Dividend Distribution Alternatives

Generally
Many options exist for making dividend distributions from a corporation. For example, the
corporation can distribute (1) cash, (2) appreciated (or depreciated) property, (3) debt
instruments issued by the corporation, (4) its own stock (including both common and preferred
stock), and (5) rights to acquire either property held by the corporation or stock of the
corporation.

Cash
Most corporate dividends are cash distributions made directly to the shareholders or to their
agents (e.g., into their bank accounts or brokerage accounts). A check (or more often, a direct
deposit) is received by the shareholder either (1) from a dividend disbursing agent (often acting
for a publicly listed corporation) or (2) directly from the corporation. The payment is presumed
to be sourced from the E&P of the corporation, thereby constituting an ordinary dividend for
federal income tax purposes.

Certain variations can occur in the context of cash distributions, however. For example, the
corporation may wish to complete the distribution for the benefit of the shareholders, but may
wish the cash amount to be held by one central agent (e.g., a trustee), pending the resolution of
some controversy with which the corporation is involved. Alternatively, the cash dividend might
be maintained by one recipient as an agent for the shareholders to enable all the shareholders,
acting together, to invest these proceeds in a new investment outside the ambit of the
corporation. In this situation, the dividend could be paid to a trustee (or other agent) delegated
to act as an agent on behalf of all shareholders.

To preserve cash (and for other reasons), a corporation may allow its shareholders (on an
individual, elective basis) to receive the dividend in the form of additional shares of the
corporation rather than cash. This is known as a dividend reinvestment plan. Under such a plan,
the shareholder can often avoid brokerage commissions and related transaction costs with
respect to the acquisition of these shares.

Property
A corporation may distribute property (other than cash) as a dividend to shareholders. This
property could consist of (1) the stock of a publicly traded corporation, (2) debt instruments of
other obligors, (3) various types of intangible property, and (4) real estate. In a closely held
corporation situation, this property might be easily divided and distributed to shareholders as
tenants in common. When a larger shareholder group exists, this property might be distributed
to an agent, to be held proportionately for all the shareholders and thereafter to be managed as
a trust or a partnership for the shareholders.

Promissory Notes
To conserve its cash (and for other reasons), the corporation may distribute its own promissory
notes to its shareholders. This distribution will be treated as a dividend to the extent of the fair
market value of the notes (assuming adequate corporate E&P). The corporation will reduce its

1
E&P by the fair market amount of the notes distribution even though no cash or other property
has been distributed.

Stock
A corporation can distribute its own stock of the same class as that already held by the
shareholders. This distribution preserves cash for the corporation because it is merely
distributing share certificates representing ownership in the corporation.

In a pro rata distribution, the receipt of these shares will not be taxable to the shareholders. In a
variety of other situations (involving the applicability of the various exceptions to nontaxable
treatment as prescribed in IRC 305(b) ), however, dividend treatment will occur when the
distribution produces ownership disproportionality after the distribution.

Dividend Distributions Must Be Sourced From E&P

A dividend distribution must come from a corporation's E&P (as defined for federal income tax
purposes). E&P are determined by reference to the corporation's taxable income (for federal
income tax purposes), with various modifications being made to this amount. These adjustments
are necessary to conform the dividend amount to the cash (and other property) that is actually
available for distribution to the shareholders as corporate profits.

Under a nimble dividend rule, E&P can be determined by reference to either (1) the current
year's E&P (without regard to any accumulated deficits in prior years) or (2) accumulated E&P. If
current earnings do not exist, the categorization of the distribution as being a dividend will be
made by reference to accumulated (or historical) E&P.

Notwithstanding the requirement that a dividend distribution must come from a corporation's
E&P, an individual shareholder will want, if possible, the distribution not to be sourced from E&P,
because then the individual would be treated as receiving (1) a return of invested capital, to the
extent of the shareholder's tax basis for the shares held, and (2) thereafter, capital gain. See
IRC 301(c)(2) , 301(c)(3) . This is particularly significant during periods when the tax rate for
capital gains distributions is substantially lower than the tax rate imposed on dividends received
by individuals. However, if the shareholder is another corporation, the recipient ordinarily will
want the distribution to be sourced from the distributing corporation's E&P, thereby allowing the
recipient to take advantage of the dividends received deduction.

Capital Gains Tax Rate

For individuals the tax rate applicable to dividends is the same as that applicable to capital gains,
but for corporations the tax rate is the same as that applicable to a corporation's ordinary
income. As enacted in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA ),
qualified dividend income received by an individual from domestic corporations is taxed at the
same rates as those that apply to net capital gain. See IRC 1(h)(11) . Thus, these dividends
are taxed at the rate of 15 percent (and, in some situations, at a lower 5 percent rate). The term
qualified dividend income means dividends received during the taxable year from (1) a
domestic corporation and (2) qualified foreign corporations. IRC 1(h)(11)(B)(i) .

Distributions of Property

Taxation to Distributor Corporation

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The distribution of appreciated property (i.e., other than U.S. dollars) by a corporation will
ordinarily trigger the requirement that it recognize gain (assuming appreciation) to the extent of
the difference between (1) its tax basis for the distributed asset and (2) the asset's fair market
value. This gain will, in turn, be added to the corporation's E&P. The dividend distribution of
depreciated property by a corporation will not enable it to recognize any accrued loss for federal
income tax purposes. The E&P of the corporation will be debited by the fair market value of the
distributed property, that amount being the dividend received by the shareholder.

Taxation to Distributee Shareholder

The receipt of appreciated property will constitute a dividend to the shareholder in an amount
equivalent to the fair market value of the property (assuming adequate E&P). The shareholder
will then take a fair market value basis in the received property.

The receipt of depreciated property will also constitute a dividend to the shareholder to the
extent of the fair market value of the property (assuming adequate E&P). The shareholder will
take a fair market value basis for the depreciated property. This means that the differential
between the higher tax basis to the corporation and the lower fair market value will be lost as a
deduction to both the corporation and the shareholder. For this reason, the corporation should
ordinarily sell the depreciated property first, thereby realizing a loss for tax purposes, and then
distribute the proceeds. Only in unique situations, for example, where the corporation may want
the property to be maintained within a small shareholder group, might the decision be made to
forgo the availability of this loss deduction.

Distributions of Encumbered Property

A corporation may distribute property encumbered by debt to shareholders as a dividend (again
assuming adequate E&P). The reduction to the corporation's E&P will be for an amount
equivalent to the net value of the property distributed. This will also be the amount of the
dividend received by the shareholder. However, the shareholder's tax basis in the property
received will include the amount of the debt (similar to the inclusion in tax basis of other
purchase money debt).

Cash Dividends

Generally
Corporations usually pay dividends in the form of cash and, for U.S. taxpayers, the cash is
usually in U.S. dollars. The distribution is ordinarily made by check, which is sent to the
shareholders, drawn on the corporation's bank account or through electronic funds transfers, and
credited to the shareholder's account, including when the shares (often of a publicly traded
corporation) are held in street name in a brokerage or similar account. Of course, the cash could
also be in the form of Euros, U.K. pounds, or some other foreign currency.

Corporate Declaration of Cash Dividend

For a corporation to be eligible to declare a dividend, it must comply with applicable state
corporation laws. This necessitates that the payment be made from permitted corporate
resources, as identified in the provisions of the locally applicable state business corporation act.
One important objective of this limitation is to preclude disbursements being made from the
corporation to the detriment of corporation's creditors.

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The ABA Section of Business Law's Model Business Corporation Act (as revised through June
2005), 6.40(a), provides that a board of directors may authorize, and the corporation may
make, distributions to its shareholders subject to any restriction by the articles of incorporation
and the limitation in 6.40(c) of that Act. A distribution is defined (in Act 1.40) as a direct or
indirect transfer of money or other property (except its own shares) or incurrence of
indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its
shares. A distribution may be in the form of a declaration or payment of a dividend; a purchase,
redemption, or other acquisition of shares; a distribution of indebtedness; or otherwise.

Section 6.40(c) of this Act provides that no distribution may be made if, after giving it effect, (1)
the corporation would not be able to pay its debts as they become due in the usual course of
business or (2) the corporation's total assets would be less than the sum of its total liabilities,
plus (unless the articles of incorporation permit otherwise) the amount that would be needed, if
the corporation were to be dissolved at the time of the distribution, to satisfy the preferential
rights upon dissolution of those shareholders whose preferential rights are superior to those
receiving the distribution. Section 6.40(d) of the Act specifies that a corporation's board of
directors may base a determination that a distribution is not prohibited either (1) on financial
statements prepared on the basis of accounting practices and principles that are reasonable
under the circumstances or (2) on a fair valuation or other method that is reasonable under the
circumstances. Section 8.33 of the Act provides that a director who votes for or assents to a
distribution in excess of what may be authorized and made pursuant to Act 6.40(a) is
personally liable to the corporation for the amount of the distribution that exceeds what could
have been distributed without violating Act 6.40(a), if the party asserting liability establishes
that, when taking the action, the director did not comply with Act 8.30 (relating to standards of
conduct for directors).

Individuals Taxed at Capital Gains Tax Rate

Applicable Income Tax Rate

The dividends received by individuals are taxed at the capital gains rate, but the dividends
received by corporations are taxed at the same rate applicable to a corporation's ordinary
income. As enacted in JGTRRA , qualified dividend income received by an individual from
domestic corporations is taxed at the same rates that apply to net capital gain. See IRC
1(h)(11) . Thus, qualified dividends are taxed at the maximum rate of 15 percent (and, in

Defining Qualified Dividend Income

The term qualified dividend income means dividends received during the taxable year from (1)
domestic corporations and (2) qualified foreign corporations. IRC 1(h)(11)(B)(i) . A qualified
foreign corporation is any foreign corporation (1) incorporated in a U.S. possession or (2) eligible
for the benefits of a comprehensive income tax treaty with the United States that the Secretary
determines is satisfactory for this purpose and that includes an exchange of information
provision. IRC 1(h)(11)(C)(i) . In Notice 2006-101, 2006-47 IRB 930 , which supersedes
Notice 2003-69, 2003-2 CB 851 , the IRS lists treaties that meet the requirements of this
provision and treaties that do not meet the requirements of IRC 1(h)(11)(C)(i)(II) . The tax
treaties with Bermuda and the Netherlands Antilles are not comprehensive income tax treaties
under IRC 1(h)(11) . The U.S.-U.S.S.R. income tax treaty, which was signed on June 20, 1973,
and currently applies to certain former Soviet Republics, does not include an information
exchange program.

The Treasury and the IRS intend to update this list as needed. Situations that may result in
changes to the list include the entry into force of new income tax treaties and the amendment or

4
renegotiation of existing tax treaties. Furthermore, the Treasury and the IRS continue to study
the operation of each U.S. income tax treaty, including the implications of any change in the
domestic laws of the treaty partner, to ensure that the treaty accomplishes its intended
objectives and continues to be satisfactory for purposes of IRC 1(h)(11)(C)(i) . It is anticipated
that any change to the list of income tax treaties that meets the requirements of IRC
1(h)(11)(C)(i)(II) will apply only to dividends paid after the date of publication of the revised
list.

Defining Qualified Foreign Corporation

A foreign corporation not otherwise treated as a qualified foreign corporation shall be so
treated with respect to any dividend paid by that corporation if the stock with respect to which
such dividend is paid is readily tradable on an established securities market in the United
States. In Notice 2003-71, 2003-2 CB 922 , the IRS identified stock that is considered readily
tradable on an established U.S. securities market for purposes of IRC 1(h)(11)(C)(ii) .
Common or ordinary stock, or an American depositary receipt in respect of such stock, is
considered readily tradable on an established U.S. securities market if it is listed on a national
securities exchange that is registered under 6 of the Securities Exchange Act of 1934 (15 USC
78f) or on the Nasdaq Stock Market. As stated in the Security and Exchange Commission's
(SEC's) Annual Report for 2002, registered national exchanges as of September 30, 2002,
include the following:

1. The American Stock Exchange;

2. The Boston Stock Exchange;
3. The Cincinnati Stock Exchange;
4. The Chicago Stock Exchange;
5. The New York Stock Exchange;
6. The Philadelphia Stock Exchange; and
7. The Pacific Exchange, Inc.

Notice 2003-71 indicated that the Treasury and the IRS are considering the future treatment of
dividends with respect to stock listed on the OTC Bulletin Board and on the electronic pink
sheets. Specifically, the Treasury and the IRS are considering whether and to what extent stock
listed on the OTC Bulletin Board and on the electronic pink sheets should be conditioned on the
satisfaction of parameters regarding the following:

1. Minimum trading volume;

2. Minimum number of market makers;
3. Maintenance and publication of historical trade or quotation data;
4. Issuer reporting requirements under SEC or exchange rules; or
5. Issuer disclosure or determinations regarding passive foreign investment
company (PFIC), foreign investment company (FIC), or foreign personal holding
company (FPHC) status.

Notice 2003-79, 2003-2 CB 1206 , 5 , states that the IRS intends to issue regulations, for
years after 2003, that provide procedures for a foreign corporation to certify that it is a qualified
foreign corporation for purposes of IRC 1(h)(11)(C) . Temporary rules provided in Notice 2003-
79 were subsequently extended by Notice 2004-71, 2004-2 CB 793 , and by Notice 2006-3,
2006-1 CB 306 . The regulations are also to provide the following:

1. Procedures for certifying that a security that is not a common or ordinary share
is equity rather than debt;

5
 2. That a foreign company is entitled to benefits under a comprehensive income
tax treaty where a security is not readily tradable on a recognized U.S. stock
exchange;
3. That the foreign corporation is not a PFIC in the taxable year in which a
dividend is paid, or in the preceding taxable year; and
4. The meaning of the requirement in the legislative history that to qualify under
a treaty for purposes of IRC 1(h)(11) substantially all of [the foreign
corporation's] income in the taxable year in which the dividend is paid must
qualify for treaty benefits.

Notice 2004-70, 2004-2 CB 724 , provides guidance regarding the extent to which distributions,
inclusions, and other amounts received by, or included in the income of, individual shareholders
as ordinary income from foreign corporations subject to certain antideferral regimes may be
treated as qualified dividend income for purposes of IRC 1(h)(11) . This notice stipulates that
distributions of previously nontaxed E&P from a controlled foreign corporation (CFC) to an
individual are qualified dividend income and, therefore, are eligible for the reduced tax rates
applicable to certain capital gains under IRC 1(h)(1) , provided the CFC is a qualified foreign
corporation. This notice also provides that IRC 951(a)(1) inclusions from a CFC and deemed or
actual distributions from an FPHC (now repealed), an FIC (also now repealed), or a PFIC are not
qualified dividend income under IRC 1(h)(11)(B)(i)(II) and, therefore, are not eligible for the
reduced tax rates applicable to certain capital gains under IRC 1(h)(1) . In addition, this notice
provides that, for purposes of IRC 1(h)(11) , the determination of whether a foreign
corporation is a PFIC is made on a shareholder-by-shareholder basis. Accordingly, distributions of
previously nontaxed E&P received by an individual from a CFC that would be a PFIC with respect
to that individual but for the application of IRC 1297(e) are qualified dividend income if the
CFC is a qualified foreign corporation.

Notice 2006-3, 2006-1 CB 306 (a sequel to Notice 2003-79 and Notice 2004-71 ) deals with
information reporting regarding distributions of securities issued by foreign corporations. In
Notice 2006-3 , the IRS extended the simplified procedures provided in Notice 2003-79 and
Notice 2004-71 to 2005 and future years. A person filling out IRS Form 1099-DIV, concerning a
distribution with respect to a security issued by a foreign corporation, can report that distribution
as a qualified dividend if the following conditions are satisfied:

1. Either the security with respect to which the distribution is made is a common
or an ordinary share, or a public SEC filing contains a statement that the security
will be, should be, or more likely than not will be treated as equity rather than
debt for U.S. federal income tax purposes; and
2. Either
a. The security is considered readily tradable on an established securities market
in the United States;
b. The foreign corporation is organized in a possession of the United States; or
c. The foreign corporation is organized in a country whose income tax treaty with
the United States is comprehensive, is satisfactory to the Secretary for purposes
of IRC 1(h)(11) , and includes an exchange of information program, and if the
relevant treaty contains a limitation on benefits provision, the corporation's
common or ordinary stock is listed on an exchange covered by that provision's
public trading test, unless the person required to file an information return knows
or has reason to know that the corporation is not eligible for benefits under that
treaty; and
3. The person required to file the IRS Form 1099-DIV does not know or have
reason to know that the foreign corporation is or expects to be, in the taxable
year of the corporation in which the dividend was paid, or was, in the preceding
taxable year, a foreign person holding company (as defined in IRC 552 ), a

6
 foreign investment company (as defined in IRC 1246(b) ), or a passive
foreign investment company (as defined in IRC 1297 ); and
4. The person required to make a return (under IRC 6042 ) determines that the
owner of the distribution has satisfied the holding period requirement (under IRC
1(h)(11) ) or it is impractical for such person to make such determination.

The IRS also indicated that it will exercise its authority under IRC 6724(a) to waive penalties
under IRC 6721 and 6722 with respect to the reporting of payments if persons required to file
IRS Form 1099-DIV make a good faith effort to report payments consistent with the rules
summarized above.

Identifying Dividends and Earnings and Profits

The Federal Income Tax Concept of Dividends

Dividends received from corporations are included in the recipient's gross income for federal
income tax purposes. IRC 61(a)(7) . A corporate distribution is a dividend if made from (1)
E&P accumulated after February 28, 1913, or (2) E&P of the current tax year (i.e., sourced from
E&P derived during that year). IRC 316 . Thus, E&P is relevant at the shareholder level for
determining the federal income tax status of corporate dividends to its shareholders. The
distribution of a dividend is a corporate disbursement made to a shareholder with respect to its
stock. The balance (if any) of any corporate distribution to the shareholders (as shareholders)
that exceeds the allocable E&P is a return of capital (under IRC 301(c)(2) ) and, thereafter,
taxable gain (under IRC 301(c)(3) ).

The concept of a dividend (defined by IRC 316 ) for federal income tax purposes is not
synonymous with the term dividend under applicable state law. Under most business
corporation acts enacted by states, a corporation is not permitted to pay dividends that might
harm creditors of the corporation or otherwise impair the capital of the corporation. See, e.g.,
the ABA Section of Business Law's Model Business Corporation Act (as revised through June
2005), 6.40(c).

IRC 316(a) provides an irrebuttable presumption that, for federal income tax purposes, every
distribution is from E&P to the extent a company has E&P. Furthermore, every distribution is
presumed to come from the most recently accumulated E&P. IRC 316(a)(2) provides that the
E&P for the current year is determined as of the close of the year without reduction by reason of
any distributions during the year. This means that a distribution will be a dividend if the
corporation has E&P at the end of the current tax year, even though it had none earlier in the
year when the distribution actually occurred. Alternatively, a distribution that appeared to be a
dividend when made may ultimately be a return of capital because the corporation has no E&P
at the end of the year or for prior years. Consequently, only to the extent of E&P will the
corporate distribution constitute a dividend for federal tax purposes. IRC 301(c)(1) .

Defining Earnings and Profits

The term earnings and profits is identified in IRC 312 , but it only furnishes limited guidance
as to the scope of the concept of E&P for federal tax purposes. The IRC 312 regulations provide
greater elaboration of the term. In essence, significant adjustments must be made to a
corporation's taxable income amount (as determined for federal income tax purposes) in
determining the E&P account. The fundamental objective is to identify that economic amount
which represents the net profits of the enterprise that can be distributed to the shareholders
without it being a distribution of their contributed capital.

7
To determine E&P, the following adjustments must be made to a corporation's taxable income:

1. Certain items that are excluded from taxable income are included in computing
E&P. For example, proceeds of life insurance excluded under IRC 101 from
gross income for federal income tax purposes and interest on state and local
government obligations excluded under IRC 103 must be included in E&P. These
items constitute positive cash balances (i.e., profits) to the corporation although
not included in gross income for federal income tax purposes.

2. Certain items that are deducted in computing taxable income may not be
deducted in computing E&P. For example, the dividends received from another
corporation must be fully included by the recipient corporation in its E&P without
regard to the dividends received deduction, which is available under IRC 243 in
determining the corporation's taxable income. The dividends received deduction
does not represent a cash cost to the recipient corporation.

3. Timing differences must be considered, both as to deferred income and

accelerated deductions. For example, income from installment sales must be
included in E&P without the benefit of the income tax deferral available under the
IRC 453 installment sales provision. Straight-line depreciation must be used in
computing E&P even though more rapid depreciation or amortization methods are
often available for computing taxable income. In Rev. Proc. 2009-37, 2009-36
IRB 309 , the IRS indicated that regulations are to be issued regarding the
computation of a corporation's earnings and profits with respect to cancellation of
debt (COD) income and original issue discount (OID) deductions that are deferred
under IRC 108(i) . These regulations generally will provide that deferred COD
income increases earnings and profits in the taxable year that it is realized and
not in the taxable year or years that the deferred COD income is includable in
gross income. OID deductions deferred under IRC 108(i) generally will decrease
earnings and profits in the taxable year or years in which the deduction would be
allowed without regard to IRC 108(i) . IRC 108(i) was added to the Code by
1231 of the American Recovery and Reinvestment Tax Act of 2009, Pub. L. No.
111-5, 123 Stat. 338 . In general, IRC 108(i) provides that, at the election of a
taxpayer, COD income realized in connection with a reacquisition after December
31, 2008, and before January 1, 2011, of an applicable debt instrument is
includable in gross income ratably over a five-taxable-year inclusion period,
beginning with the taxpayer's fourth or fifth taxable year following the taxable
year of the reacquisition. Generally, if a taxpayer makes an IRC 108(i) election
and reacquires (or is treated as reacquiring) the applicable debt instrument
generating the COD income for a new debt instrument with OID, then interest
deductions for this OID also are deferred, as provided in IRC 108(i)(2) .

4. Certain items not deducted in computing taxable income can be deducted in

computing E&P. For example, federal income taxes paid are not available for
making distributions to shareholders and, therefore, must reduce E&P. In Rev.
Rul. 2009-25, 2009-38 IRB 365 , the IRS ruled that an interest expense
disallowed under IRC 264(a)(4) reduced earnings and profits for the taxable
year in which that interest would have been allowed as a deduction, but for the
specific disallowance provision. Under this provision, an interest expense
deduction is not allowed for interest paid or accrued on any indebtedness
concerning a life insurance policy.

This process of determining the appropriate amount of E&P can occur well after the year during
which the taxable income was reported. No statute of limitations applies to foreclose an

8
analysis of E&P attributable to prior years, so, theoretically, this analysis could go back to the
beginning of the corporation's existence.

The accounting treatment of a specific item may also control the timing for the inclusion of that
item in earnings and profits. In Priv. Ltr. Rul. 200817029 , the IRS noted that a taxpayer was
permitted (consistent with Rev. Proc. 2004-34, 2004-1 CB 991 ) to recognize as income certain
intellectual property licensing fees over a specified period, rather than in the year of receipt. This
was considered a proper method of accounting and, as such, enabled the deferral of inclusion of
the income items in the earnings and profits account until included in gross income. See also
Priv. Ltr. Rul. 200817029 , which provides a discussion of the tax accounting rules permitting the
inclusion of advance payments in gross income to be postponed until a subsequent year.

Determining the Source of Corporate Distributions

Rev. Proc. 75-17, 1975-1 CB 677 , specifies the requirements for correctly determining the
source of corporate distributions. Taxpayers should analyze their capital stock, paid-in surplus,
and capital surplus accounts. Special computations are required for each year for which a
consolidated return was filed, including an identification of intercompany profits and losses that
were eliminated from consolidated taxable income. Rev. Proc. 75-17 includes exhibits showing
(1) a year-by-year analysis of E&P, (2) a summary of year-by-year differences in surplus and
E&P, and (3) a corporate balance sheet. For modified E&P computations for purposes of the
alternative minimum tax (i.e., to determine adjusted current earnings), see IRC 56(g)(4) .

The IRS periodically refines the definition of earnings and profits through published rulings.
See, e.g., Rev. Rul. 2001-1, 2001-1 CB 726 , where the IRS ruled that, if a corporation transfers
stock upon the exercise of an option that was granted in connection with the performance of
services and to which IRC 421 does not apply (i.e., a nonstatutory stock option), and the
option did not have a readily ascertainable fair market value at the time of grant, the E&P of the
service recipient is reduced by the amount of the deduction allowed to it under IRC 83(h) and
162 by reason of such exercise.

Impact of Corporate Adjustments on E&P

The adjustments to a corporation's E&P are not limited to the inclusion of taxable income, as
adjusted, and a reduction by ordinary dividend distributions. During its history, a corporation
may be involved in various transactions that may impact its E&P, such as:

1. Distributions of property in kind, which may cause gain recognition for the
property that is includable in E&P (less applicable income tax liabilities);
2. Distributions of stock to its shareholders, which might constitute a taxable
dividend necessitating an adjustment of E&P;
3. Distributions in partial liquidation, or in redemption of a portion of its stock,
whether treated as a dividend or as a capital distribution, which will necessitate
adjustments to E&P; or
4. Mergers, consolidations, complete liquidations, spin-offs, and other transactions
where one corporation succeeds to the property and tax attributes of another
corporation, which will necessitate adjustments to E&P.

IRS Reporting Requirements

9
A corporation must annually report to the IRS, on IRS Form 1099-DIV (see Form 9.1(d) ), the
dividends paid to its shareholders. See IRC 6042 . A corporation should make sure it has
sufficient E&P to cause distributions to be treated as dividends for federal income tax purposes.
On IRS Form 1099-DIV separate blocks are provided to identify dividend and nondividend
distributions. A payment must be reported as a dividend if the payor cannot determine whether
it should be classified otherwise.

Constructive Dividends

Identification of Possible Disguised Dividends

Dividend treatment is not applicable to a payment by a corporation to a shareholder unless the
amount is paid to the shareholder in his capacity as such. Reg. 1.301-1(c) . Thus, payments
to shareholders, for services or property received by the corporation from the shareholders, will
not constitute dividends. The objective of such payments, of course, may be to direct the
maximum amount from the corporation into the hands of the shareholders in a form that is
deductible under IRC 162 , or is otherwise available as a deduction to the corporation if it is a
C corporation. Consequently, the IRS closely monitors corporate payments to shareholders to
determine whether they constitute disguised dividends. If the IRS determines a disguised
dividend exists, it will pursue the matter even though no formal dividend has been declared or
other corporate action has been undertaken concerning a dividend distribution.

Usually, constructive dividends apply to closely held corporations. With respect to publicly held
corporations, the officers and directors have fiduciary responsibilities to all of the shareholders
and, under applicable securities laws, must disclose dividend arrangements. Consequently,
publicly held corporations often seek to avoid situations that might lead to IRS or shareholder
challenges of excessive payments to corporate officers. See generally Bittker & Eustice, 8.05 .

The IRS may be less motivated to pursue an apparent constructive dividend if the revenue to be
generated by an audit is limited, such as a situation involving an individual shareholder who
would be treated as receiving a dividend subject to a maximum 15 percent income tax rate,
rather than a maximum 35 percent tax rate if receiving compensation, interest, or rent from a
closely held corporation. Of course, the corporation would not receive a deduction for the
dividend paid, but would ordinarily receive a deduction for the compensation, interest, or rent
paid. In addition, it is less appealing for the government to pursue apparent constructive
dividends at a time when the dividend tax rate to individuals is the same as the capital gains tax
rate. Similarly, if the dividend is deemed paid to another corporation, the availability of the 70
percent (or greater) dividends received deduction to the recipient would significantly reduce the
tax deficiency amount obtainable from the shareholder.

In Priv. Ltr. Rul. 200935009 , the IRS determined that where a parent corporation of a
consolidated return group that sponsors a stock-based compensation plan, including restricted
stock unit awards, transferred its stock to employees of subsidiaries who held these awards, the
reimbursements to the parent by the subsidiaries for the fair market value of these stock awards
would not constitute a dividend distribution by the subsidiaries (within the meaning of IRC
301).

Litigation

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Because constructive dividends are laden with individual facts and circumstances, litigation
occurs at regular intervals. The challenge for taxpayers is to frame the relevant facts in the best
possible light for themselves. Often, taxpayers can be successful in frustrating IRS challenges
only through litigation. Various Tax Court decisions have found constructive dividends not to be
present. See, e.g., Jones v. Comm'r, TC Memo. 1997-400 (amounts not constructive dividends
because paid to shareholder in his capacity as president and director, and not used for personal
benefit); Martin v. Comm'r, TC Memo. 1997-492 (50 percent shareholder did not receive
constructive dividend as a result of lending corporate funds to friend; no showing that
shareholder received any benefit therefrom); Eugene D. Lanier, Inc. v. Comm'r, TC Memo. 1998-
7 (married taxpayers did not receive constructive dividend as a result of their wholly owned
corporation's transfer of money to their son's election committee; amount transferred satisfied
obligations that were the liability of the committee and that were not guaranteed by candidate);
Ciaravella v. Comm'r, TC Memo. 1998-31 (amounts paid for advertising expenses incurred in an
individual shareholder's car-racing business did not result in constructive dividend, since such
business benefited the corporation, which leased and sold jet aircraft); Asher v. Comm'r, TC
Memo. 1998-219 (construction of loft used by shareholder as office space did not, despite
existence of personal amenities, result in constructive dividend).

In AJF Transp. Consultants, Inc. v. Comm'r, TC Memo. 1999-16 , however, fuel reimbursement
checks cashed by a transportation company's sole shareholder were included in that
shareholder's gross income as constructive dividends. In Spera v. Comm'r, TC Memo. 1998-22 ,
the taxpayer was not able to defeat constructive dividend treatment by characterizing a portion
of the dividends as a nontaxable return of basis in a loan made to the corporation. Similarly, see
Priv. Ltr. Rul. 200215036 , where discounts provided to shareholders on food and beverage
purchases, golf membership dues, and cart rental and range fees were treated as constructive
dividends. The IRS noted that if a corporation transfers property to a shareholder for an amount
less than its fair market value, the excess value constitutes a distribution of property and, to the
extent the distribution is derived from the corporation's E&P, constitutes a dividend.

In Hood v. Comm'r, 115 TC 172 (2000) , the Tax Court held that legal fees paid by a successor
corporation to defend a sole shareholder against criminal tax charges connected with a sole
proprietorship were not deductible by the corporation and constituted constructive dividend
income to the shareholder.

The IRS has been successful in asserting that extraordinary compensation amounts might
constitute a dividend distribution, rather than deductible compensation. See, e.g., Pediatric
Surgical Assocs. PC v. Comm'r, TC Memo. 2001-81 , where the Tax Court agreed with the IRS
that a portion of bonuses paid to shareholder surgeons who worked for a surgical corporation
was nondeductible, a disguised dividend, and not compensation paid to the corporate officers.

In Notice 2000-60, 2000-2 CB 568 , the IRS issued a warning about a constructive dividendtype
transaction that will be treated as a tax shelter listed transaction. Notice 2000-60 describes a
situation where a subsidiary (S) uses cash to purchase stock of its parent (P) from P's
shareholders. From time to time, S transfers P shares to P employees in satisfaction of P's stock-
based employee compensation obligations (e.g., upon the exercise by an employee of a
nonstatutory option to purchase P stock). In a few years, S will sell any remaining P stock, and
then S will liquidate or P will sell its S stock. When S liquidates or P sells its S stock, P claims a
capital loss under IRC 331 or IRC 1001 because S has already transferred most of its P stock
to the P employees, which has substantially reduced the value of S without a corresponding
downward adjustment in P's basis in its S stock. Because S claims to have shifted all of its basis
in the P stock to S's shares of P stock remaining after the transfers to the P employees, S also
reports a capital loss on the sale of its remaining P stock immediately before S's liquidation or
sale. The IRS indicated that to permit a controlled subsidiary to avoid distribution treatment for
transfers made on behalf of a parent corporation merely by purchasing some shares of the
parent corporation's stock would contravene the framework governing the treatment of such

11
distributions under IRC 301 . The transfers by S to P's employees are properly characterized as
distributions by S to P with respect to P's stock, subject to the rules of IRC 301 and 311 ,
followed by compensatory transfers by P to P's employees. Alternatively, the IRS indicated that it
may disregard the described steps and treat the transaction as a redemption by P . Notice 2000-
60 is mentioned in Notice 2004-67, 2004-2 CB 600 , where the IRS again identified and
reaffirmed listed transactions for which corporate taxpayers may need to disclose their
participation (as prescribed in Temp. Reg. 1.6011-4T ). Notice 2004-67, 2004-2 CB 600 , was
updated by Notice 2009-59, 2009-31 IRB 170 , which reaffirmed that this issue is a listed
transaction.

Corporate Payments to Third Parties

Related Family Members as Recipients

The IRS may challenge not only arrangements between shareholders and their closely held
corporations but also payments made by the corporation to third parties, particularly relatives of
shareholders of closely held corporations. The corporation could pay compensation to the relative
and a determination would then be required concerning whether that compensation is excessive.
If so, the IRS might assert that the excessive amount was paid (in the form of a dividend) to the
shareholder who thereafter transferred that excess to the actual recipient, whether in the form of
a gift, a loan, or compensation, or for some other purpose.

Triangular Distributions
Transactions between two corporations under common control can be treated as constructive
distributions to the controlling shareholder of these corporations. This result can occur even
though no funds (or other benefits) actually pass through the hands of the common owner. See,
e.g., Rev. Rul. 78-83, 1978-1 CB 79 , where a diversion of income from one subsidiary to
another subsidiary was held to be a constructive dividend distribution to the parent corporation
and, subsequently, a capital contribution by the parent corporation to the recipient corporation.
Of course, the common owner would be entitled to a dividends received deduction and, by
reason of the capital contribution treatment, would obtain tax basis for the shares of the
recipient subsidiary corporation.

Subsequent Adjustments
If constructive dividend treatment is successfully applied by the IRS, certain correlative
adjustments must also be made. For example, the E&P of the distributing corporation will be
reduced by the amount ultimately determined to be a dividend distribution. In the process of
making this adjustment, the parties may ascertain that the E&P of the corporation is inadequate
for the constructive dividend to constitute an actual distribution of a dividend. Under these
circumstances, the distributions would be treated under IRC 301(c) as a recovery of tax basis
in the shares held by the distributee and, thereafter, a capital gains distribution. Of course, the
burden to prove the absence of E&P will be on the corporation and the shareholder. See, e.g.,
Reg. 1.162-8 , second sentence, which specifies that in the case of excessive compensation
payments made by a corporation, if such payments correspond or bear a close relationship to
stockholders and are found to be a distribution of E&P, the excessive payments will be treated as
a dividend. However, the assumption in this rule must be that adequate E&P exist.

The IRS's assertion of a constructive dividend can be negated if a shareholder can reverse a
distribution. Shareholders usually cannot deduct a repayment merely because the original
payment was improper. However, under the Oswald approach, an agreement between the

12
corporation and the shareholder can be implemented prior to the distribution to mandate a
repayment to the corporation if the transaction is unraveled for federal tax purposes. Of course,
the agreement must be in existence at the time of the original transaction. Furthermore, during
an audit examination, the IRS representative may request information concerning the existence
of any such arrangement, and may then argue that the taxpayer knew the arrangement was not
bona fide from its inception. See Oswald v. Comm'r, 49 TC 645 (1968) , acq. 1968-2 CB 2; Rev.
Rul. 69-115, 1969-2 CB 50.

Nondividend Distributions and Extraordinary Dividends

Corporate Distributions Subject to Special Treatment

Some corporate distributions to shareholders may be subject to special rules either because (1)
they do not constitute dividends (as defined for federal income tax purposes) or (2) their
amounts cause them to be categorized as extraordinary dividends. In these circumstances,
special federal income tax treatment will be applicable, including tax reporting requirements.

Nondividend Distributions
If a corporation has neither accumulated nor current E&P, a distribution to its shareholders (as
shareholders) will not be a dividend includable in their gross income under IRC 61(a)(7) .
This assumes that the distribution itself (e.g., of appreciated property) will not trigger gain that
will generate current E&P. As specified in IRC 311(b) , the distribution of appreciated property
will cause gain recognition of that appreciation to the corporation, and that gain (after applicable
income tax) is includable in E&P. This treatment results because of the repeal of the General
Utilities doctrine in the Tax Reform Act of 1986. Of course, the risk of increasing E&P does not
exist if cash (at least in the form of U.S., not foreign, money) is being distributed. Furthermore,
if gain is realized on a property distribution, E&P may still not result if the gain would be
absorbed by, and be less than the net operating loss accumulated for, that year.

Under IRC 301(c)(2) , a nondividend distribution is applied against, and reduces the adjusted
basis of, the shareholder's stock. If the distribution is greater than the adjusted basis of the
stock, the excess is subject to IRC 301(c)(3) and will be treated as gain from the sale or
exchange of property (and, therefore, capital gain, assuming the stock is a capital asset).

Of course, to have nondividend treatment, the absence of E&P must be demonstrated by the
recipient or the payor. The principle that unauthorized withdrawals from a corporation would not
constitute dividend income if E&P is absent was reaffirmed in US v. D'Agostino, 145 F3d 69 (2d
Cir. 1998) (citing DiZenzo v. Comm'r, 348 F2d 122 (2d Cir. 1965) , as earlier authority).
However, to enable tax basis recovery, the shareholder's tax basis must itself be adequately
demonstrated. In Hawthorne v. Comm'r, TC Memo. 1999-31 , cash distributions were held to
constitute gains from the sale or exchange of property (IRC 301(c)(3)(A) ) where the
shareholder failed to establish the basis in the shares.

Aggregating Share Basis in Determining Stock Gain

When receiving nondividend distributions, a question arises concerning how the shareholder
must determine gain when holding multiple blocks of the corporation's stock. For example, the
shareholder may hold both high- and low-basis shares. If so, is the shareholder (1) entitled to

13
first recover his or her aggregate basis for all shares held or (2) must the distribution be
allocated on a share-by-share basis in determining gain? If the distribution is treated as made on
a share-by-share basis, the shareholder may be treated as recognizing gain on the low-basis
shares, even though the tax basis attributable to the high-basis shares has not been completely
recovered.

Bittker & Eustice, 8.02[5] , observes that when a stock redemption is treated as a sale under
IRC 302(a) , or when corporate assets are distributed in complete liquidation, the shareholders
generally compute gain or loss on a share-by-share basis, and the same approach presumably
should be applied to the computation of shareholder gain under 302(c)(2) and 301(c)(3) .
However, Bittker & Eustice also recognize that there is an argument for aggregate treatment
under IRC 301(c)(2) , noting Fink v. Comm'r, 483 US 89 (1987) , where the court applied the
aggregate method in a case involving a capital contribution of stock to the corporation.

Extraordinary Dividends
Because a corporate shareholder is taxed on a reduced basis upon the receipt of a dividend (by
reason of the dividends received deduction), this shareholder may desire to receive significant
dividends (as defined for federal income tax purposes), rather than capital distributions (which,
after basis recovery, would produce fully taxed capital gain). This is often referred to as dividend
stripping, and it used to arise in situations where (1) stock would be acquired shortly before its
ex-dividend date, (2) a dividend was then received that was eligible for the 70 percent dividends
received deduction, and (3) the stock would then be sold (after satisfying the IRC 246(c)
holding period requirement for the dividends received deduction). A corporation would end up
with (1) dividend income taxable at a low effective tax rate because of the dividends received
deduction and (2) a short-term capital loss on the sale of stock, which often was used to offset
previously realized unrelated capital gain.

To avoid the possible exploitation of this opportunity, a special rule under IRC 1059 provides,
in certain situations, for a tax basis reduction for the amount of a dividend that was not eligible
for the dividends received deduction. A shareholder must reduce its basis for stock it owns to the
extent of the nontaxed portion of any extraordinary dividend. An extraordinary dividend is
received when it equals or exceeds a prescribed threshold percentage of the basis of the
underlying stock, unless the stock was held for more than two years before the dividend
announcement date or unless certain other conditions are satisfied. This percentage is 5 percent
for preferred stock and 10 percent for other stock (i.e., common stock), as received during a
specified period.

The shareholder has the option to show the fair market value of its stock in the corporation as of
the day before the ex-dividend date, and to use that amount, rather than its adjusted stock
basis, in calculating the 5 percent or 10 percent thresholds. See Rev. Proc. 87-33, 1987-2 CB
402 , which provides guidance to taxpayers on how to make a special election available under
IRC 1059(c)(4) to substitute, in certain situations, the fair market value for the taxpayer's
basis.

Distributions of Property to Shareholders

Making Appreciated Property Distributions

Rather than distributing cash to the shareholders (or to a trust for the shareholders), a
corporation might distribute property that has appreciated in fair market value in the hands of
the corporation. This appreciated property might include government bonds, corporate bonds,

14
corporate stock, real property, inventory, and a variety of other properties, both tangible and
intangible.

Proportionate interests in the property could be distributed directly to the shareholders. To

facilitate distributions to a large or dispersed group of shareholders, property might be
transferred to a trust or other arrangement where the property can be held (in noncorporate
form) on behalf of the shareholders. This situation does not arise, obviously, where the
corporation has only one shareholder to whom the property is transferred in a dividend.

Federal Income Tax Consequences to the Distributing

Corporation on Appreciated Property Distributions

Gain But Not Loss Recognized on Distribution

A corporation is required to recognize the gain realized on a dividend distribution of appreciated
property to its shareholders. IRC 311(b) . The tax rate on recognized gain could be 35 percent,
because ordinary income and capital gain are subject to the same rate at the corporate level.
Loss, however, is not recognized by the corporation on an appreciated property distribution. IRC
311(a) .

The income tax impact of gain recognition may be lessened if the corporation has a loss
carryover that can diminish the gain realized on the distribution. In the closely held corporate
context, a high incomeproducing asset may be distributed to the shareholders, because the
effective income tax rates applicable to shareholders may be lower than those applicable to the
corporation. The issue of gain recognition might also be solved through an S corporation election,
but the election may not be available in all situations. See Chapter 6 .

Alternatively, the corporation may be uncertain about the value of the property. If no loss
carryover is available, the corporation will want to take the position that the property's fair
market value is low. If a loss carryover is available, the corporation may want to take the
position that the property's fair market value is high. Either way the IRS could attempt to
challenge the valuation.

Corporation's E&P Reduction

When gain is recognized on an appreciated property distribution, a corporation's E&P will be
adjusted to reflect this gain. IRC 312(b)(1) . Furthermore, as a result of this distribution, E&P
will be reduced by an amount equal to the fair market value of the distributed property. IRC
312(b)(2) . The E&P reduction for the distribution will be for the net value of the property. For
example, if the distributed property is subject to debt, the net equity value will be reduced by
the debt, and this will be the amount of the dividend distribution. If, however, depreciated
property is distributed, the reduction in E&P will be to the extent of the corporation's tax basis
for the distributed property. IRC 312(a)(3) .

Valuation of Distributed Property

The IRS may challenge the actual value of the property distributed for purposes of determining
the amount of gain to the corporation on the distribution. See Tech. Adv. Mem. 200443032 ,
where the corporation transferred various business assets into several limited partnerships and,

15
thereafter, distributed the partnership interests to the shareholders. The corporation asserted
that the value upon the distribution was to be determined by reference to the value of the
several limited partnership interests, taking into account minority interest positions and the lack
of marketability of the partnership interests, rather than the operational assets themselves. The
IRS concluded that the value of the distribution was to be determined by reference to the value
of the operational assets being distributed, even though directly held by several partnerships.
Consequently, from the IRS's perspective, the value of the dividend distribution cannot be
suppressed by first infusing the operational assets into a limited partnership, with the
partnership interests constituting the assets subsequently being distributed by the corporation.

Federal Income Tax Consequences to Recipient Shareholder

of Appreciated Property Distributions
Shareholders are required to report the entire net value of property received as a dividend,
assuming that the distributing corporation has adequate E&P. The dividend realized by the
shareholders will be in an amount equivalent to the net fair market value of the property
received. If the property received is subject to debt, the amount of the dividend would be the fair
market value of the property, reduced by the liability attached to the distributed property.

Because the distribution is includable in gross income, the recipient shareholders receive a fair
market value basis for the property interest received. IRC 301(d) specifies that the tax basis
for the property in the hands of the shareholders will be the fair market value of the property at
the time the property is received. If the property is subject to debt when received as a dividend,
the shareholder will be treated as purchasing that property for its fair market value (excluding
the impact of the debt). This is consistent with the long-established doctrine from Crane v.
Comm'r, 331 US 1 (1947) , which specified that acquisition indebtedness is includable in basis
for the acquired property.

Assignment of Income Risk

The corporation may distribute property as a dividend when, in fact, it really is an assignment of
income to be realized by the corporation. For tax planning purposes, the corporation and
shareholders would want to distribute this type of asset before the IRS could assert that it had
been transformed into income and treated as already economically realized by the corporation.

Distribution of Corporation's Own Obligations

Format
In lieu of distributing cash or other property, a corporation may distribute it own debt obligations
to its shareholders. Such a distribution is ordinarily (but not necessarily) evidenced by
promissory notes, bonds, debentures, or other forms of securities issued by the corporation. See
Chapter 4 for various examples of forms of promissory notes, bonds, and debentures. The
assumption in this context is that the corporation is actually distributing a debt obligation, rather
than only having declared a future dividend, in which event the future payment will constitute
the corporate distribution.

Federal Income Tax Consequences to Distributor

No Gain Recognition

16
The corporation does not recognize gain on the distribution of its own obligations. IRC
311(b)(1)(A) . This is consistent with the general rule that the issuance of a debt instrument is
not an income realization event to the debtor.

E&P Adjustments
The corporation's E&P is reduced by the principal amount of the distributed obligations, rather
than by their fair market value. See IRC 312(a)(2) . However, if obligations distributed by the
corporation have OID, E&P is decreased by the aggregate issue price of the obligations. The
issue price is the obligations' fair market value if they are publicly traded and bear adequate
stated interest. See IRC 312(o) . If the obligations are not publicly traded but bear adequate
stated interest, their issue price is the stated redemption price at maturity. See IRC
1273(b)(4) .

The E&P gain recognition rules under IRC 312(b) , relating to the corporate distribution of
appreciated property, do not apply to a corporation's distribution of its own obligations.
Accordingly, the corporation's E&P will not be increased by the distribution. Absent such an
exception, the distribution of the corporation's obligations, deemed to have a zero tax basis in
the hands of the corporation, would cause the entire value of the obligations to be added to the
corporation's E&P.

Federal Income Tax Consequences to Shareholder

Under IRC 301(b)(1) , the distribution of a corporation's own debt obligations is a distribution
of property to a shareholder. A dividend will be received by the shareholder to the extent of the
fair market value of the obligations received, assuming the corporation has adequate E&P. In the
unlikely event that the debt obligations cannot be reasonably valued as of the time of their
distribution, open transaction treatment would be applied.

The federal income tax basis for the distributed obligations in the hands of the shareholders is
the fair market value of the obligations when distributed (being the same amount as the dividend
distribution). IRC 301(d) . Any payments on the note in excess of its basis would be treated as
a sale or exchange of the note eligible for capital gains treatment. See IRC 1271(a)(1) .

Distribution of Corporation's Common Stock

Possible Stock Dividend Alternatives

To conserve its cash, a corporation may distribute dividends in the form of its own stock, rather
than in cash, property, or debt. Furthermore, a corporation may distribute its own stock to
reduce the value per share of its outstanding stock, thereby making the trading value of those
shares more attractive, particularly to individual investors. A variety of stock distribution
alternatives might be considered by the corporation, including the following:

1. Common stock on common stock of the same class as the outstanding stock on
which the stock dividend is paid;
2. Common stock on common stock that is of a different category (e.g., nonvoting
common distributed with respect to the holdings of voting common stock);
3. Common stock on preferred stock;
4. Preferred stock on common stock;
5. Preferred stock on preferred stock in the same class as the outstanding stock
on which it is paid; and

17
 6. Preferred stock of a different class on the outstanding preferred.

Corporate Authorization
A corporation must authorize the distribution of its own shares as a dividend. The procedures for
authorizing the distribution is governed by the business corporation laws of the state in which
the corporation is incorporated. The ABA Section of Business Law's Model Business Corporation
Act (as revised through June 2005), 6.23(a), specifies that, unless the articles of incorporation
provide otherwise, shares may be issued pro rata and without consideration to the corporation's
shareholders or to the shareholders of one or more classes or series. An issuance of shares
under this subsection is a share dividend. Section 6.23(b) provides that shares of one class or
series may not be issued as a share dividend in respect of shares of another class or series
unless (1) the articles of incorporation so authorize, (2) a majority of the votes entitled to be
cast by the class or series to be issued approve the issue, or (3) there are no outstanding shares
of the class or series to be issued. Section 6.23(c) specifies that if the board of directors does not
fix the record date for determining the shareholders entitled to a share dividend, it is the date on
which the board of directors authorizes the share dividend.

The Official Comment to these provisions notes that a share dividend is solely a paper
transaction, no assets are received by the corporation for the shares, and any dividend paid in
shares does not involve the distribution of property by the corporation to its shareholders. The
Official Comment does indicate that share dividends may create problems when a corporation
has more than a single class of shares. The requirement that a share dividend be pro rata only
applies to shares of the same class or series. If there are two or more classes entitled to receive
a share dividend in different proportions, the dividend will have to be allocated appropriately.
The Official Comment further observes that the distribution of shares of one class to holders of
another class may dilute the equity of the holders of the first class. Therefore, the distribution of
shares of one class to the holders of another class is permitted only if one or more of the
following conditions are met: (1) the articles of incorporation expressly authorize the
transaction; (2) the holders of the class being distributed consent to the distribution; or (3) there
are no holders of the class being distributed.

Fractional Share Considerations When Stock Dividend

Distributed
A stock distribution will often lead to fractional shares for many shareholders. A corporation
desiring to avoid the issuance of fractional shares as part of a stock dividend may issue script
certificates, which can then be combined and exchanged for whole shares. If the shares of the
corporation are publicly traded, the corporation may arrange with a securities broker or dealer to
provide a mechanism for shareholders to sell their fractional interests or to purchase enough
fractional interests to constitute a whole share. Alternatively, the corporation may simply
distribute cash in settlement of all fractional claims. See ABA Section of Business Law's Model
Business Corporation Act (as revised through June 2005), 6.04(a).

The Official Comment to this provision indicates that the corporation may authorize the
immediate sale of all fractional share interests, thereby avoiding the expense and delay of script
certificates and the inconvenience of recognizing fractional shares. While this procedure denies
shareholders the benefit of any subsequent rise in the market, it protects them against any
subsequent decline and ensures them of recognition based on market values contemporaneous
with the transaction. As noted, because these transactions involve less than one full share for
each shareholder, the amount involved in subsequent price changes is usually modest.

18
Federal Income Tax Consequences to Recipient Shareholder
of Stock Dividend Distributions

Tax-Free Treatment
A stock dividend is usually tax-free for federal income tax purposes, but this rule is subject to
numerous exceptions. IRC 305(a) provides that stock dividends are tax-free to the recipient
shareholders except as otherwise provided in this section.

Exceptions to Tax-Free Treatment

The exceptions to IRC 305(a) are specified in IRC 305(b) , and they are complex. The
distribution arrangements discussed immediately below are taxable to a corporation's
shareholders.

A Distribution Where Any Shareholder May Elect To Receive The

Stock Dividend In Lieu Of Money Or Other Property

Under IRC 305(b)(1) , this taxable treatment applies to all shareholders, even though only
some shareholders (or none) may actually make this election. Reg. 1.305-2(a) provides that
under IRC 305(b)(1) , if any shareholder has the right to an election or option with respect to
whether a distribution shall be made either in money or any other property, or in stock or rights
to acquire stock of the distributing corporation, then, with respect to all shareholders, the
distribution of stock or rights to acquire stock is treated as a distribution of property to which IRC
301 applies regardless of

1. Whether the distribution is actually made in whole or in part in stock or in stock

rights;
2. Whether the election or option is exercised or exercisable before or after the
declaration of the distribution;
3. Whether the declaration of the distribution provides that the distribution will be
made in one medium, unless the shareholder specifically requests payment in
another;
4. Whether the election governing the nature of the distribution is provided in the
declaration of the distribution, in the corporate charter, or arises from the
circumstances of the distribution; or
5. Whether all or some of the shareholders make the election.

The IRS may consider an informal pattern of granting shareholders' requests to redeem their
stock as evidence of an election to take the distribution either in stock or cash. See Rev. Rul. 83-
68, 1983-1 CB 75 . See also Priv. Ltr. Rul. 200348020 , where a corporation intended to
distribute a combination of stock and cash having a value equaling or exceeding the
corporation's E&P. The shareholders would receive a right entitling them to elect to receive 100
percent cash, 100 percent common stock, or a fixed percentage of cash with the remaining
percentage to be paid in common stock of the corporation. The IRS determined that all of the
cash and stock would be treated as a distribution of property with respect to the corporation's
stock to which IRC 301 would apply, and the distribution would be taxable under IRC
305(b)(1) to the shareholders as dividends, to the extent of the corporation's E&P.

19
A Distribution That Is One Of A Series Of Distributions Where Some
Shareholders Receive Cash Or Property And Other Shareholders
Increase Their Proportionate Interests In The Corporation's E&P

Under IRC 305(b)(2) , if a corporation has two classes of common stock outstanding and cash
dividends are paid on one class and stock dividends are paid on the other class, the stock
dividends are treated as distributions to which IRC 301 dividend treatment applies. The
regulations imply that, if the distributions occur within thirty-six months of each other, the stock
and property distributions contemplated by IRC 305(b)(2) can be linked together for purposes
of applying this provision. Reg. 1.305-3(b) . The regulations specify that the distribution of
cash in lieu of fractional shares to which shareholders would otherwise be entitled shall not be
subject to the IRC 305(b)(2) recognition rule if the purpose of the distribution is to save the
corporation the trouble, expense, and inconvenience of issuing and transferring fractional shares,
issuing script certificates representing fractional shares, or issuing full shares representing the
sum of fractional shares, and is not intended to give the particular group of shareholders an
increased interest in the corporation's assets or E&P.

A distribution where some shareholders receive common stock and other shareholders receive
preferred stock. Under IRC 305(b)(3) , all of the shareholders will be taxable under IRC 301
on the receipt of their stock, whether they receive common stock or preferred stock. This
treatment applies because of the actual increase of the proportionate interest of one shareholder
group and, therefore, the decrease in the proportionate interest of another shareholder group.

A stock dividend on preferred stock (other than an increase in the conversion ratio of convertible
preferred stock solely to recognize the effect of a stock dividend or stock split with respect to the
stock into which such convertible stock is convertible). Under IRC 305(b)(4) , this treatment
is premised on the analysis that any addition to the stock ownership of a class that has an
enhanced future participation in the corporation's equity does so at the expense of the other
classes of stock. Thus, this situation can produce a shift in the proportionate ownership of the
future increase of the corporation's E&P and equity growth.

Any Distribution Of A Corporation's Convertible Preferred Stock,

Unless The Corporation Can Establish That It Will Not Result In A
Disproportionate Distribution

Under IRC 305(b)(5) , adjustments made for a conversion ratio of convertible preferred stock
to avoid a shift in the proportionate interest should alleviate the application of IRC 305(b)(4) .
Reg. 1.305-6(a)(2) specifies that the distribution of convertible preferred stock is likely to
result in a disproportionate distribution when (1) the conversion right must be exercised within a
relatively short period after the distribution and, (2) taking into account such factors as the
dividend rate, the redemption provision, the marketability of the stock, and the conversion price,
it is anticipated that some shareholders will exercise their conversion rights and some will not.
However, if the conversion right may be exercised over a period of many years and the dividend
rate is consistent with market conditions at the time of distribution, no basis exists for predicting
when and to what extent the stock will be converted, and it is therefore unlikely that a
disproportionate distribution will exist.

Pursuant to IRC 305(c) , regulations were issued treating a wide variety of transactions as
constructive distributions of stock with respect to the stock of any shareholder whose
proportionate interest in the corporation's earnings or assets is increased by the transaction.
These transactions include (1) changes in conversion ratios, (2) changes in redemption prices,
(3) unreasonable call-premium provisions, (4) dividend-equivalent periodic redemption plans,
and (5) similar arrangements. Reg. 1.305-7 .

20
Distribution of the Same Class of Common Stock
Usually, a stock dividend is distributed in a way that does not cause inclusion in gross income
(i.e., does not fit within any of the IRC 305(b) exceptions). This is achieved most easily
through a pro rata distribution of common stock by a corporation that has only one class of
common stock outstanding. Under IRC 305(a) , this standard type of stock dividend continues
to enjoy a tax-free character. This has been the situation since Eisner v. Macomber, 252 US 189
(1920) .

Stock Split
Similar federal income tax treatment is applicable to shareholders receiving stock in a stock split.
In a stock split, the shareholder may receive one or two shares for each share presently held, as
a opposed to a stock dividend, where the shareholder may receive one share for each ten shares
presently held.

Allocation of Shareholder's Tax Basis When a Tax-Free Stock

Dividend Occurs
Stock dividends that are received tax-free under IRC 305(a) require an allocation of each
shareholder's tax basis, pursuant to IRC 307 , in the original shares among the total shares
held after the transaction. This allocation is made in proportion to the fair market values of the
old stock and the new stock on the date of distribution. Furthermore, those new shares have a
tacked holding period under IRC 1223(4) .

If, however, the stock distribution is taxable, the basis of the distributed stock in the hands of
the shareholders is its fair market value, as determined under IRC 301(d) . The holding period
of stock received in such a taxable distribution commences the day after its acquisition. See Rev.
Rul. 76-53, 1976-1 CB 87 .

Tax Treatment of Fractional Share Proceeds Received by

Shareholders
The use of cash to eliminate fractional shares will not be treated as a disproportionate
distribution under IRC 305(b)(2) . Reg. 1.305-3(c) . This assumes that the purpose of the
cash distribution is to avoid the expense of issuing fractional shares and that the total cash paid
does not exceed 5 percent of the total fair market value of the stock distributed. The treatment
by the shareholders of the cash received under these circumstances will be determined under the
IRC 302 stock redemption rules, usually enabling sale or exchange treatment. See the
discussion of these rules at Bittker & Eustice, Chapter 9.21 .

Federal Income Tax Consequences to Distributing

Corporation of Stock Dividend Distributions
The corporation that distributes a tax-free stock dividend does not reduce its E&P when making a
nontaxable distribution of its stock. IRC 312(d)(1)(B) . However, taxable stock dividends are
treated like distributions by a corporation of its own obligations or analogous to cash dividends.

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The corporation's charge to E&P for such distributions is the fair market value of the stock. The
expenses incurred in issuing a stock dividend cannot be deducted by the corporation under IRC
162 .

Distribution of Stock Rights by Corporation

Purposes for a Stock Rights Distribution

A corporation may distribute either rights to purchase its shares or warrants to purchase its
shares. Ordinarily, the terms rights and warrants are interchangeable for federal tax
purposes.

Often, stock rights are sold on a favorable basis so as to encourage their exercise by the
shareholder receiving them. For the corporation, this is an alternative method for raising capital.
For the shareholders, stock rights provide an uncomplicated method for further equity
investment in the corporation. If the stock rights are sold at a discount, the shareholders may
want to exercise those rights to maintain their proportionate future participation in the earnings
of the corporation. This will be especially significant when the shareholder group is limited and
changes in share percentages can cause significant shifts in shareholder control of the
corporation.

Corporate Authorization to Issue Stock Rights

A corporation must appropriately authorize the issuance of rights for the purchase of its shares
or other securities. The ABA Section of Business Law's Model Business Corporation Act (as
revised through June 2005), 6.24(a), specifies that a corporation may issue rights, options, or
warrants for the purchase of its shares or other securities. The board of directors shall determine
(1) the terms upon which the rights, options, or warrants are issued and (2) the consideration
for which the shares or other securities are to be issued. The authorization by the board of
directors for the corporation to issue such rights, options, or warrants also constitutes
authorization of the issuance of the shares or other securities for which the rights, options, or
warrants are exercisable. Section 6.24(b) provides that the terms and conditions of such rights,
options, or warrants may include, without limitation, restrictions or conditions that (1) preclude
or limit the exercise, transfer, or receipt of such rights, options, or warrants by any person or
persons owning or offering to acquire a specified number or percentage of the outstanding
shares or other securities of the corporation, or by any transferee or transferees of any such
person or persons, or (2) invalidate or void such rights, options, or warrants held by any such
person or persons or any such transferee or transferees.

The Official Comment to the provision above notes that many state business corporation statutes
contain stipulations authorizing the creation of rights, options, and warrants. Even though
corporations undoubtedly have the inherent power to issue these instruments, specific
authorization is needed because of the economic importance of rights, options, and warrants,
and because it is necessary to confirm the broad discretion of the board of directors in
determining the consideration to be received by the corporation for their issuance. This comment
further specifies that the issuance of rights, options, or warrants is a matter of business
judgment and that, in appropriate cases, incentive plans may provide for exercise prices that are
below the current market prices of the underlying shares or other securities.

The Official Comment observes that 6.24(a) does not require shareholder approval of rights,
options, or warrants, but that prior shareholder approval may be sought as a discretionary
matter. Shareholder approval may also be required in order to comply with the rules of national
securities markets (see, e.g., N.Y.S.E. Listed Company Manual, 309.00). In the federal income

22
tax context, shareholder approval for the issuance of stock options will be required for the
benefits under stock option plans, such as those under IRC 422(b)(1) , to be available.

Under 6.24(a), the board of directors may designate the interests being issued as options,
warrants, rights, or by some other name. These interests may be evidenced by certificates,
contracts, letter agreement, or in other forms that are appropriate under the circumstances.
Rights, options, or warrants may be issued together with, or independently from, the
corporation's issuance and sale of its shares or other securities.

Federal Income Tax Consequences to Recipient Shareholder

of Stock Rights Distributions

Tax-Free Receipt of Rights by Shareholder

A pro rata distribution to shareholders of a right to purchase additional shares of the
corporation is ordinarily a tax-free event pursuant to IRC 305 . However, this assumes that the
distribution is not subject to one of the exceptions in IRC 305(b) , where income recognition is
required upon distributions in lieu of money, disproportionate distributions, and similar
distribution events. Similarly, the exercise of such rights by the shareholders for the purchase of
the corporation's shares is also tax-free.

Tax Basis Allocation Between Stock and Rights

The original tax basis for the shares on which the rights are issued is allocated between the stock
and the rights if the rights are either exercised or sold. IRC 307(a) . This allocation of the basis
is to be in proportion to the fair market value of the stock and the rights as of the date of the
rights distribution. Reg. 1.307-1(a) . In the case of the exercise of the rights, the tax basis
amount allocated to the rights is added to the cost of the stock acquired upon exercising the
rights. Reg. 1.307-1(a) , 1.307-1(b) . In the situation of a sale of the rights, the amount
allocated to the rights is used to determine the shareholder's gain or loss on the sale. If the
rights expire, however, no tax basis allocation is permitted. Under such circumstances, no capital
loss is incurred by the shareholder and the allocated tax basis reverts to the underlying shares.

Exception to Tax Basis Allocation Rule

This rule of tax basis allocation is subject to an exception. If the fair market value of the stock
rights when distributed is less than 15 percent of the fair market value of the old stock at the
time of distribution, the basis of the rights will be zero. This rule avoids the necessity of a tax
basis adjustment when the value of the distributed rights is small. However, the shareholder
may elect to allocate tax basis under the method provided in IRC 307(a) . This method may be
elected if the rights have depreciated in value since issuance and the shareholder wants to
generate a loss on their sale, thereby enabling the potential of offsetting other capital gains. If
the shareholder sells his or her rights, the holding period of the underlying shares is tacked to
the holding period for the rights if the tax basis of the rights is determined under section 307 .
See IRC 1223(4) .

Federal Income Tax Consequences to Distributing

Corporation of Stock Rights Distributions

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Tax-Free Treatment to Distributing Corporation
The distribution of stock rights will not cause income recognition to the corporation. Even though
the rights may have some value, and the corporation's tax basis in those rights will be zero, the
corporation will recognize no income upon their distribution. See IRC 311(a)(1) , which
specifies that no gain or loss shall be recognized to a corporation on the distribution of its stock
or rights to acquire its stock.

E&P Adjustment
If the stock rights distribution to shareholders is tax-free, the corporation's E&P will not be
reduced by the value of the rights. As noted below, if, however, the distribution of rights is
taxable as a dividend, the corporation's E&P will be reduced by a corresponding amount,
assuming there is an adequate amount of E&P.

Taxable Distribution of Rights

Receipt by Shareholder of Taxable Rights

A distribution of stock rights may be taxable because the shareholders have an option to take
property from the corporation rather than stock rights. In this situation, the distribution will be
treated (under IRC 305(b) ) as a distribution of property to which IRC 301 (i.e., dividend
treatment) applies. Consequently, the receipt of these rights will cause ordinary dividend
recognition to the shareholders, assuming (1) that the rights can be valued and (2) that the E&P
is equal to or greater than the fair market value of the rights. This income tax recognition will
establish a cost basis for these rights in the hands of the shareholders.

The shareholder may subsequently sell the rights, exercise the rights, or allow them to lapse.
The shareholder's sale of the rights would produce a gain or loss, depending on the tax basis for
the rights and the amount received upon the sale. The exercise of the rights would cause the tax
basis for the rights to be added to the purchase price for the shares in establishing the total tax
basis for those shares in the hands of the shareholder. The lapse of these rights would ordinarily
enable a deductible tax loss to the extent of the basis previously established for these rights.

Distribution by the Corporation of Taxable Rights

The distribution of stock rights will not cause income recognition to the corporation even though
it may be taxable to the recipient shareholders. See IRC 311(a)(1) , which specifies that a
corporation will recognize no gain or loss upon a distribution of its stock rights. This provision
does not limit tax-free treatment to the corporation to only those situations where the
shareholder also does not recognize income.

When the stock rights distribution is treated as taxable to the shareholder, the corporation can
reduce its E&P by the fair market value of the rights. IRC 312(d) specifies that a stock or stock
rights distribution shall not be considered a distribution of the corporation's E&P if the
shareholder recognizes no gain from the receipt of the stock rights or if the distribution was not
subject to tax in the hands of the shareholder by reason of IRC 305(a) . More precisely, Reg.
1.312-1(d) states that, in the case of a distribution of stock or rights to acquire stock, a portion
of which is includable in income by reason of IRC 305(b) , the E&P shall be reduced by the fair

24
market value of such portion. However, this regulation specifies that no E&P reduction shall be
made if a distribution of rights to acquire stock is not includable in income under the provisions
of IRC 305 .

Other Types of Stock Rights Distributions

A corporation may distribute other types of stock rights, such as poison pill rights plans and
rights included in unbundled stock units. In a poison pill situation, a rights plan may be adopted
to allow shareholders of a potential target corporation to acquire the target's stock at a
significant discount upon the occurrence of certain triggering events. The ownership stake of a
hostile acquirer is thereby diluted and the hostile acquisition may then become unacceptably
expensive. See Rev. Rul. 90-11, 1990-1 CB 10 , indicating that no income tax consequences to
the corporation or the shareholders arise merely from a corporation's adoption of such a plan.
Since its issuance, this revenue ruling has been cited on numerous occasions in private letter
rulings to support that the mere adoption of a poison pill rights plan will not be treated as a sale
event. If the rights do actually become available when the identified triggering event occurs,
shareholders will probably be taxed under IRC 305(b)(2) .

Stock Splits

Generally
The objective of a stock split is ordinarily the same as that of a regular stock dividend (i.e., to
have a tax-free distribution). In contrast to a stock dividend, a stock split will produce a much
larger number of shares outstanding and, thereby, a much greater reduction of the fair market
value per share outstanding prior to the time of the stock split.

As identified in the New York Stock Exchange, Listed Company Manual, 703.02, a stock split is
a distribution of 100 percent or more of the outstanding shares of a corporation (as calculated
prior to the distribution). A partial stock split is identified as a distribution of 25 percent or more,
but less than 100 percent, of the outstanding shares (as calculated prior to the distribution). A
stock dividend is defined as a distribution of less than 25 percent of the outstanding shares (as
calculated prior to the distribution). A stock split requires a transfer from paid-in capital for the
par or stated value of the shares issued, but not where there is to be a change in the par or
stated value of the shares.

A fractional share distribution is less likely to occur with a stock split than with a stock dividend.
In a stock split, the shares distributed may be one or two shares for each share held. If a stock
split occurs on the basis of one share for every two shares held, only those shareholders holding
an uneven number of shares would need to deal with the fractional share issue.

Corporate Authorization Required for Stock Split

Appropriate corporate authorization for a stock split will be required, often by a vote of a
majority of the shareholders. Revised Model Business Corporation Act, Fourth Edition (2008)
Revised Model Business Corporation Act, Fourth Edition (2008), 6.23(a), specifies that, unless
the articles of incorporation provide otherwise, shares may be issued pro rata and without
consideration to the corporation's shareholders or to the shareholders of one or more classes or
series. An issuance of shares under this subsection is identified as a share dividend. The Official
Comment to this provision further specifies that the par value statutory treatment of share
dividend transactions previously distinguished a share split from a share dividend. In a share
split the par value of the former shares was divided among the new shares and there was no

25
transfer of surplus into the stated capital account as in the case of a share dividend. Because
the above-mentioned Act eliminated the concept of par value, the distinction between a split
and a dividend was not retained; accordingly, both types of transactions are referred to simply
as share dividends.

Of course, many state business corporation codes retain some form of par value requirements,
and this must be taken into consideration. Furthermore, the Official Comment to the ABA Section
of Business Law's Model Business Corporation Act notes that a distinction between share
dividends and share splits continues in other contexts, for example in connection with
transactions by publicly held corporations. See NYSE Listed Company Manual, 703.02(a), for
corporations that have optionally retained par value for their shares.

Federal Income Tax Consequences to Recipient of Stock Split

Distributions
A stock split is usually treated as tax-free for federal income tax purposes, but this rule is subject
to numerous exceptions. Section 305(a) provides that stock dividends, including stock splits, are
tax-free to recipients except as otherwise provided in this section. See, e.g., Priv. Ltr. Rul.
9709004 , where the IRS ruled that a regulated investment company's stock split would not
result in a deemed distribution under IRC 305(a) . The existence of redemption rights in this
investment company before and after the distribution would not cause the distribution to be
taxable under IRC 305(b) or IRC 305(c) . Under IRC 311(a) , no gain or loss would be
recognized to the investment company upon the distribution of the new shares with respect to
the old shares.

Similar to stock dividends, the use of cash to eliminate fractional shares in a stock split ordinarily
should not be treated as a disproportionate distribution under IRC 305(b)(2) . See Reg.
1.305-3(c) . This assumes that the purpose of the cash distribution is to avoid the expense of
issuing fractional shares and that the total cash paid does not exceed 5 percent of the total fair
market value of the distributed stock. The income tax treatment by the shareholders of the cash
received under these circumstances will be determined under the IRC 302 stock redemption
rules.

Federal Income Tax Consequences to Distributing

Corporation of Stock Split Distributions
The corporation distributing its shares in a stock split does not recognize gain on the distribution.
IRC 311(a)(1) . Furthermore, the corporation that distributes a tax-free stock dividend does
not reduce its E&P account when making a nontaxable distribution of its stock. IRC
312(d)(1)(B) . The costs of implementing the distribution of stock in a stock split are not
deductible under IRC 162 .

Reverse Stock Split

In some situations, the value of a corporation's shares may have declined so much that the per-
share value is quite small. Corporate shares may become delisted on an exchange if their value
dips too low. To increase the value of shares, a corporation may engage in a reverse stock
split. In a reverse stock split, a corporation can restructure itself so as create a situation where
each outstanding share becomes, for example, only one fifth of a share. Stated alternatively, five
outstanding shares become one share. This result would occur even if a shareholder does not
transmit his or her share certificates to the corporation for new post-reverse stock split shares.

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For federal income tax purposes, the tax basis for the old shares would be attributed to the new
shares (now reduced in number).

Dividend Reinvestment Plan

Objective of a Dividend Reinvestment Plan

As a method of increasing its capital, a corporation may offer to its shareholders an opportunity
to reinvest their cash dividends in additional stock of the corporation. Dividend reinvestment
under a plan usually continues until the shareholder withdraws from the plan. Such a plan may
be made more attractive to the shareholder by offering a price advantage over open market
purchases of the stock. This can be accomplished by purchase discounts or by bringing to the
attention of the shareholder the brokerage commissions that would be incurred if the shares
were purchased through a securities dealer.

Alternative Types of Dividend Reinvestment Plans

A dividend reinvestment plan may be administered so that the shares are purchased directly
from the corporation with the cash dividends otherwise to be received. In this situation, the net
assets of the corporation are not reduced by the amount of the dividend that is otherwise
payable in cash. Alternatively, the shares may be purchased in the open market, thereby not
increasing the number of outstanding shares of the corporation. This technique would not allow,
however, the cash dividend amount to be retained by the corporation, which is often the primary
objective.

Taxability of the Distribution

If a corporation pays cash dividends, which the taxpayer can receive and retain at her option,
the stock received under a dividend reinvestment plan is not a tax-free distribution of a stock
dividend. See IRC 305(b)(1) . In effect, shareholders participating in a dividend reinvestment
plan constructively receive cash dividends and thereafter reinvest them by purchasing additional
shares of the corporation.

If the shareholders receive a price reduction under a dividend reinvestment plan, the amount
includable in gross income as a dividend under IRC 301 is the fair market value of the stock
that is purchased with the dividend-sourced cash. This amount is equal to the sum of the cash
dividend and the price discount. The shareholders do not realize gross income, however, on the
value of the brokerage commissions that they would have paid had they purchased the shares on
the open market, rather than through the corporation's dividend reinvestment plan.

For the income tax treatment of a dividend reinvestment plan under which the shareholders
cannot elect to receive stock or cash dividends, see Rev. Rul. 77-149, 1977-1 CB 82 . In that
situation, if the shareholder (or its agent) first receives the cash and then buys the stock, the
cash amount is taxed as a dividend. Under the facts in this ruling, a bank received the dividend
distribution and then acted on behalf of the shareholder in acquiring shares of the dividend-
paying corporation. The dividend status was determined without reference to IRC 305(b)(1) .
Rev. Rul. 77-149 is distinguished in Rev. Rul. 78-375, 1978-2 CB 130 , and Rev. Rul. 79-42,
1979-1 CB 130 . Rev. Rul. 78-375 involved a dividend reinvestment plan where the shareholder
could not only elect to receive stock with a greater fair market value than the cash dividend the
shareholder might have instead received, but also could purchase through the plan additional
stock from the corporation at a discount price less than the fair market value of the stock. In
Rev. Rul. 79-42 , a corporation transferred cash dividends to an agent who purchased stock for

27
the shareholders directly from the corporation for 95 percent of the average closing market
prices on the dividend payment date. The parties were treated as having received distributions to
which IRC 301 applies, by reason of IRC 305(b)(1) , with the amount of the dividend being
the fair market value of the stock.

Numerous IRS releases (e.g., Publication No. 17, Your Federal Income Tax) provide
instructions about the tax effects of dividend reinvestment plans. For example, Publication 17
indicates that a member of a dividend reinvestment plan who uses dividends to buy more stock
at a price equal to its fair market value must report the dividends deemed received as income.
This publication also indicates that if the dividend reinvestment plan permits a shareholder to
buy more stock at a price less than its fair market value, the shareholder must report as income
the fair market value of the additional stock on the dividend payment date. Presumably, this
income amount is limited to the difference between the purchase price and the fair market value
for the stock. Furthermore, the shareholder must report as income any service charge subtracted
from the cash dividends before the dividends were used to buy the additional stock. However,
the publication notes, the shareholder may be able to deduct this service charge.

The IRS has issued numerous private letter rulings in the dividends reinvestment context. For
example, in Priv. Ltr. Rul. 9509039 , the IRS indicated (with only minimal explanation) that the
purchase by either shareholders or employees of a corporation's stock at a discount under a
stock discount purchase plan was not to be treated as a distribution of the corporation's stock
under IRC 305(b) . Accordingly, the IRS ruled that the purchaser would realize no income as a
result of the purchases under the discount purchase program. See also Priv. Ltr. Rul. 9634024 ,
which involved the utilization by a real estate investment trust (REIT) of a dividend reinvestment
plan and the related federal income tax effects. In Priv. Ltr. Rul. 9750033 , a REIT allowed its
shareholders (1) to elect to have their dividends reinvested into REIT stock at a discount price
(the Reinvestment Program), (2) to invest additional funds in exchange for REIT stock at the
same discount price (the Cash Purchase Program), or (3) to do both. Shareholders who
participated solely in the Cash Purchase Program were not treated as having received a
distribution of the discount amount of the stock to which IRC 301 applies by reason of IRC
305(b) . Therefore, these shareholders were determined not to realize income as a result of
these purchases. Shareholders who participated in both the Cash Purchase Program and the
Reinvestment Program, however, were treated as having received at the time of the purchase a
distribution of the discount amount of the stock to which IRC 301 applies by reason of IRC
305(b)(2) . Similarly, see Priv. Ltr. Rul. 200414022 , where the IRS ruled that a shareholder's
purchase of stock through a corporation's stock discount purchase program would not be treated
as a distribution of corporate stock under IRC 305(b) and that the shareholder would not
recognize income as a result of the purchase. In Priv. Ltr. Rul. 200618008 , the IRS ruled that
REIT shareholders who participate in a dividend reinvestment plan are to be treated as receiving
an IRC 301 distribution of property in connection with any cash dividend declared by the REIT.
The stock sale would not be treated as an IRC 301 property distribution.

Tax Basis to Shareholders for Acquired Stock

The tax basis to the shareholder for the stock acquired under a dividend reinvestment plan would
be its fair market value. See IRC 301(d) . The holding period for the stock acquired in this
transaction would commence as of the time of its acquisition. No tacking would occur for this
purpose because a new tax basis would be applicable to this stock.

Adjustment to Corporation's E&P

Because a transaction involving the cash deemed transferred to a shareholder is a dividend
distribution, the corporation would be entitled to reduce its E&P account by the dividend amount.

28
That charge to E&P would be the fair market value of the stock. See Reg. 1.312-1(d) , 1.305-
2(b), Ex. (2); Rev. Rul. 76-186, 1976-1 CB 86 .

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