Contents
- The classical system: why double tax drives behavior
- Sections 301 & 316: the statutory waterfall
- E&P: the dividend gatekeeper (and the nimble dividend rule)
- Shareholder rates: QDI vs ordinary + NIIT
- Stock redemptions: exchange treatment tests (302) + attribution (318)
- Timing strategies: dividends, comp, rent, and stock dividends
- Constructive dividends: common recharacterizations
- Anti-avoidance: AET and PHC tax
- Liquidation rules: 331/336 and subsidiary 332
- Compliance: 1099-DIV, 5452, 8937
1) The classical system: the “double layer” is the whole game
C Corps are separate taxpayers. Earnings are taxed once at the entity level and again on distribution to shareholders, which creates a planning tension: minimize dividends, or at least manage the character and timing of distributions. :contentReference[oaicite:2]{index=2}
2) Sections 301 and 316: the distribution waterfall
Federal tax law applies a tiered ordering rule to distributions: (1) dividends to the extent of current or accumulated E&P, (2) then return of capital to the extent of stock basis, and (3) then capital gain once basis is exhausted. This means the same cash payment can be tax-free to one shareholder and taxable to another depending on basis—even when everyone gets the same dollar amount. :contentReference[oaicite:3]{index=3}
Why this matters
Corporate law labels don’t control. A payment called a “dividend” can be return of capital if E&P is absent, while a payment labeled “salary” can be recharacterized as a dividend if it’s not truly for services. :contentReference[oaicite:4]{index=4}
3) E&P: the dividend gatekeeper (and the nimble dividend rule)
E&P measures a corporation’s capacity to pay dividends without eroding contributed capital. It is not the same as taxable income and not the same as GAAP retained earnings; it requires adjustments (including depreciation differences and treatment of tax-exempt items). The “nimble dividend” rule allows dividends out of current-year E&P even if accumulated E&P is negative—so prior losses don’t necessarily make distributions tax-free. :contentReference[oaicite:5]{index=5}
Common E&P trap: accelerated depreciation
Tax depreciation can exceed E&P depreciation (ADS/straight-line adjustments), meaning you may show low taxable income but still have E&P that turns distributions into taxable dividends. :contentReference[oaicite:6]{index=6}
Allocation ordering
Current E&P is allocated pro rata across distributions during the year; accumulated E&P is applied chronologically after current E&P is exhausted—details that matter when distributions are uneven. :contentReference[oaicite:7]{index=7}
4) Shareholder rates: qualified dividends, holding periods, and NIIT
Once a distribution is a dividend, the next question is rate: qualified dividends generally receive long-term capital gain rates if holding period and issuer requirements are met. High-income shareholders can also owe the 3.8% Net Investment Income Tax (NIIT), increasing the effective tax rate on dividends. :contentReference[oaicite:8]{index=8}
Quiet pitfall: hedging can break qualified status
If a shareholder reduces risk of loss (certain options/short sales), holding period can be suspended, converting what would have been qualified dividends into ordinary dividends. :contentReference[oaicite:9]{index=9}
5) Stock redemptions: the sale vs dividend battleground
Redemptions can produce capital gain treatment (basis recovery) if they qualify under Section 302(b). If they fail, proceeds are treated as dividends to the extent of E&P—often a much worse outcome. The key safe harbors include substantially disproportionate redemptions and complete termination of interest, but family/entity attribution rules under Section 318 can cause “unexpected ownership” that ruins eligibility. :contentReference[oaicite:10]{index=10}
Complete termination + family waiver
A full exit can still fail if family attribution applies—unless the shareholder meets the waiver conditions (no continuing interest other than as a creditor and a 10-year agreement). Consulting arrangements can be fatal. :contentReference[oaicite:11]{index=11}
Deal structuring insight: “Zenz” pattern
In some M&A contexts, a redemption paired with a stock sale can effectively convert cash extraction into exchange treatment— if the steps are structured so the redemption is tested after the sale. :contentReference[oaicite:12]{index=12}
6) Timing strategies: dividends, compensation, rent, and stock dividends
Because dividends are nondeductible, closely held C Corps frequently prefer deductible value transfers (reasonable wages, rent, benefits). But the report emphasizes the IRS’ recharacterization tools and the importance of aligning substance with form. It also outlines how stock dividends are often non-taxable under Section 305—unless exceptions apply (cash election, disproportionate distributions, preferred stock rules, or deemed distributions via conversion feature changes). :contentReference[oaicite:13]{index=13}
7) Constructive dividends: where audits are won or lost
Constructive dividends commonly arise from corporate payment of personal expenses, bargain sales to shareholders, “loans” with no real debt terms, and excessive compensation or rent. The theme is consistent: poor documentation converts an intended deduction into a nondeductible dividend. :contentReference[oaicite:14]{index=14}
8) Anti-avoidance: Accumulated Earnings Tax and PHC tax
The Code penalizes corporations that retain earnings beyond reasonable business needs to avoid shareholder tax. The report explains how AET risk is evaluated (including working capital analyses like the Bardahl approach) and why boards should document specific, definite, and feasible business plans supporting retention. Separate penalty regimes can apply to personal holding companies with passive-income characteristics. :contentReference[oaicite:15]{index=15}
9) Liquidation: the final distribution has its own rules
Liquidating distributions are generally treated as a stock sale to the shareholder (Section 331), allowing basis recovery and capital gain/loss. But the corporation also recognizes gain/loss as if it sold distributed property at FMV (Section 336), creating a corporate-level toll charge. Subsidiary liquidations into an 80% parent can qualify for nonrecognition (Section 332), with carryover basis rules. :contentReference[oaicite:16]{index=16}
10) Compliance: reporting is how you prove character
Shareholders generally see dividends on Form 1099-DIV (including the qualified portion). Corporations making nondividend distributions may need Form 5452 to substantiate that distributions exceeded E&P. If an action affects basis (splits, certain distributions, reorganizations), Form 8937 may be required. :contentReference[oaicite:17]{index=17}
Bottom line
If you only remember one thing: dividends are an E&P concept. Track E&P and stock basis like financial controls, not “tax return artifacts.” Then, if you need exchange treatment (capital gains), use Section 302 safe harbors and attribution analysis up front—because fixing a failed redemption later is usually impossible without a new taxable transaction. :contentReference[oaicite:18]{index=18}