Small business tax solutions.

Q. What are the federal income tax consequences of distributing appreciated property from a corporation to its shareholders when the property is subject to debt?

A. The consequences are relatively straightforward. From the corporation's perspective, Internal Revenue Code section 311 (1) requires the corporation to recognize gain if the property distributed is appreciated (has a fair market value in excess of its basis) and (2) does not allow the corporation to recognize loss if the property has a fair market value less than its tax basis.

Under IRC section 301, a share-holder potentially is subject to tax on the amount distributed--defined in section 301(b) as the fair market value of the property received. A shareholder has dividend income to the extent of the corporation's current or accumulated earnings and profits, calculated as of the end of the tax year in which the property is distributed; the balance will be return of basis or capital gain.

Thus, to the shareholder receiving the property the tax consequences turn on the corporation's earnings and profits. In a simple situation in which appreciated property is distributed, earnings and profits are increased by the excess of the property's fair market value over its basis--for this purpose the basis calculated under the earnings and profits rules. After the tax consequences to shareholders are calculated, the earnings and profits are reduced by the fair market value of the property distributed.

Example 1. Corporation X owns land with a fair market value of $200 and a basis (for tax and earnings and profits purposes) of $150. If the corporation distributes the land to shareholder Adams, X has $50 of taxable income, its earnings and profits are increased by $50 and Adams has received a $200 distribution which--if there are no other current or accumulated earnings and profits--represents a $50 dividend and a $150 return of basis and capital gain. After the tax consequences to Adams are calculated, earnings and profits are reduced by the property's full fair market value.

The analysis becomes murkier when the property is subject to debt. So long as the debt does not exceed the property's basis, the gain calculation does not change from the corporation's perspective. TO the shareholder, the property's fair market value is the gross fair market value less the debt. In calculating earnings and profits to characterize the distribution, the only change is that earnings and profits are increased for the reduction in the corporation's liabilities--this represents an increase in the corporation's net worth.

Example 2. Assume the property in the first example is subject to a $25 debt. The corporation still has a $50 gain (the excess of fair market value over basis), Adams receives a distribution of only $175 because of the debt and the corporation's earnings and profits are increased by the $50 gain and the $25 debt distributed. The net result to Adams is a reduction in the potential total income--from $200 to $175--but an increase in income that might be treated as a dividend--from $50 to $75. After calculating the character of the distribution to Adams, corporation X's earnings and profits would be reduced by $200, the full fair market value of the property distributed.

The picture becomes even cloudier if the debt exceeds the property's fair market value. Under section 311, the corporation's gain is calculated not on the excess of the fair market value over basis but on the excess of the debt amount over the property's basis. The shareholder will have no income because the net fair market value of the property received will be zero. While the IRC is unclear, earnings and profits should be increased by the amount of the gain, calculated by taking into account the liabilities distributed.

Example 3. Assume the same facts as in the first two examples except the property is subject to a $250 debt. For tax purposes, the corporation has a $100 gain--the excess of the liabilities over basis. Adams receives a distribution of zero because there is no net value to the property received. Corporation X's earnings and profits, on an interim basis, should be increased by $100--the section 311(b) gain. At the close of the year, taking into account the distribution, X's earnings and profits should be (1) decreased by the fair market value of the property distributed ($200) and (2) increased by the liabilities assumed to the extent they do not exceed the property's fair market value. As a result of these adjustments, there is no additional net increase in earnings and profits.

STEPHANIE A. MERGEL is a tax attorney with Shanley & Fisher in Morristown, New Jersey. BRYAN E. BLOOM is a tax attorney with WRH Partners, also in Morristown.