Question

Petrel Corporation has accumulated E & P of $85,000 at the beginning of the year. Its current-year taxable income is $320,000. On December 31, Petrel distributed business property (land: fair market value of $140,000, adjusted basis of $290,000) to Juan, its sole shareholder. Juan assumes a $70,000 liability on the property. Included in the determination of Petrel's current taxable income is $16,000 of income recognized from an installment sale in a previous year. In addition, the corporation incurred a Federal income tax liability of $67,200, it paid life insurance premiums of $4,500, and received term life insurance proceeds of $150,000 on the death of an officer.

Assume Petrel Corporation is taxed at the 21% tax rate.

The E & P of Petrel Corporation after the property distribution is $_______ on December 31.

What happens if Petrel instead sells the property at its fair market value, used $70,000 of the proceeds to pay off the liability, and then distributed the remaining cash and any tax savings to Juan?

If Petrel had sold the business property at its fair market value, it would have a recognized loss  of $_______. After paying off the loan and any taxes associated with the sale, Juan receives a dividend of $_________. The E & P of Petrel Corporation after the property sale and distribution of cash to Juan is $_________.

Answer 1

Corporate Distributions

Distributions made by the corporation to its shareholders are treated as follows:

• As taxable dividend income to the extent of higher of
  • Current Earning & Profit (CEP) or
  • Sum of Current Earning & Profit and Accumulated Earning & Profit before distribution
• Remaining dividend to the extent of shareholders basis are treated as non-taxable return of capital which reduces the shareholder's basis
• Dividend in excess of E&P and shareholder basis are taxable capital gain distributions

First we need to calculate the Current Earnings and Profit

Particulars	Amount
Current year taxable income	320,000
Less: Installment sale in the previous year	16,000
Less: Federal Income tax liability disallowed	67,200
Less: Life insurance premium paid for an officer	4,500
Add : Proceeds from the life insurance of an officer	150,000
Current Earnings and Profit	382,300

Given Accumulated Earning & Profit = $85,000

Therefore Sum of Current Earning & Profit and Accumulated Earning & Profit before distribution = $467,300

Also, when an appreciated property is distributed to a shareholder as dividend, property is distributed to the shareholder at Fair Market Value and the gain is recognized by the corporation. However losses are not deductible except in the eent of complete liquidation of the company.

Therefore in the given case, amount of dividend distribution = Adjusted basis of the land - Mortgage value = $290,000 - $70,000 = $220,000

Therefore the E & P of Petrel Corporation after the property distribution is $ 247,300 (467,300 - 220,000) on December 31.

If Petrel had sold the business property at its fair market value, it would have a recognized loss  of $150,000 (290,000 - 140000)

Net proceeds from the property after paying off the loan of $70,000 = $140,000 - $70,000 = $70,000

Tax saving on the sale of property at loss = $150,000 * 21% = $31,500

After paying off the loan and any taxes associated with the sale, Juan receives a dividend of $101,500 (70,000 + 31,500).

The E & P of Petrel Corporation after the property sale and distribution of cash to Juan is $365,800 (467,300 - 101,500)

Kindly up vote

Answer 2

Th last part fails to recognize that net income will change from $320,000 to $170,000 (Loss on sale of land). Therefore, income tax will change to $35,700 ($170,000 * 21%). Total E&P should be $310,300.