacking” would occur for this purpose because a new tax basis would be applicable to this stock.

Adjustment to Corporation's E&PBecause a transaction involving the cash deemed transferred to a shareholder is a dividend distribution, the corporation would be entitled to reduce its E&P account by the dividend amount. That charge to E&P would be the fair market value of the stock. See Reg. §§   1.312-1(d) , 1.305-2(b), Ex. (2); Rev. Rul. 76-186, 1976-1 CB 86 .