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Sec. 1059 requires a corporate shareholder to reduce the stockbasis of its subsidiary when it receives an extraordinary dividend fromthe subsidiary within the first two years of owning thesubsidiary”s stock. The procedures for recalculating basis in thatscenario are clear, but the effect of these basis adjustments on thecorporate shareholder”s earnings and profits (E&P) is not asclear. Earnings and Profits E&P essentially is a quantitative measure of acorporation”s ability to make distributions to its shareholders inexcess of distributions considered a return of capital. Although theCode refers to E&P numerous times, nowhere does it provide acomprehensive list of procedures necessary to calculate E&P. CertainCode sections that clearly have some effect on a corporation”sE&P, including Sec. 1059, provide little or no guidance forcalculating E&P. The lack of clear statutory guidance leadspractitioners, as a pragmatic matter, to look elsewhere, including tothe legislative history, IRS guidance, and case law, for an appropriateanswer. Economic Reality Problem With the Dividends-Received Deduction Congress enacted Sec. 1059 in 1984 to prevent corporateshareholders from engaging in “dividend stripping”transactions. The following example illustrates Congress”s concernwhen it passed the section. Example: Prior to the enactment of Sec. 1059, corporation P purchased 50% of the common stock of corporation S for $500. S has undistributed E&P of $1,000. Shortly thereafter, S declares a dividend, with P receiving a $200 dividend distribution. P, upon receipt of the dividend, properly claims an 80% dividends-received deduction (DRD) under Sec. 243 equal to $160 (80% x $200) and includes the remaining $40 in taxable income. The distribution reduces the total fair value of S by the amount of the distribution, thus reducing the fair value of P”s stock in S.

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Under the law in effect prior to the passage of Sec. 1059, P makesno adjustment to the basis in its S stock because the distribution ismade out of S”s E&P. When P subsequently sells its devalued Sstock for $300 ($500 – $200), P could claim a $200 artificial capitalloss ($300 proceeds – $500 basis). Here, P”s $200 capital losscould not be used to offset the $40 of ordinary dividend income, but itcould be used to offset P”s capital gain to the extent it had any.Sec. 1059 is designed to prevent corporate shareholders from creatingsuch artificial capital losses to offset capital gains. Sec. 1059 Sec. 1059 requires a corporation that receives an”extraordinary dividend” on shares of stock to reduce thebasis in those shares of stock (but not below zero) by the nontaxedportion of the dividend. Sec. 1059(c) defines an extraordinary dividendas any dividend that exceeds 10% of a corporate shareholder”Ecommon stock basis (or 5% for preferrec stock). An extraordinarydividend also includes non-pro-rata dividend-equivalent redemptions anddividends arising by operation of Sec. 304. In the example, S”s $200 dividend distribution to P isconsidered an extraordinary dividend because it exceeds $50, which is10% of P”s basis in its S stock ($500 x 10%). Accordingly, P mustreduce its basis in the S stock by the nontaxed portion of the dividend,resulting in an adjusted basis of $340 ($500 basis – $160 nontaxedportion of the dividend). When P later sells its S stock, instead ofrecognizing a $200 loss, as in the pre-Sec. 1059 example, P recognizes aloss of only $40 ($300–$340), achieving a much closer approximation ofthe “true” economics of the transactions. How Is E&P Affected? When a corporate shareholder receives a distribution out ofE&P, the corporate shareholder generally increases its E&P bythe full amount of the distribution without regard to Sec. 243 (seeFriedel, Galanis, and Allen, BNA Tax Management U.S. Income Portfolio762-3d: Earnings and Profits, for an in-depth discussion of the E&Prules). However, when a corporate shareholder receives a distributionthat is treated as a return of capital–i.e., all or a portion of thedistribution is applied directly to reduce the basis of the stock towhich the distribution is made–Sec. 312(f) (2) precludes the corporateshareholder from increasing its E&P by the amount of thedistribution attributable to a return of capital.

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