Under the double-tax regime of sub chapter C,

gains from the sale of appreciated property are taxed twice.

First, at the corporate level when property is sold,

and again at the shareholder level when the proceeds are distributed as dividends.

What if instead of selling appreciated property,

a corporation distributes appreciated property directly to shareholders?

The rules you have learned about so far indicate that shareholders receive

a dividend to the extent of the corporation's current and accumulated ENP.

What about the corporation?

Does it assume the property was sold at

fair market value and recognized the built-in gain?

Is the corporation entitled to non-recognition since the distribution did not

result in any economic wherewithal to pay tax on the built-in gain?

What about built-in lost property?

Believe it or not, these are among some of

the most controversial questions ever created by sub chapter C. In this lesson,

you will examine the tax implications of

property distributions for the shareholder and the corporation.

However, because this is a controversial issue,

you will first consider how the rise and fall of

a famous Supreme Court opinion shaped existing laws.

You will then apply the new concepts to Sunchaser Shakery.

To fully understand the tax rules regarding property distributions,

it is important to start at the beginning.

General Utilities & Operating Company v. Helvering (1935).

This case was the first time the US Supreme Court considered

the corporate level tax effects of

a non liquidating distribution of appreciated property.

Although I will briefly explain the case,

I recommend that you read it on your own as well.

General Utilities hoped to sell property with an adjusted basis of

$2,000 to an unrelated entity for $1 million.

However, to avoid the $998,000 gain that would result,

it instead distributed the property to its shareholders

with an understanding that they would sell the property.

Days later, the shareholders did just that.

Not surprisingly, the IRS contended that

the distribution was a taxable event for the corporation.

More specifically, the IRS claimed

the corporation created an indebtedness to its shareholders by

declaring a dividend and use of

appreciated property to discharge that indebtedness was thus a taxable event.

Focusing almost exclusively on this argument,

the Supreme Court held that the corporation should not recognize a gain because

the distribution was not a sell and the corporation did

not discharge indebtedness with appreciated assets.

Despite the narrow focus of the decision,

many courts and practitioners interpreted it as implying that

a distributing corporation does not recognize a gain or

loss when making a property distribution with respect to its stock.

The General Utilities decision directly threatened the double-tax regime

by creating a tax law distinction between a distribution of

appreciated property and the sale of that same property by

the corporation followed by a distribution of the proceeds to shareholders.

In the case of a sale at the corporate level,

the corporation recognizes a gain and correspondingly increases ENP.

On the distribution of the sale proceeds,

the shareholders receive taxable dividends to the extent of corporate ENP.

Under the General Utilities doctrine however,

the corporation could distribute the same asset

to shareholders without recognizing any gain.

Although the shareholders would be taxed on the distribution,

the appreciated asset avoids the corporate level tax and

non-corporate shareholders receive a fair market value basis in the asset.

As you might expect, the General Utilities decision received heavy criticism.

Despite the criticism, Congress codified

the General Utilities decision and the Internal Revenue Code of 1954.

More specifically, it enacted Section 311(a)2 which stipulates that as a general rule,

a corporation recognizes no gain or loss on the non liquidating distribution of property.

Despite codification, the courts frequently applied common law doctrines such as

substance over form to override the statute and attribute income to the corporation.

Congress itself also chipped away at the rule by adding various exceptions over time.

Finally in 1986, Congress repealed the General Utilities rule in

the context of both non-liquidating and

liquidating distributions of appreciated property.

In other words, the non-recognition rule that stems from

the General Utilities decision remains in effect,

but for non-liquidating distributions of appreciated Property,

section 311 (b) takes over.

Specifically this section provides that if a corporation distributes

appreciated property other than its own obligations and a non liquidating distribution,

it must recognize gain in an amount equal to the excess of

the fair market value of the property over its adjusted basis.

If the property is subject to a liability or if

the shareholder assumes a liability in connection with the distribution,

the fair market value of the distributed property is

treated as not less than the amount of the liability.

In other words, if the liability is greater than the fair market value,

the liability amount becomes a fair market value for purposes of computing gain or loss.

Notice that the General Utilities rule still applies to disallow recognition

of loss on the distribution of property that has declined in value.

The non-liquidating distribution of property

has several effects on the corporation's ENP.

Gain recognized by the corporation on the distribution

of property increases current ENP while

the distribution itself reduces accumulated

ENP by the adjusted basis of the distributive property.

However this rule is modified by Section 312(b)(2) for appreciated property other than

a corporation's own debt obligations which

provides a fair market value is substituted for a adjusted basis.

The purpose of this modification is to allow the distribution of appreciated property

to reduce accumulated ENP in an amount equal to the fair market value.

The net result of these two adjustments is the same as if the corporation had sold

the property and then distributed cash equal to the fair market value of the property.

In other words, the corporation would have increased current ENP by the gain

recognized and then decreased accumulated ENP by the same amount.

Section 312 (c) also requires an adjustment for

any liabilities assumed by the shareholder or to which the property is subject.

The adjustment reduces the amount charged to ENP and reflects

that relief from liability is an economic benefit to the distributing corporation.

This slide summarizes all the affirmation effects for the distributing corporation.

It will be helpful to review these concepts at the end of the lesson.

The rules thus far have focused on the distributing corporation.

The rules governing the effects for shareholders are

basically the same as those for cash distributions.

That is the amount of the distribution is

the fair market value of the distributed property

reduced by any liabilities assumed by

the shareholder or to which the property is subject.

The shareholders basis and the distributed property is

its fair market value as of the date of the distribution.

Lesson 5.3.1 Property Distributions: Concepts

Taxation of Business Entities I: Corporations

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