Taxation of Dividend

[Harvey Lucas]

Widow is 100% shareholder in a CCorp.

She aquired her stock when her spouse died last year.

They lived in a community property state and we have determined that her basis in the stock/corporation is $80,000.

The Corporation has $80,000 cash in a bank account.

The corporation is/was a mortgage broker and has many appointments/affiliations with lenders.

Widows son, who is also in the mortgage business, would like to keep those appointments/affiliations in place as it would be time consuming and dificult to liquidate the existing corporation and reaffiliate a new corporation with all the lenders.

Because of this I am thinking that we should do a stock sale. The widow would sell 100% of her stock in the corporation to the son.

The corporation is on a fiscal year that ends 6-30-07.
The corporation has E&P of $9000.

I am thinking that the corporation would declare a dividend on 6-20-07 for $80,000 that would leave the corporation with zero cash.

The widow would include $9000 of the dividend as Taxable Qualified Dividends because such dividends are taxable to the extent of E&P.

The balance of the $80,000 dividend, ie, $71,000 would be a tax free return of basis and would not be taxable.

The corporation at that point has no saleable value on the open market.

It has only minimal value to the son since if he aquired it he would not have to go thru a lengthy reaffiliation process with all the lender suppliers.

We would have the widow sell 100% of her stock to the son on 7-1-07 for the nominal sum of $1000.

The widow would report this sale her 2007 1040.

The $9000 taxable dividend she recieved above does not reduce her basis since basis was established as fmv at the time of death and the only reduction since then was the $71,000 tax free portion of the $80,000 dividend.

Thus her remaining basis for purposes of the stock sale is $9000.

She will report the $1000 sale on her 2007 1040, along with her $9000 basis and will report a $8000 long term capital loss from the stock sale transaction.

I do not do a lot of work with C corps and so I wanted to run this all by the wisdom of this board.

Does anyone see any problems/issues regarding how I intend to handle this?

Thank you in advance for your time in considering this.

Sincerely,

Harvey Lucas

[Jiggers]

Dividend

Harvey,
You are mixing apples and oranges.

The $80,000 basis of the stock is her outside basis. This is the stepped-up basis of her stock on the death of her husband.

If she sells the stock, and the stock only, for $80,000 to her son, and the cash MUST come from her son and not the corporation, she would have zero gain.

If the cash comes from the corporation as dividends from the retained earnings of the corporation, she will have $80,000 of dividend income.

If the cash comes from the corporation as purchase of her stock, and the corporation will have "Treasury Stock" now on the books, she would have zero gain. But, who would own the stock of the corporation? Itself? Her son wouldn't own the stock.

[Maribeth]

How about the son purchases $1000 of stock from the corporation. The corporation then buys back the mother's stock for $80,000. That would leave the mother with no taxable gain and the son would now own 100% of the outstanding stock.

Maribeth

[Harvey Lucas]

Apples and Oranges?

Thank you Jiggers, but with all due respect, I'm pretty sure my apples and oranges are in seperate baskets.

Correct me if I am wrong but I think the "outside/inside basis" approach applies mostly to flow thru entities like partnerships and S-Corps and not C-Corps. I am dealing with a C-Corp

Lets focus for a moment only on the first part of the illustration, ie, the taxation of my proposed $80,000 dividend distribution from the corporation to the widow 100% shareholder.

As I state earlier, the E&P of the corporation is $9000.
However, the corporation has $80,000 of cash sitting in its bank account.
I want to declare a dividend and distribute the entire $80,000.

TaxBook page 18-12, Distributions to shareholders, Cash Distributions says "a dividend is taxable to the shareholder up to the E&P of the corporation. Distributions in excess of E&P are considered a return of capital and are not taxable up to the shareholders basis in stock. Distributions in excess of stock basis are capital gain to the shareholder"

The "OtherBook" says the same thing, page C-8, Dividends and Return of Capital.

Her basis in the stock has been established at $80,000, which was the FMV of the corporation on the date of death of her spouse, ie, the corporation was worth the value of the cash that it had in the bank. It had $80,000 then and it has $80,000 now.

According to the TaxBook reference above, a distribution of the $9000 E&P does not reduce her basis, however, the distribution of the $71,000 extra amount does. Accordingly, after the $80,000 distribution her basis in her stock is $9000. Right?

I report the $9000 E&P distribution on her 2007 1040 as a qualified dividend. Right?

I report the $71,000 return of basis on her 2007 1040 schedule D and indicate a cost basis of $71,000 indicating that it is a tax free return of basis. Right?

I have the corporation file a "Form 5452" to indicate the taxable and nontaxable portion of the $80,000 dividend. Right?


Harvey Lucas

[cpaprincess]

That seems like an awful lot of hoop-jumping, and the widow still has to pay tax on the $9000 dividends.

I like Maribeth's suggestion that the son purchase stock in the company; however, there would need to be additional shares available to be issued to the son (example 1000 shares authorized upon incorporation, only 500 shares issued). If this is not the case, the corporation can always go through the legal process to provide for more shares to be issued. But then again, this might cost too much to do. I would definitely talk to an attorney about what options are available. But the cost of the attorney may be just about the same as the amount of tax the widow pays on the $9000 in dividends (or more!)

[Corduroy Frog]

Legal Process

Surely, there is no legal maneuvering if the corporation has authorized (but not outstanding) shares it can sell or issue to the son. It seems like a corporate resolution would be all that would be necessary. Of course, this may not be true in all states.

Unsure of what has to happen if there no available authorized shares, and this may also vary from state to state. A good argument for not issuing all the shares upon incorporation.

[Harvey Lucas]

$1000 Stock Purchase (before dividend) Smells Fishy

Thank you all for your input.

I am still leaning in favor of my initial approach, ie, declare and pay a $80,000 dividend to mom.

I would not feel comfortable suggesting that the son buy $1000 of stock from the corporation when it is sitting on $80,000 in the bank and then he magically becomes the 100% owner of the corporation by way of a stock redemption of moms stock.

My gut says that IRS would argue that the son bought the stock for less than FMV and that we were simply trying to avoid tax on a dividend..

It seems like the right thing to do is declare and pay the dividend. The tax on the $9000 taxable portion is not that signifigant. Especially since later when she sells the now broke corporation for $1000 she will enjoy a small capital loss that will partially offset tax on the $9000 taxable dividend.

Also, this approach seems to offer the least hoop jumping of the other options, ie, we declare and pay the dividend by simply drafting some minutes and writing mom a check.

Next, son writes a check to mom for $1000 to buy 100% of the stock in the Corporation. I will suggest they should have a stock purchase and sale agreement but they could probably draft a simple agreement for this themselves.

Seems straight forward to me...unless I am overlooking something?

Thank you,

Harvey Lucas

[Harvey Lucas]

Oops..correction!

[QUOTE=Harvey Lucas;39671
It seems like the right thing to do is declare and pay the dividend. The tax on the $9000 taxable portion is not that signifigant. Especially since later when she sells the now broke corporation for $1000 she will enjoy a small capital loss that will partially offset tax on the $9000 taxable dividend.
[/QUOTE]

I overlooked the fact that the related party rules bar a loss deduction on the sale of the stock from mother to son.

Also, as I have researched further I see that the reporting requirements on the 5452 form appear quite comprehensive. Apparently when you declare a dividend to be wholly or partially non-taxable IRS wants you to prove it. This seems to be an invite for further IRS inquiry? (Does anyone have any hands on experience with the filing of a 5452 and the aftermath of such a filing?)

With these considerations I am now considering a diferent appraoch, ie, simply disolve the corporation.

If I disolve the corporation, the widow will receive a liquidation dividend of $80,000. And, since her basis in the corporation is $80,000, the entire distribution would be tax free.

The corporation will issue her a 1099-DIV indicating that the $80,000 is a liquidation dividend.

She will report the transaction on her 2007 sch D as $80,000 sale, $80,000 cost and zero gain.

This approach seems more straight forward and less likely to draw challenge or inquiry from IRS.

The only downside is that the son will have to form a new entity and reaffiliate with all the suppliers.

Comments?

Thank You
Harvey Lucas