MEMORANDUM
Dear Sir,
This memo is written to address the problems faced by the Big Corp. as a result of the bankruptcy of its subsidiary Sub Corp. the memo discuss the different statutory and regulatory matters applicable in this matter. It also recommends the solution on whether the dividends paid by the company should be treated as a return on capital or ordinary dividends.
At first, it is important to understand the basic difference between preferred and ordinary stocks. Preferred shareholders have a preferred claim to the earnings and profits of the company. When the company has excessive cash and decides to distribute dividend among its shareholders, preferred shareholders are given priority in paying dividends before paying to common shareholders. Moreover, when the company gets insolvent, it must liquidate all its assets to pay creditors and suppliers. After paying creditors, if any cash is retained, it is used for paying off the preferred shareholders .
Another big difference between common and preferred shareholders is that dividend paid to preferred shareholders is generally at a higher rate and is different from common shareholders. Secondly, preferred stockholders are usually paid regularly after an interval of time while it is not the case with common stockholders who are paid at the discretion of the board of directors. Therefore, preferred stock is sometimes also regarded as the fixed income security and its price do not fluctuate much like common stock. Fixed income security means that dividends are guaranteed and in case if the company doesn't pay out any dividend, it will be required to pay before any future payments on stocks.
Tax on preferred dividends
The dividend on the preferred dividend is fixed; they are taxed in a manner that is different from other fixed sources of income such as interest. Most of the preferred dividends are qualified and the tax levied on them is lower than the normal dividend. The majority of the preferred shareholders are required to pay 15% dividend, except only a few investors who pay 20% due to higher income.
Though preferred stocks are categorized as equity, they have characteristics of a bond, stated par value and fixed dividend amount. As compared to ordinary shareholders, preferred shareholders come first in the payment of dividend distributions and as well as company's liquidation events. However, one drawback of the preferred shareholder is that they do not have a voting right like that of the common shareholder. If the company gets short on cash, the management of the company and those charged with governance may decide to withhold the dividend payments, from both the ordinary shareholders and preferred shareholders, until the cash becomes available. If the dividend of preferred shareholders is withheld, they are considered as accrued and are paid cumulatively at a later period when the cash is available to the company.
Form 1099 and Form 5452
Form 1099-DIV is a form sent by companies to its investors. It carries the record of all the taxable capital gains and the dividends that are paid to the investors. It also includes those dividends that are reinvested in a given tax year. The final amount stated on the form represents the total amount attributed to each investor as a return for the year. This amount is then reported by the company to the IRS. This form is also used by the investors to report their income from investment in the income tax return each year. It is important to note that form 1099-DIV is not sent to those investors who received or reinvested less than $10 per fund, in total.
The constituents of form 1099-DIV include ordinary dividends, qualified dividends, non-taxable distributions, capital gains, withholding income tax, foreign tax and foreign source of income from every account in the investment company.
The company that has made a non-dividend distribution to its stockholders is required to file form 5452 under the tax laws. If the company is part of the consolidated group, the parent company is then required to file form 5452.
Non-dividend distributions are those distributions that are made to shareholders in the normal course of business. Non-dividend distributions are considered to be fully or partially taxable since the current and accumulated earnings and profits of the paying company are less than the distributions. Non-dividend distributions do not include distributions exchanged for stock in liquidation or redemptions or the tax-free stock dividends.
Ordinary dividends
Ordinary dividends are taxable and are the most common type of dividend paid by the companies. These dividends are paid out of the earnings and income and are considered to be the ordinary income of an individual. In other words, ordinary dividends are not regarded as the capital gains. It is safe to assume any dividends received on common or prefer stocks to be the ordinary dividends unless the paying company mentions otherwise. Ordinary dividends are shown in part 1a of the form 1099-DIV.
Ordinary dividends should not be confused with qualified dividends. Qualified dividends are also ordinary dividends and are subject to the same tax rate that applies to capital gain i.e. 0%, 15%, or 20% at maximum. The maximum tax rate on qualified dividend is decided as follows:
0% of the amount that is otherwise taxed at the rate of 10% or 15%.
15% of the amount that is otherwise taxed at the rate greater than 15%, but less than 39.6%.
20% of the amount that is otherwise taxed at the 39.6%.
Furthermore, in order to qualify for the maximum rate, it is necessary that dividends are paid by the US Corporation or a foreign corporation that is qualified. Secondly, it is also necessary that dividends should not be listed under the unqualified dividends and should meet the holding period. Holding period means that the stocks must be held for more than 60 days during the period of 121 days period that begins exactly 60 days before the date of the ex-dividend .
Capital gain distributions
Capital gain dividends, also known as capital gain distributions, are paid by the mutual funds or investment companies to their stockholders. These dividends are reflected in the part 2a of the form 1099-DIV . capital gain dividend are always reported as long-term capital gains, regardless of the holding period of shares of the company.
If the capital gains are undistributed, the company is required to pay tax on them. An individual is required by law to treat his part of these gains as distributions regardless of whether he received them or not. However, these gains, if not received, are not required to be included in form 1099-DIV. undistributed gains are reported by individuals in part 1 of form 2439.
Non-dividend distributions and Liquidating distributions
Non-dividend distributions refer to the distributions by the company that is not made out of earnings and profits (“Form 5452” 2). Non-dividend distributions are shown in the form 1099-DIV in part 3. It is important to note that these non-dividend distributions are not taxed until the basis in the stocks are recovered fully by the stockholders. This nontaxable portion of the stock is referred to as the return of capital. It means that it is regarded as the return on investment in the shares of the company. If a person purchases a stock of the company at a different quantity and at different times, and he cannot possibly identify the shares that are subject to the non-dividend distributions, then the basis of earliest purchase will be reduced first for the purpose of adjustment. Once the basis of share is reduced to zero, any additional non-dividend distributions received by the individual will be treated as capital gains. the fact that capital gain should be identified as the long-term capital gain or short-term capital gain depend solely on the holding period of the stock.
Liquidating dividends, also known as liquidating distributions, are paid by the company at the time when it is getting partially or completely liquidated. These distributions are also the part of a return of capital. Moreover, these dividends could be paid in one or more partial installments. Liquidating distributions are shown in box 8 or 9 in the form 1099-DIV.
Statutory and Regulatory Framework
It is allowed in the code section 165 to deduct the amount for any loss that has incurred within the period of a taxable year and has not been reimbursed through insurance. The section described can be put into practice for a number of losses comprising of those losses that are suffered due to valueless securities. It is essential to ensure that if any security that is classified as capital asset turns insignificant within the period of a tax year, then such losses will be recorded as the loss from the disposal or replacement of a capital asset. It has been realized by all the tax practitioners that utilization of the capital losses is a significant difficulty for the taxpayers. Also, the deferred period for the capital losses is recognized as unfavorable situation as compared to that of net operating losses.
In the Code Sec. 165(g)(3), the domestic companies are permitted to a common loss on stock which is held in the other corporation if the essential conditions are fulfilled. Primarily, it is necessary for the taxpayer to have the ownership of more than 80 percent of the voting stock . In addition, the taxpayer should have the ownership of 80 percent of the total worth of the stock of other company. The secondary requirement explains that gross receiving that needs to be greater than 90 percent, for each and every tax year of the other company should be earned from sources that are not passive activities such as rents, dividends, royalties, interest or gain from the disposal of stock (“26 U.S. Code § 165 – Losses”). The third requirement enlightens that stock that is owned by the domestic company must turn valueless within the period of the tax year. It is explicitly clarified in the regulations that for a deduction to be permitted, the loss will be confirmed by an absolute transaction that is fixed by the specific identifiable occurrence and is sustained throughout the taxable year .
In the case of the liquidation of a controlled subsidiary, the code sec. 332 allows the tax-free treatment with the stockholders. However, if the shareholder does not receive the payment on the liquidation of the company, then the Code Sec. 332 regulation will not be applicable. Preference in the payment will be given to the creditors and preferred shareholders for their debts and liquidation. After that, the shareholder will be allowed to obtain his payment for the common stock. However, the shareholder will not receive his amount for stock in the liquidating company and the code sec 332 will not be applicable in case the liquidation company gets bankrupt on the date of liquidation.
Guidance on CODE SEC. 165 (g) (3)
IRS have put forward three regulations and administrative rulings in the past years that deals with the (1) active gross receipt test, (2) whether abandonment of a security constitute an identifiable event, and (3) how related party debt should be treated for purposes of determining whether a subsidiary is worthless . The direction and knowledge provided by the IRS are helpful for the worldwide tax planners in understanding the recent situation of IRS in relation to the ordinary valueless stock deductions in a post- check- the- box- era.
Moreover, in order to prove that stock has become worthless, an identifiable event must occur in the tax year. The examples of identifiable events include insolvency, liquidation, cessation of business activities, or government ruling.
Once the identifiable event has been established, the taxpayer must prove that the stock had a value at the beginning of the tax year, but then it became completely worthless during the tax year period. The burden of proving worthlessness lies on the taxpayer. Usually, in order to prove worthlessness, the tax payer shows the lack of potential value and lack of liquidating value that occurred during the tax year.
The lack of liquidating value means that the balance sheet got insolvent during the tax year. However, it is important to note that liquidating value is not always measured on the historical balance sheet. Assets and liabilities of the company must be adjusted to indicate the difference between fair market value and book value. Furthermore, equity principles and traditional debts should also be evaluated to consider whether balance sheet insolvency exists. Finally, the effect of contribution to the capital of debt held by the shareholder prior to the identifiable event must also be considered.
Worthless Stocks
If taxpayer establishes that a stock has become worthless, and the timing is correct, the next thing to determine is the character of the loss. Usually, the rule is that a worthless stock should be characterized as capital . Utilization of capital loss can only be done through capital gain income. This makes it more difficult for taxpayers, those who do not have capital gain income, to utilize the capital gain income in the carry forward or carryback period. In this regard, section 165g offers relief to the taxpayer and allows them to change the loss to the ordinary if the security is stock in an affiliate. For the worthless company to qualify as an affiliate, two conditions must be met. First, the company must own 80% or greater voting power and 80% of the total value of the company’s stock. Secondly, 90% of the gross receipts of the company must be from sources other than interest, dividends, annuities, royalties, and gains from sale or exchange of stocks.
Guidance on Earnings and Profits
The amount of accumulated earning and profits is usually referred to the amount at the end of the preceding tax year. It is calculated by adding current earning and profits in beginning earning and profits, and then deducting current and accumulated distributions. The resulting figure will be the accumulated earning and profits at the end of the year (“Publication 542” 18).
When the company earns profits, it is given two choices, either it can retain the profits to reinvest in the business, or it can distribute the profits in the form of dividends to its stockholders. The taxability of the distribution depends on the fact that whether the distribution is categorized as dividend or return of capital. Since the return of capital is not considered to be the profit, it is not taxable. On the other hand, dividends are taxable twice. First, the company pays tax on its total profits and then the shareholder pays tax on the dividend received.
Current earning and profits are equivalent to the taxable income less the income tax paid on it. Any current income, which is not paid as a dividend, is retained by the company which in turn increases its accumulated earning and profits. Accumulated earning and profits are the total retained profits from previous tax years.
Recommendation and Conclusion
The company has a choice to either pay the dividends from current earning and profits or accumulated earning and profits. If the total dividends paid to the shareholders exceeds the sum of accumulated and current earnings and profits, the dividend percentage will then be calculated by multiplying the total dividend paid by the total earnings and profits and divided by the total dividend paid. The remaining portion of the dividend will be considered as the nontaxable return of capital. On the other hand, if the company does not earn profits in the current year and there is a deficit, dividends can still be paid from the accumulated earnings and profits (Johnson 497).
Moreover, if current earnings and profits are negative, it will be netted with accumulated earnings and profits to determine whether the distribution is a taxable dividend or return of capital. In the given case, the company paid out the dividends total of $30,000,000. The net earnings and profits of the company at the year-end were -$2.5 billion ($2.5 billion - $5 billion). Hence, the dividend payment is in excess of earnings and profits due to which it shall be treated as the return of capital to the extent of stock basis.
Works Cited
“26 U.S. Code § 165 - Losses." 2016. Web. 8 June 2016 <https://www.law.cornell.edu/uscode/text/26/165>.
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McHoney, Douglas L. and J. Michael Cornett. Applying Recent Code Section 165(g)(3) Guidance in an International Context. December 2007. Web. 8 June 2016 <http://tax.cchgroup.com/images/FOT/ITJ_33-06_McHoney-Cornett.pdf>.
Nitti, Tony. Determining the Taxability of S Corporation Distributions: Part I. 31 December 2013. 8 June 2016 <Determining the Taxability of S Corporation Distributions: Part I - See more at: http://www.thetaxadviser.com/issues/2014/jan/nitti-jan2014.html#sthash.OMZKL9jF.dpuf>.
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"Publication 542." March 2012. IRS. 8 June 2016 <https://www.irs.gov/pub/irs-pdf/p542.pdf>.
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