C and S Corporations for Estate Planners: Stock Dividends

A brief overview of a complex topic

Table of Contents

1. Intro

2. IRC Section 305, in a Nutshell

3. Example 1

4. Example 2

5. Example 3

6. Example 4

7. Stock Basis, and Valuation

8. S Corporation Treatment

9. Conclusion

Intro

There has been a bit of a lull in the series on C and S corporations for estate planners, as the lowest-hanging fruit is exhausted leaving several tax principles that come with numerous exceptions and rabbit holes. It is difficult to balance mastery of the tax principles of C and S corporations with the knowledge needed to be a better issue-spotter and idea person as an estate planner.

That being said, we are now trending into two important areas:

• One, the issuance of corporate stock in exchange for a capital contribution; and

• Two, the issuance of corporate stock not in exchange for a capital contribution but instead as a stock dividend.

The first subject - issuance of corporate stock for a capital contribution - is covered by IRC Section 351, and often forms the starting point to discuss corporate taxation. But, in estate planning, you are rarely brought in to counsel on corporate formations. There are some issues that are important in corporate formation (such as the investment company rules) that we will later discuss, but many estate planning situations will involve the transfer of stock between existing shareholders. Likewise, there are situations where a transaction involves (as an alternative) the issuance of new shares to an existing shareholder, sometimes in exchange for old shares and other times in exchange for nothing.

This is where the next sequential Code provision in our coverage - IRC Section 305 - comes into play (after coverage of IRC Section 304 in a prior article).

IRC Section 305, in a Nutshell

Typically, when a corporation distributes cash or property to an existing shareholder, the taxation is covered by IRC Section 301. Such a distribution usually is taxed as ordinary income to the shareholder, to the extent of C corporation earnings & profits (E&P) or, in the case of an S corporation, to the extent of the greater of shareholder basis or the accumulated adjustments account (AAA). Likewise, the distribution of appreciated property is treated as a deemed sale under IRC Section 311(b). In such a case, the amount of the distribution to the shareholder is treated as the fair market value of the property for purposes of IRC Section 301.

However, we find a unique carve-out in IRC Section 311(a)(1) - noting a general rule that no gain or loss is recognized to a corporation on distribution of its own stock, or rights to acquire its stock. This is where IRC Section 305 comes in.

Generally, IRC Section 305(a) provides that a shareholder does not have to include in gross income the value of any stock distributed to such shareholder. But, as with any situation, there are exceptions surrounding situations where this right can be abused.

To aid our discussion, let’s explore some examples. We will not dive into the special provisions of IRC Section 305 dealing with preferred stock, but we will explore some of the situations that often fly under the radar.