Rev. Rul. 74-339

Advice has been requested concerning the computation of earnings and profits available for the payment of dividends in a taxable year during which a corporation makes distributions to its shareholders in the ordinary course of business and also redeems stock from some of its shareholders.

The corporation, which files its Federal income tax returns on the basis of a calendar year, had a deficit in accumulated earnings and profits of 60x dollars at January 1, 1973, and had 60x dollars of earnings and profits of the taxable year 1973.

On April 1, 1973, the corporation redeemed some of its stock and the distributions with respect thereto qualified as distributions in exchange for the stock under section 302(a) of the Internal Revenue Code of 1954. On July 1, 1973, the corporation made distributions of 60x dollars to its shareholders to which section 301 of the Code applied. These combined distributions exceeded the corporation's earnings and profits of the taxable year (current earnings). The question presented is how to determine the earnings and profits available for the payment of dividends.

Generally, when a corporation redeems some of its common stock, the proper charge to earnings and profits is the pro rata portion of the total earnings and profits of the corporation thereof attributable to the shares redeemed. See Rev. Rul. 70-531, 1970-2 C.B. 76. On the other hand, distributions to which section 301 of the Code apply are charged to earnings and profits and to the extent thereof are dividends as defined in section 316. Thus, whether ordinary distributions are dividends depends upon the rule used to determine the order in which ordinary distributions, redemption distributions, and other type distributions are charged to earnings and profits. Under the facts of this case, if redemption distributions are first charged against earnings and profits, or if they are ranked equally with ordinary distributions, only a portion of the ordinary distributions will be dividends. But, if ordinary distributions take priority, the total amount, 60x dollars, distributed on July 1, 1973, will be dividends because they are covered in full by the current earnings.

Section 316 of the Code defines a dividend as follows:

(a) General Rule.--For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders--

(1) out of its earnings and profits accumulated after February 28, 1913, or

(2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.

Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. To the extent that any distribution is, under any provision of this subchapter, treated as a distribution of property to which section 301 applies, such distribution shall be treated as a distribution of property for purposes of this subsection.

Section 115(a)(2) of the Revenue Act of 1936, predecessor of section 316(a)(2) of the 1954 Code, was enacted to enlarge the definition of a dividend to include distributions out of earnings and profits of the taxable year so that a corporation with a deficit in accumulated earnings and profits could pay taxable dividends and be entitled to a dividend paid credit therefor. Section 1.316-2(b) of the Income Tax Regulations (Article 115-2 of Regulations 94 under the 1936 Act) states that if the earnings and profits of the taxable year (computed as of the close of the year without diminution by reason of any distributions made during the year and without regard to the amount of earnings and profits at the time of the distribution) are sufficient in amount to cover all the distributions made during that year, then each distribution is a taxable dividend.

In the case of Baker v. United States, 308 F. Supp. 1129 (1970), aff'd per curiam, 460 F.2d 827 (8th Cir. 1972), United States District Court for the District of Nebraska interpreted the language of section 316(a)(2) of the Code and other sections pertinent to this matter to mean that current earnings and profits were applied to dividends without diminution by redemption or liquidation distributions. In reaching this conclusion, the court considered not only the Congressional language used in the pertinent sections, but also the Congressional purpose behind their enactment.

Accordingly, since distributions subject to section 301 of the Code take priority over distributions subject to section 302(a), the current earnings in the amount of 60x dollars are available for the payment of dividends undiminished by any redemption distributions.

See Rev. Rul. 74-338, page 101, for the rules applicable to different factual situations.