Property Dividends

What are the tax consequences of receiving property (as opposed to money) in a distribution from your corporation? The consequences should be looked at from several angles.

First, the amount of the distribution is the fair market value of the property reduced by any liabilities you assume or liabilities to which the property is subject. The amount of the distribution is a dividend if there are sufficient earnings and profits (E&P) in the corporation to cover the distribution. If the value of the distributed property (less debt) exceeds E&P, the excess isn't a dividend. Instead, the excess is a nontaxable return of capital which is first applied against your basis until it is reduced to zero and then represents taxable gain.

Second, your basis in the distributed property is equal to its fair market value at the time of its distribution. For basis purposes, the value isn't reduced by any debt to which the property is subject. Your basis will measure your future gain or loss on the sale of the property or the depreciation deductions if the property is depreciable in your hands. Note that your basis can be different from the basis your corporation had in the property.

It's important to choose the property to be distributed carefully. The corporation recognizes gain from the distribution as if it had sold the property. (The gain is the excess of the fair market value of the property (including liabilities you assume or take subject to) minus the corporation's basis.) On the other hand, if the corporation has a loss on the property, it cannot claim the loss. Accordingly, from a tax standpoint, it would be better for the corporation to sell loss property and distribute the proceeds rather than distribute the property itself.

Finally, the distribution has an impact on the corporation's E&P. The E&P is increased by any gain the corporation recognizes. However, it is then reduced by the greater of the corporation's basis in the distributed property or the value of the property. If the property is subject to debt, the reduction in E&P is reduced by the amount of the debt.

Example: The ABC Corporation has earnings and profits of $100,000 when it distributes an asset to Sally, a shareholder. The asset is worth $10,000, ABC's basis in it was $6,000, and it is subject to a debt of $1,000.

Sally is taxed on a dividend of $9,000 (value minus debt) and her basis in the asset is $10,000 (value unreduced by the debt).

ABC is taxed on $4,000 of gain on the disposition of the asset (value of $10,000 minus basis of $6,000). ABC's E&P is first increased by this $4,000 of gain to $104,000. However, on the distribution, E&P is decreased by $9,000 ($10,000—the higher of basis or value—reduced by the $1,000 debt), to wind up at $95,000.

Danger of distribution creating E&P. Be alert to the danger imposed by the E&P increase described above which occurs when gain property is distributed. The corporation and shareholder may believe the corporation has no E&P so that dividend treatment will be avoided on the distribution. But the distribution of gain property itself creates E&P which can cause dividend treatment.