Sec. 301(e)—Some Unusual Consequences

Sec. 301(e) requires special adjustments to a corporation's earnings and profits (E&P) when it makes a distribution to a "20% corporate shareholder." Isolating the effect of Sec. 301(e) on the distributing corporation, its 20% corporate shareholders and its remaining shareholders can be difficult. The result might even be considered abnormal when Sec. 301(e) is coupled with the task of disentangling the taxable income consequences from the E&P consequences.

Why Sec. 301(e) Exists

In 1984, Congress enacted Sec. 301(e) out of concern that some corporations were taking advantage of the dividends- received deduction (DRD) under Sec. 243 to extract "phantom" earnings from other corporations at an inappropriately low overall tax rate. This potential arose because, to "more accurately reflect economic gain and loss," Congress had reduced or eliminated certain deductions corporations could claim in computing their E&P. As a result, corporations could generate positive current E&P, even though they had no taxable income or net operating losses.

Phantom E&P increases dividend income dollar-for-dollar for most shareholders, but the tax cost to corporate shareholders is much less because of the DRD under Secs. 243 and 245. As a general rule, corporations prefer to receive low-taxed dividends, preserving their tax basis in the distributing corporation's stock and reducing gain (or increasing loss) on a subsequent disposition. Sec. 301(e) denies corporate shareholders this potential advantage. Under Sec. 301(e), a corporation must recompute its E&P when it makes a distribution to any 20% corporate shareholder, thereby reducing the dividend available for the DRD in that corporate shareholder's hands.

Sec. 301(e)

Sec. 301(e) provides that, solely for purposes of determining the taxable income of any 20% corporate shareholder (and its adjusted basis in the stock of the distributing corporation), Sec. 312 is to be applied to the distributing corporation as if it did not contain subsections (k) and (n). For this purpose, a 20% corporate shareholder is defined, for any distribution, as a corporation that owns (directly or indirectly) either:

• Stock in the distributing corporation possessing at least 20% of the total combined voting power of all classes of stock entitled to vote; or
• At least 20% of the total value of all the stock of the distributing corporation (excluding nonvoting preferred stock).

Note: Sec. 301(e)(3) expressly preserves the application of Sec. 312(n)(7), which governs the proper reduction to a corporation's E&P attributable to redemptions.

By reducing the distributing corporation's E&P, the dividend reported by some corporate shareholders is reduced, triggering Sec. 301(c)(2) (basis reduction in the distributing corporation's stock) and (3) (gain recognition):

Example: X Corp. is owned equally by individual A and B Corp. X has no accumulated E&P. Its current E&P for year 1 is $100. B is eligible for the 80% DRD under Sec. 243(c). X is a fixed-asset-intensive corporation. X's accelerated depreciation is $130, while the straight-line method depreciation would have been $50, an $80 difference for year 1. The basis of X's stock in B's hands is $25; B has held this stock for more than one year.

X distributes $100 ratably to A and B at the end of year 1. The distribution to A results in $50 of dividend income under Sec. 301(c)(1). For B, Sec. 301(e) requires X to recompute E&P without applying Sec. 312(k). This reduces the $100 of current E&P by $80 (the difference between accelerated and straight-line depreciation), leaving only $20 of E&P for distribution to all 20% corporate shareholders. Because B owns 50% of X's stock, B presumably is entitled to half this modified amount. As a result, B recognizes $10 of dividend income under Sec. 301(c)(1), $25 of nontaxable return of capital under Sec. 301(c)(2) and $15 of long-term capital gain under Sec. 301(c)(3).

Scope of Sec. 301(e)

The E&P adjustments apply only to distributions made to certain 20% corporate shareholders. For all other shareholders, Sec. 312(k) and (n) still apply. In the example, A, the individual shareholder, received a $50 dividend, regardless of B's treatment.

Although Sec. 301(e) operates directly on the distributing corporation's E&P, Congress intended its effects to be felt indirectly, through the taxable income and basis consequences in the 20% corporate shareholder's hands. The actual E&P consequences of the distribution are unaffected. In the example, X had $100 of current E&P (after properly applying Sec. 312(k) and (n)), and it distributed $50 each to A and B. Under Sec. 312(a)(1), X must reduce its E&P by $100.

From B's perspective, the E&P consequences of this rule are complicated. The $25 stock basis reduction and $15 capital gain recognized for taxable income purposes must be ignored. Instead, B's current E&P should increase by $50, because the $50 distribution was entirely a dividend for E&P purposes.

Note: Sec. 301(e) does not apply to corporations that file a consolidated return. Those corporations apply the normal stock basis adjustment and E&P adjustment rules under Regs. Secs. 1.1502-32 and -33. Also, Sec. 301(e) has only two purposes: (1) computing the dividend income of a 20% corporate shareholder and (2) determining that shareholder's adjusted basis in the distributing corporation's stock.

Unanswered Questions

It is not clear how Sec. 301(e) affects the 20% corporate distributee's E&P basis in the distributing corporation's stock. In the example, B's E&P was increased by the full $50 on receipt of the E&P dividend. Accordingly, no reduction in B's basis in its X stock for E&P purposes might be expected. However, Sec. 301(e)(1) expressly applies "for purposes of determining the taxable income of any 20 percent corporate shareholder (and its adjusted basis in the stock of the distributing corporation)." (Emphasis added.) One might conclude that B must determine its E&P basis in X's stock after applying the special adjustments required by Sec. 301(e).

Viewing the quoted parenthetical language in context, however, and keeping the purposes of E&P in mind, the better interpretation would seem to be that the adjusted basis referred to is B's basis for taxable income purposes. Under this approach, B's basis in the X stock for E&P purposes would be unaffected. While more accurate, this disconnect between tax basis and E&P basis means B will have to compute the E&P gain or loss from a later disposition of X's stock separately from the taxable gain or loss.

In the example, B reported a $10 dividend, even though X's modified E&P (after applying Sec. 301(e)) was $20. This result illustrates another open question: should the 20% corporate shareholder claim 100% of the modified E&P, or only its allocable share?

At first, there is a temptation to charge B with the entire $20. (Under this approach, B would include $20 of dividend income, claiming an 80% DRD for that amount, reduce its tax basis in X's stock to zero on receipt of the next $25 worth of that distribution, and then recognize $5 of capital gain.) However, this approach fails to take into account the possibility that X, in theory, could have more than one 20% corporate shareholder. It seems inappropriate for B's consequences to depend on whether the other shareholders happen to be corporations entitled to a DRD. By instead limiting B's share of the modified E&P to just $10, Sec. 301(e) would produce consistent treatment for all 20% corporate shareholders.

Recall that Sec. 301(e) only applies to 20% corporate shareholders entitled to a DRD under Secs. 243245. Even if a corporation owns the requisite amount of stock in the distributing corporation, Sec. 246(c) forbids any DRD unless the shareholder satisfies certain minimum holding period requirements. Almost always, that stock must be held at least 45 days (90 days in the case of certain preferred stock), although the clock is suspended under Sec. 246(c)(4) for periods during which the shareholder has reduced its risk of loss (e.g., through the use of puts and calls).

Presumably, Sec. 301(e) would not apply if B had owned the X stock for less than the required period. In that case, B would have to consider Sec. 1059, which reduces basis (and, in many cases, forces current gain recognition) on receipt of so-called "extraordinary dividends." It does not appear that Sec. 1059 modifies the distributing corporation's E&P along the lines of Sec. 301(e).

Another open question concerns whether Sec. 301(e) applies to S corporations that receive dividends from 20%-owned subsidiaries. An S corporation is not entitled to any DRD, because it computes its taxable income as an individual (under Sec. 1363(b)). As a result, Sec. 301(e) seems to be inconsistent with subchapter S and, thus, should not apply, even when the S corporation owns more than 20% of the distributing corporation's stock.

Conclusion

Sec. 301(e) is a trap for the unwary. The first stumbling block is recognizing its relevance for any corporate shareholder with a greater-than-20% ownership interest in a subsidiary (outside of the consolidated return setting). The second (and more cumbersome) problem is applying the provision. With little published guidance readily available, its practical application truly can seem bizarre.

From David J. Stalter, MBA, MST, and David Friedel, J.D., LL.M., Washington, DC