CORPORATE LAW & PLANNING STRATEGIES
DIVIDENDS & DISTRIBUTIONS

Corporate “Distributions”

[1] Definition

A corporation’s “distribution to its shareholders” is defined as either of the following: [Corp. Code § 166]

(1)The transfer of cash or property by a corporation to its shareholders without consideration, whether by way of a dividend or otherwise [see [2], below ], except for a dividend in shares of that corporation [see § 9.17[1]]; or
(2)The purchase or redemption by a corporation of its own shares for cash or property [see [3], [4], below ].

Such a transfer, purchase, or redemption by a subsidiary of the corporation also falls within the definition of a “distribution” [Corp. Code § 166; see Corp. Code § 189 (“subsidiary” defined as corporation in which parent corporation owns shares possessing more than 50 percent of voting power)].

The following transactions are specifically excluded from the definition of “distribution” [Corp. Code § 166]:

(1)Satisfaction of a final judgment of a court or tribunal of appropriate jurisdiction ordering the rescission of the issuance of shares;
(2)The rescission by a corporation of the issuance of its shares, if the board determines that (a) it is reasonably likely that the holder or holders of the shares in question could legally enforce a claim for the rescission, (b) the rescission is in the best interests of the corporation, and (c) the corporation is likely to be able to meet its liabilities (except those for which payment is otherwise adequately provided) as they mature; and
(3)The repurchase by a corporation of shares issued by it under an employee stock purchase plan [see Corp. Code § 408], if the board determines that (a) the repurchase is in the best interests of the corporation, and (b) the corporation is likely to be able to meet its liabilities (except those for which payment is otherwise adequately provided) as they mature.

Throughout this chapter, the term “distribution” has the meaning described in Corporations Code Section 166.[2] “Dividend”

The General Corporation Law does not define the term “dividend.” However, that term generally refers to a corporation’s payment to its shareholders of corporate profits, as a return on their investment [see Estate of Talbot (1969) 269 Cal. App. 2d 526, 535, 74 Cal. Rptr. 920]. Shareholders have no vested right to a dividend until it has been declared by the corporation’s board of directors pursuant to resolution [Miller v. McColgan (1941) 17 Cal. 2d 432, 436, 110 P.2d 419, overturned on other grounds, Henley v. Franchise Tax Board, (1953) 122 Cal. App. 2d 1; see § 9.200]. Although a dividend may take the form of cash or other property, a dividend in the form of the corporation’s own shares [see § 9.17 [1], below] does not constitute a distribution subject to statutory financial tests [Corp. Code §§ 166, 500, 501; see § 9.11]. For further discussion of dividends, see § 9.200.[3] “Repurchase”

The term “repurchase” is not defined in the General Corporation Law, either. It traditionally means a corporation’s acquisition of its outstanding shares for value, or a subsidiary’s acquisition of the parent corporation’s shares for value [see Ballantine & Sterling, California Corporation Laws, vol. 1, Ch. 8, Dividends and Reacquisition of Shares ]. Corporations Code Section 207(d) specifically grants corporations the power to purchase their own shares, bonds, debentures, and other securities. However, the articles of incorporation, the bylaws, or corporate agreements may limit a corporation’s repurchase of its shares [see Corp. Code § 505; see also § 9.11[7]]. See § 9.222[1] for further discussion of issues specifically applicable to the repurchase of shares.[4] “Redemption”

Although the General Corporation Law does not define the term “redemption” [see Corp. Code § 180 (“redemption price” defined)], that term generally means a corporation’s reacquisition of outstanding shares pursuant to a right of redemption or repurchase held by the corporation that is one of the rights, preferences, privileges, or restrictions of those particular shares [see Ballantine & Sterling, California Corporation Laws, Ch. 8, Dividends and Reacquisition of Shares (Matthew Bender) ]. Corporations are specifically authorized to redeem any or all redeemable shares upon proper notice and payment [see Corp. Code § 509]. For coverage of issues unique to the redemption of shares, see § 9.220[1].[5] Determination of Time Distribution Was Made

A distribution in the form of a dividend is deemed to be made on the date it is declared [Corp. Code § 166]. A distribution in the form of a purchase or redemption of shares is deemed to be made on the date that the corporation transfers cash or property to the shareholders, regardless of whether the distribution is made pursuant to a preexisting contract [Corp. Code § 166]. However, if the corporation issues securities [see Comm. Code § 8102 (definition)] in exchange for shares, the distribution is made on the date that the corporation acquires the shares in the exchange [Corp. Code § 166]. In the case of a sinking fund payment [see § 9.220[1][e]], the corporation is deemed to have transferred cash or property when it delivers the cash or property to a trustee for the holders of preferred shares to be used for the redemption of the shares, or when the corporation physically segregates cash or property in trust for that purpose [Corp. Code § 166].[6] Valuation of Retained Earnings, Assets, and Liabilities for Purposes of Authorizing Distribution

For purposes of the General Corporation Law provisions regarding distributions [see Corp. Code §§ 500 et seq.], the board of directors may base a determination that a distribution is not prohibited under the required statutory tests on any of the following [Corp. Code § 500(c); see Corp. Code §§ 500(a), 501; see also § 9.12]:

•Financial statements prepared on the basis of accounting practices and principles that are reasonable under the circumstances;
•A fair valuation; or
•Any other method that is reasonable under the circumstances.

Restrictions on Distributions

[1] In General

The General Corporation Law restrictions on corporation distributions discussed below are necessary to impose some control over the corporation’s ability to pay dividends to its shareholders. Before the enactment of statutes governing corporate distributions, the United States Supreme Court held that the capital stock of an incorporated company is a fund set apart for the payment of its debts, and substitutes for the personal liability of the owners of an unincorporated business [Sanger v. Upton (1875) 91 U.S. 56, 60, 23 L. Ed. 220]. Although this “trust fund” theory has been criticized [see Ballantine & Hills, “Corporate Capital and Restrictions Upon Dividends Under Modern Corporation Laws,” 23 Calif. L. Rev. 229, 231–235 (1935)], the capital of a corporation nonetheless remains the primary source for payment of corporate debts [see Ballantine & Sterling, California Corporation Laws, Ch. 8, Dividends and Reacquisition of Shares (Matthew Bender)]. In addition to protecting the corporation’s creditors, restrictions on distribution protect preferred shareholders with dividend or liquidation preferences against junior shareholders, and protect all shareholders against mismanagement and impairment of their investment [see Ballantine & Sterling, California Corporation Laws, Ch. 8, Dividends and Reacquisition of Shares (Matthew Bender); Ballantine & Hills, “Corporate Capital and Restrictions Upon Dividends Under Modern Corporation Laws,” 23 Calif. L. Rev. 229, 233 (1935)].

California law does not restricts the sources from which a corporation may pay dividends, but instead requires the corporation to meet the requirements of several financial tests set forth in the General Corporation Law [see Corp. Code §§ 500, 501] before it may make any valid “distribution to its shareholders” [see Corp. Code § 166 (definition); see also § 9.10[1]]. First, a corporation must meet either of two basic financial tests: a “retained earnings” test [see Corp. Code § 500(a)(1)]; see also [2], below], or simplified “balance sheet” test [see Corp. Code § 500(a)(2); see also [2], below]. In addition, a corporation must satisfy a test related to its general solvency [see Corp. Code § 501; see also [2], below]. There are several exclusions from the tests [see § 9.12]. Whether or not a corporation satisfies these tests is determined by the board of directors based on either reasonable accounting practices and principles, a fair valuation, or any other method that is reasonable under the circumstances [see Corp. Code § 500(c); see also § 9.12].[2] Statutory Tests

As mentioned in [1], above, a corporation must satisfy certain statutory financial tests to purchase or redeem its shareholders’ shares under an entity purchase agreement not funded by insurance. Under the General Corporation Law, the purchase or redemption by a corporation of its shares for cash or property is a “distribution to its shareholders” [Corp. Code § 166]. In order to make a valid distribution to its shareholders, a corporation’s board of directors must determine in good faith that either [Corp. Code § 500(a)]:

1.The amount of the corporation’s retained earnings immediately prior to the distribution equals or exceeds the sum of the amount of the proposed distribution plus preferential dividends arrears amount; or
2.Immediately giving the distribution, the value of the corporation’s assets would equal or exceed the sum of its total liabilities plus the preferential rights amount.

With regard to the “retained earnings test” described in 1., above, “retained earnings” means the balance of net profits after the deduction of distributions to shareholders, and transfer to capital accounts under generally accepted accounting principles [see Corp. Code § 114; Ballantine & Sterling, California Corporation Laws, Ch. 8. Dividends and Reacquisition of Shares, § 141.06[3] (Matthew Bender)]. “Preferential dividends arrears amount” is the amount, if any, of cumulative dividends in arrears on all shares having a preference with respect to payment of dividends over the class or series to which the applicable distribution is being made. If the articles of incorporation provide that a distribution can be made without regard to preferential dividends arrears amount, then the preferential dividends arrears amount will be zero [Corp. Code § 500(b); see Corp. Code § 163.1 (“cumulative dividends in arrears” defined)].

With regard to the “balance sheet test” described in 2., above, the “preferential rights amount” is the amount that would be needed if the corporation were to be dissolved at the time of the distribution to satisfy the preferential rights, including accrued but unpaid dividends, of other shareholders upon dissolution that are superior to the rights of the shareholders receiving the distribution. If the articles of incorporation provide that a distribution can be made without regard to any preferential rights, then the preferential rights amount will be zero [Corp. Code § 500(b)].

Under the balance sheet test, a corporation may incur indebtedness without affecting the ability to make distributions provided the terms of indebtedness provide that payment of principal and interest is to be made only if, and to the extent that, payment of a distribution to shareholders could then be made. Under these circumstances, the indebtedness is not a liability for purposes of the test [see Corp. Code § 500(e)(1)]. If indebtedness is issued for any distribution, including one to pay the purchase price for a repurchase of outstanding shares, each payment of principal or interest on the indebtedness will be treated as a distribution, the effect of which is measured on the date the payment of the indebtedness is actually made [Corp. Code § 500(e)(2)].

In addition to passing either the retained earnings or balance sheet test, a corporation must pass a “general solvency” test before making a distribution to the shareholders. Under that test, neither a corporation nor any of its subsidiaries may make a distribution to the corporation’s shareholders if the corporation or subsidiary making the distribution is, or as a result of the distribution would be, likely to be unable to meet its liabilities as they mature, except those liabilities whose payment is otherwise adequately provided for [Corp Code § 501; see Flynn v. California Casket Co. (1951) 105 Cal. App. 2d 196, 205–206, 233 P.2d 131].

In the case of a distribution by a corporation of cash or property in payment by the corporation in connection with the purchase of its shares [Corp. Code § 500(b)]:

1.There must be added to retained earnings all amounts that had been previously deducted from retained earnings with respect to obligations incurred in connection with the corporation’s repurchase of its shares and reflected on the corporation’s balance sheet, but not in excess of the principal of the obligations that remain unpaid immediately prior to the distribution; and
2.There must be deducted from liabilities all amounts that had been previously added to liabilities with respect to the obligations incurred in connection with the corporation’s repurchase of its shares and reflected on the corporation’s balance sheet, but not in excess of the principal of the obligations that will remain unpaid after the distribution, provided that no addition to retained earnings or deduction from liabilities may occur on account of any obligation that is a distribution to the corporation’s shareholders at the time the obligation is incurred [Corp. Code § 500(b); see Corp. Code § 166 (when distribution is made)].

[3] Factors Considered by Board When Applying Statutory Tests

The board of directors may base a determination that a distribution to shareholders is not prohibited by the retained earnings, balance sheet, or general solvency tests [see Corp. Code §§ 500(a), 501; see also § 9.12] on any of the following [Corp. Code § 500(c)]:

•Financial statements prepared on the basis of accounting practices and principles that are reasonable under the circumstances;
•A fair valuation; or
•Any other method that is reasonable under the circumstances.

Accounting practices and other methods that are “reasonable under the circumstances” are not the same as “generally accepted accounting practices,” which is the more formal standard generally adopted by the General Corporation Law [see Corp. Code § 114] and applicable before the adoption in 2011 of legislation designed to simplify and clarify the tests and standards governing corporate distributions [see 2011 Cal. Stats., ch. 203, § 2 (AB 571)]. The reasonableness standard effectively enables the board of directors to consider, among other things, the fair market value of the corporation’s assets in determining their value.

The adoption of a “reasonable under the circumstances” standard, however, does not preclude application of generally accepted accounting practices when applying the statutory tests of Corp. Code §§ 500(a) and 501 to determine whether a proposed distribution to shareholders is prohibited.[4] Restrictions Imposed by Corporate Instrument

The General Corporation Law permits a corporation to provide additional restrictions on the declaration of dividends or the purchase or redemption of the corporation’s own shares, pursuant to provisions (1) in its articles, (2) in its bylaws, or (3) in any indenture or other agreement entered into by the corporation [Corp. Code § 505]. For example, senior preferred shares and corporate debt instruments often contain specific contractual restrictions on distributions

Exceptions to Financial Tests

[1] Broker-Dealers

The retained earnings, balance sheet, and solvency tests [see Corp. Code §§ 500(a), 501; see also § 9.11[2]] do not apply to a corporation licensed as a broker dealer [see Corp. Code §§ 25210 et seq.] if the corporation, immediately after giving effect to any distribution, is in compliance with the net capital rules of the Commissioner of Corporations and the Securities and Exchange Commission. Those rules require broker dealers to limit aggregate indebtedness to a certain percentage of his or her net capital [see 10 Cal. Code Reg. § 260.216.12; 17 C.F.R. § 240.15c3-1].[2] Regulated Investment Companies

The retained earnings and balance sheet tests [see Corp. Code § 500(a); see also § 9.11[2]] do not apply to any dividend declared by a regulated investment company [see I.R.C. § 851 (definition)] to the extent that the dividend is necessary to maintain the status of the corporation as a regulated investment company under the provisions of the Internal Revenue Code [Corp. Code § 504(a)(1); see I.R.C. §§ 851–855]. None of the restrictions on “distributions” [see Corp. Code §§ 500–511] apply to any purchase or redemption of shares redeemable at the option of the holder by a registered open-end investment company [see 15 U.S.C. § 80a-5(b)] under the United States Investment Company Act of 1940 [see 15 U.S.C. §§ 80a-1–80a-64], as long as the right of redemption remains unsuspended under the provision of that Act and the corporation’s articles and bylaws [Corp. Code § 504(b)].[3] Real Estate Investment Trusts

The retained earnings and balance sheet tests [see Corp. Code § 500; see also § 9.11[2]] do not apply to any dividend declared by a real estate investment trust [see I.R.C. § 856 (definition)] to the extent that the dividend is necessary to maintain the status of the corporation as a real estate investment trust under the provisions of the Internal Revenue Code [ Corp. Code § 504(a)(2); see I.R.C. § 856 et seq.].[4] Deceased or Disabled Shareholders

None of the statutory tests [see Corp. Code §§ 500, 501; see also § 9.11[2]] apply to a purchase or redemption of shares of a deceased shareholder from the proceeds in insurance on that shareholder’s life in excess of the total amount of all premiums paid by the corporation for that insurance, in order to carry out the provisions of a buy-sell agreement between the corporation and that shareholder to purchase or redeem those shares on the shareholder’s death [Corp. Code § 503(a)]. A similar rule applies to the proceeds of disability insurance used to purchase a disabled shareholder’s shares [see Corp. Code § 503(b)]. Even if the proceeds exceeding the premiums paid by the corporation are inadequate for the redemption, those proceeds received by the corporation should increase its retained earnings and enable it to pass the statutory balance sheet tests [see Ballantine & Sterling, California Corporation Laws, Ch. 4, Close Corporations, § 63.03[b][I] (Matthew Bender)].[5] Holders in Due Course

Notwithstanding the General Corporation Law provisions governing corporate distributions [see Corp. Code §§ 500–511], a holder in due course [see Com. Code § 3302 (defined as a holder who takes an instrument for value, in good faith, without notice that it is overdue, dishonored, or subject to defenses or claims)] of a negotiable instrument issued by a corporation for the purchase or redemption of shares, or a person who acquired the instrument through that holder, may enforce the instrument if he or she did not receive notice that it was issued for that purpose [Corp. Code § 511]. Rather than providing an actual exception from the restrictions on corporate distribution, Corp. Code § 511 deprives the corporation of the defense to payment based on its inability to make a distribution at the time the instrument is payable [see Corp. Code §§ 500, 501 (financial tests)]. It eliminates conflicts between the restrictions on distributions set forth in the Corporations Code and the rights of holders in due course set forth in the Commercial Code

Shareholders’ Civil Liability for Receiving Improper Distributions

[1] In General

Any shareholder who receives a “distribution” [see Corp. Code § 166 (definition); see also § 9.10[1]] prohibited by the General Corporation Law [see Corp. Code §§ 500–511], with knowledge of facts indicating the impropriety of the distribution, is liable to the corporation for the benefit of all the creditors or shareholders entitled to bring an action [see [2], below] for the amount received plus interest at the legal rate on judgments [see Cal. Const., art. XV, § 1; Code Civ. Proc. § 685.010] until paid [Corp. Code § 506(a)]. The shareholder need only know the “facts” that render the distribution improper; he or she need not actually know or believe that the distribution is in fact illegal [England v. Christensen (1966) 243 Cal. App. 2d 413, 431, 52 Cal. Rptr. 402 (interpreting prior law)]. The shareholder’s liability, however, cannot exceed the corporation’s liabilities to nonconsenting creditors at the time of the violation, or the injury suffered by nonconsenting shareholders, as the case may be [Corp. Code § 506(a); see [2], below].[2] Right to Bring Suit

Any one or more creditors of the corporation (1) whose debts or claims arose prior to the time of the distribution, and (2) who have not consented to the distribution, may bring suit in the name of the corporation to enforce the liability to creditors arising from a violation of the retained earnings, balance sheet, or general insolvency test [Corp. Code § 506(b); see Corp. Code §§ 500(a), 501; § 9.11]. It is irrelevant whether the creditors have reduced their claims to judgment [Corp. Code § 506(b)].

Any one or more shareholders who have preferred rights (1) to cumulative dividends in arrears [see Corp. Code § 500(a)(1)], or (2) on dissolution [see Corp. Code § 501(a)(2)], who have not consented to the applicable distribution, and to the extent the applicable shares with preferential rights were outstanding at the time of distribution, may bring suit in the name of the corporation to enforce the corporation’s liability to shareholders arising from a violation of either the retained earnings test or the balance sheet test Corp. Code § 506(b); see Corp. Code § 500(a); see also Corp. Code § 163.1 (“cumulative dividends in arrears” defined)]. There is no right to sue on behalf of the corporation, however, for shareholders with preferential rights if, in the case of the retained earnings test, the preferential dividends arrears amount is zero [see Corp. Code § 500(a)(1); § 9.11[2]], or in the case of the balance sheet test, the preferential rights amount [see Corp. Code § 500(a)(2); 9.11[2]] is zero. A cause of action with respect to an obligation to return an illegal distribution must be brought within four years after the date of distribution [Corp. Code § 506(b)].

Any shareholder sued for receiving an improper distribution may implead all other shareholders who are liable, and may compel contribution either in the same action or in an independent action against shareholders not joined in the action [Corp. Code § 506(c)].

For an example and discussion of the complaint used in an action for damages against the shareholders for receiving an improper distribution, and for a cross complaint used to implead other shareholders in the main action to recover damages see California Forms of Pleading and Practice, Ch. 164, Corporations: Dividends and Reacquisitions of Shares §§ 164.51 and 164.52 (Matthew Bender), respectively.[3] Non-Exclusive Liability

The General Corporation Law provisions imposing shareholder liability for receiving improper distributions do not affect any liability that a shareholder may have under the Uniform Voidable Transactions Act [Corp. Code § 506(d); see Civ. Code § 3439 et seq.]. Under that Act, a creditor is entitled to any of the following remedies for a fraudulent transfer or obligation [Civ. Code § 3439.07(a); see Civ. Code § 3439.08 (limitations)]:

(1)Avoidance of the transfer or obligation to the extent necessary to satisfy the creditor’s claim;
(2)Attachment or other provisional remedy against the asset transferred or its proceeds, in accordance with the procedures set forth in Code of Civil Procedure Sections 481.010–493.060 [see California Forms of Pleading and Practice, Ch. 62, Attachment (Matthew Bender)]; or
(3)An injunction against further disposition of the asset, appointment of a receiver, or any other relief required under the circumstances.

Under the Act, there are three main types of fraudulent transfers. The first is a transfer or obligation that the debtor made with actual intent to hinder, delay, or defraud any creditor [Civ. Code § 3439.04(a)(1); see, e.g., Chen v. Berenjian (2019) 33 Cal. App 5th 811, 814–815, 245 Cal. Rptr. 3d 378 (creditor brought action against debtor and debtor’s brother for fraudulent transfer involving sham lawsuit, stipulated judgment, and levy and assets transfer to evade legitimate creditor’s attempt to execute on his judgments); see also Universal Home Improvement, Inc. v. Robertson (2020) 51 Cal. App. 5th 116, 120–122, 264 Cal. Rptr. 3d 686 (reviewing legislative history of § 3439.04)]. The second is a transfer or obligation that a debtor made without receiving a reasonably equivalent value in the exchange, if the debtor (1) was engaged or about to engage in a business or transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction, or (2) intended to incur (or believed or reasonably should have believed that he or she would incur) debts beyond his or her ability to pay as they became due [Civ. Code § 3439.04(a)(2)]. Finally, a transfer or obligation is fraudulent to a creditor whose claim arose before the transfer was made or the obligation was incurred if the debtor (1) did not receive a reasonably equivalent value in exchange, and (2) was insolvent at that time or became insolvent as a result of the transfer or obligation [Civ. Code § 3439.05]. Because the term “transfer” includes every payment of money [see Civ. Code § 3439.01(i)], it includes corporate “distributions” [see Corp. Code § 166 (definition)

Directors’ Civil Liability for Making Improper Distributions

[1] In General

The directors of a corporation who approve a “distribution to its shareholders” [see Corp. Code § 166 (definition); see also § 9.10 [1]] that fails to meet the financial tests set forth in the General Corporation Law [Corp. Code §§ 500, 501; see § 9.11[2]], are jointly and severally liable to the corporation for the benefit of all creditors or shareholders entitled to enforce that liability [Corp. Code §§ 316(a), (c), 506(b); see [3], below]. A director who is present at a board or committee meeting at which action authorizing the distribution is taken and who abstains from voting is considered to have approved the distribution [Corp. Code § 316(b)].

This general rule imposing liability, however, is subject to two exceptions [see Corp. Code § 309; see also [2], below].[2] Exceptions to General Rule

A director’s civil liability for approving an improper distribution is subject to the exculpatory provisions of Corporations Code Section 309 [Corp. Code § 316(a)]. That section first provides that a director who performs his or her duties in accordance with its provisions [see discussion, below] will not be liable for any alleged failure to discharge his or her obligations as a director [Corp. Code § 309(c)]. Furthermore, it provides that the corporate articles may limit or eliminate a director’s liability for monetary damages, to the extent provided in Corporations Code Section 204(a)(10) (which prohibits limiting or eliminating personal liability for certain improper actions) [Corp. Code § 309(c)]. For an example and discussion of such an article provision, see Ch. 3, Articles of Incorporation, § 3.280.

Under Corporations Code Section 309, a director must perform his or her duties as a director, including the duties as a member of any committee on which he or she serves, (1) in good faith, (2) in a manner that he or she believes to be in the best interest of the corporation and its shareholders, and (3) with the care (including reasonable inquiry) that an ordinarily prudent person in a like position would use under similar circumstances [Corp. Code § 309(a)]. In performing these duties, a director is entitled to rely on information, opinions, reports, or statements (including financial statements and other financial data) that have been prepared or presented by any of the following [Corp. Code § 309(b)]:

(1)One or more officers or employees of the corporation whom the director believes to be reliable and competent in the matters presented;
(2)Counsel, independent accountants [see Corp. Code § 115], or other persons, as to matters that the director believes to be within that person’s professional or expert competence; or
(3)A committee of the board on which the director does not serve, as to matters within its designated authority, which the director believes to merit confidence.

The director may rely on information furnished by the above, however, only when acting in good faith, after reasonable inquiry when the need is indicated by the circumstances, and without knowledge that would cause that reliance to be unwarranted [Corp. Code § 309(b)].[3] Persons Entitled to Enforce Liability

The following persons may bring suit in the name of the corporation against any or all directors liable for approving an improper distribution [Corp. Code §§ 316(c), 506(b)]:

(1)Any one or more creditors of the corporation whose debts or claims arose prior to the time of the distribution to shareholders and who have not consented to that distribution, whether or not they have reduced their claims to judgment; or
(2)Any one or more holders of preferred shares outstanding at the time of the distribution who have not consented to the distribution.

Shareholders bringing suit need not comply with the requirements normally imposed on shareholder derivative actions [Corp. Code §§ 316(c), 506(b); see Corp. Code § 800; see also § 9.14[2]].

For an example and discussion of the complaint used in an action for damages against the directors for approving an improper distribution, see California Forms of Pleading and Practice, Ch. 164, Corporations: Dividends and Reacquisitions of Shares, § 164.50 (Matthew Bender).[4] Damages, Contribution, and Subrogation

The damages recoverable from a director are the amount of the illegal distribution. If the illegal distribution consists of property, the recoverable damages are the fair market value of that property at the time of the illegal distribution. In addition, damages include interest (at the legal rate applicable to judgments) on the amount of the distribution or the fair market value of the property, from the date of the distribution until paid, plus any reasonably incurred costs of appraisal or other valuation. However, damages may not exceed (1) the liabilities of the corporation owed to nonconsenting creditors at the time of the violation, and (2) the injury suffered by nonconsenting shareholders, as the case may be [Corp. Code § 316(d)].

A director who is sued for approving an improper distribution may implead all other directors who are liable, and may compel contribution either in the same action or in an independent action against directors not joined as parties in that action [Corp. Code § 316(e)]. Any director who is held liable for approving an improper distribution is entitled to be subrogated to the rights of the corporation against shareholders who received the distribution [Corp. Code § 316(f)(1)]. He or she or may proceed against the person or persons who are liable to the director as a result of the subrogation by either (1) filing a cross-complaint against them in the same action, or (2) bringing an independent action against them [Corp. Code § 316(f)].

Directors’ Criminal Liability for Improper Distributions

Any director of a corporation who concurs, knowingly and with a dishonest or fraudulent purpose, in any vote or act of the directors to make any dividend or distribution of assets except as permitted by law is guilty of a misdemeanor if the improper dividend or distribution of assets was designed either to defraud creditors or shareholders or to give a false appearance of the value of the corporation’s stock, thereby defrauding subscribers or purchasers. The misdemeanor is punishable by a fine up to $1,000, imprisonment for up to one year, or both [Corp. Code § 2253].

C Corporation Distributions-Tax Aspects and Characterization

C corporations may distribute money or property to shareholders. The method used to make a corporate distribution will determine the tax consequences of the withdrawal. Generally, nonliquidating distributions (those that don’t dissolve the business) will take the form of dividends or a nontaxable return of capital to the shareholders. Of course, a corporation can distribute money in a number of other ways, as well, including payment of wages, fringe benefits, loans, and payment of rent. However, some of these deductible expenses can be reclassified by the IRS as taxable “constructive dividends” under certain conditions.
How Are Distributions Taxed?

The corporation itself does not recognize gain on a distribution of cash to its shareholders. Rather, the shareholders are the ones who must be concerned with taxation. Although distributions of cash or property to the shareholders will reduce the corporation’s earnings and profits (E&P), such distributions will not reduce the corporation’s taxable income. The corporation pays tax on the taxable income, and the shareholders pay tax on dividends received.
Dividends

A distribution from a corporation is included in a taxpayer’s gross income to the extent that it constitutes a dividend. A taxable dividend is defined as a distribution from current or accumulated earnings and profits (E&P) of the distributing corporation (computed at the end of the year). Accumulated E&P refers to sums accumulated prior to the taxable year.

A distribution is treated as coming first from current E&P. If current E&P is sufficient to cover all distributions during the taxable year, such distributions are treated as dividends, and it is unnecessary to consider accumulated E&P. Accumulated E&P is relevant only if current E&P is insufficient to cover a corporate distribution. Distributions in excess of current E&P are dividends to the extent of accumulated E&P. The remaining balance is treated as return of capital to the extent of the shareholder’s basis in his or her stock, and any excess is treated as taxable gain.

Example: ABC Corporation has current E&P of $20,000 and accumulated E&P of $55,000. During the year, ABC distributed a total of $100,000 in dividends. Of this amount, $75,000 will be treated as taxable dividends, and the remaining $25,000 will be treated as a nontaxable return of capital (to the extent of a shareholder’s stock basis) or as a taxable gain to the shareholders.
Constructive Dividends

If a corporation with E&P makes a distribution to a shareholder and does not report the payment as a taxable dividend, the IRS will sometimes reclassify this distribution as a constructive dividend, which means a de facto dividend. The distribution is then taxed the same as a regular dividend.

The following are some examples of transactions that may result in constructive dividends:

A corporation makes payments to a shareholder’s family member without a corresponding level of services provided by the family member
A corporation allows a shareholder the personal use of corporate property (such as an airplane, auto, or entertainment facility)
A corporation pays personal expenses of an owner/employee and the expenses cannot be substantiated
A stockholder purchases property from a corporation at below fair market value

Return of Capital

A distribution in excess of the corporation’s earnings and profits is generally viewed as a nontaxable return of capital to the shareholder. In other words, it is seen as merely a recovery or return of the shareholder’s investment in the corporation. The amount of this distribution first reduces the basis of the shareholder’s stock. Then, any amount in excess of the stockholder’s adjusted basis will be treated as a capital gain from the sale or exchange of property.
Wages for Services

Wages paid to a shareholder for services rendered in an employee capacity are deductible by the corporation and taxable to the shareholder. Unlike income in the form of dividend distributions, wages are not double taxed. This creates an incentive for a shareholder in a C corporation to take as high a wage as possible to minimize overall taxes on corporate earnings.

Wages paid to the shareholder must be based on services rendered and will be scrutinized by the IRS. In fact, the IRS will reclassify a portion of the wages as constructive dividends if they do not represent “reasonable compensation.” Some of the factors a court would consider to determine whether compensation is “reasonable” include the following:

How does the amount of compensation compare with the amount of dividends paid?
Would an unrelated outside investor consider the compensation reasonable?
How does the compensation compare with the profit performance of the corporation?
Was the level of compensation arranged in advance, or was it based on corporate profit?
What is the typical level of compensation in the corporation’s industry?

Fringe Benefits

Funds can also be distributed by the corporation in the form of fringe benefits. Fringe benefits, such as health insurance, medical reimbursement plans, company cars, education, and group term life insurance, are tax-deductible corporate business expenses by the corporation. Excessive fringe benefits distributed to an owner/employee may also be treated as constructive dividends.
Loans

A corporation can lend money to a shareholder. However, the IRS will reclassify the loan as a dividend distribution if the loan is not well documented. The loan must be a bona fide one, with a written promissory note signed and dated by both the lender (the corporation) and the borrower (the shareholder). The promissory note should state the time period for repayment and the interest rate to be charged.

The interest rate must be a reasonable one, based on current market conditions. However, if the principal balance of the loan does not exceed $10,000, the below market interest rate rules will not apply. In fact, the interest rate can be as low as zero percent. This exception does not apply, however, if the principal purpose of the loan is to avoid federal tax. The IRS and the courts use the following criteria to determine if corporate loans to shareholder loans are really loans or should be treated as taxable dividend distributions:

Whether a ceiling existed on the amounts advanced
Whether or not security was given for the loan
Whether the stockholder was in a position to repay the loan
Whether there existed a repayment schedule or an attempt to repay
Whether there was a set maturity date
Whether interest was charged
The amount of the loan
The extent to which the shareholder controls the corporation
The earnings and dividends history of the corporation
Whether a promissory note was drawn up
Whether the corporation made systematic attempts to obtain repayment
The corporation’s ratio of debt to equity

Rent Payments

A corporation can pay rent to a shareholder for use of the shareholder’s personal property. The corporation gets a tax deduction for rent paid, and the shareholder reports rental income on his or her personal return. However, the IRS will reclassify rent as a dividend when payments are unreasonable. This may happen, for example, when a corporation pays rent to a shareholder in excess of the fair market rental value of the property.

S Corporation With No AE&P

I am writing in response to your recent phone call inquiring about the federal income tax treatment of distributions by S corporations with no accumulated earnings and profits (“AE&P”). The tax consequences of distributions by S corporations with no AE&P are explained below.

Consequences to Corporation
In general, an S corporation recognizes no gain or loss as a result of a nonliquidating distribution of property with respect to its stock. However, if appreciated property (that is, property with a fair market value exceeding its adjusted basis) is distributed, gain is recognized by the corporation as if the property were sold to the distributee at its fair market value. For this purpose, if the property distributed is subject to a liability (or the shareholder assumes a liability of the corporation in connection with the distribution), the fair market value of the property is deemed to be no less than the amount of the liability.
For example, assume an S corporation distributes, to its sole shareholder, property with a fair market value of $500 and an adjusted basis of $200. Upon the distribution, the corporation would recognize a $300 gain. This gain would, in turn, pass through to the shareholder and increase his or her basis in the stock.
Consequences to Shareholder
The amount of any distributions to S corporation shareholders is tax free to the extent of their basis in the stock. These tax-free distributions reduce the shareholder’s stock basis (but not below zero). Any distribution in excess of basis is taxed as gain from the sale or exchange of the stock. Assuming the shareholder is not a dealer in the stock, the gain will be a capital gain. The capital gain will be either long-term (more than one year) or short-term (one year or less) depending on the shareholder’s holding period for the stock. The amount of the distribution equals the amount of money and the fair market value of any property distributed.
In determining how much (if any) of the distribution is taxable, the adjusted basis of the stock is computed after taking into account the shareholder’s pro rata share of any corporate income or loss for the year. Thus, for example, even if a shareholder has no basis in his or her stock at the beginning of the year, distributions during the year will be tax free, provided an equal (or greater) amount of corporate income is passed through to the shareholder at the end of the corporation’s year.
Please note that this letter does not necessarily cover all of the possible tax consequences of an S corporation distribution that may apply in your particular situation. For example, the distribution may have different tax consequences for alternative minimum tax and state tax purposes. Thus, before making an actual distribution, you may wish to give me a call so we can determine all of the possible tax consequences in your particular situation.

S Corporation With AE&P
I am writing to you in response to your recent question regarding the treatment, for federal income tax purposes, of distributions by S corporations with accumulated earnings and profits (“AE&P”). The rules that apply at the corporate and the shareholder level are summarized below.
Consequences to Corporation
In general, an S corporation recognizes no gain or loss as a result of a nonliquidating distribution of property with respect to its stock. However, if appreciated property (that is, property with a fair market value exceeding its adjusted basis) is distributed, gain is recognized by the corporation as if the property were sold to the distributee at its fair market value. For this purpose, if the property distributed is subject to a liability (or the shareholder assumes a liability of the corporation in connection with the distribution), the fair market value of the property is deemed to be no less than the amount of the liability.
For example, assume an S corporation distributes to its sole shareholder, property with a fair market value of $500 and an adjusted basis of $200. Upon the distribution, the corporation would recognize a $300 gain. This gain would, in turn, pass through to the shareholder and increase his or her basis in the stock.
Consequences to Shareholder
The taxation of distributions to shareholders by S corporations with AE&P is determined under a 5-tier distribution system, as follows:
1. Distributions of the corporation’s accumulated adjustments account (“AAA”) that do not exceed the shareholder’s stock basis, are tax free and reduce stock basis (but not below zero).
2. Distributions (if any) of the corporation’s remaining AAA are taxed as a capital gain to the extent those distributions exceed the shareholder’s stock basis. The gain will be long-term to the extent the stock has been held by the shareholders for more than one year.
3. Distributions in excess of AAA are taxable as a dividend to the extent of the corporation’s accumulated earnings and profits (AE&P).
4. Distributions in excess of AE&P are tax free to the extent of any remaining stock basis and reduce basis (but not below zero).
5. Distributions in excess of AE&P and stock basis are taxed as capital gain. The gain will be long-term to the extent the stock has been held by the shareholders for more than one year.
To illustrate these rules, assume that at the end of an S corporation’s year, the corporation has an AAA of $30,000 and AE&P of $20,000, and the shareholder has a $75,000 basis in the corporation’s stock. During the year, the corporation distributed $100,000 to the shareholder. The tax consequences of the distribution would be as follows:
Amount of
Distribution Taxability AAA AE&P Stock Basis
$30,000 $20,000 $75,000
$ 30,000 Tax free (30,000) — (30,000)
20,000 Dividend — (20,000) —
45,000 Tax free — — (45,000)
5,000 Capital gain — — —
——– ——- ——– ——–
$100,000 — — —
Please note that this letter does not necessarily cover all of the possible tax consequences of an S corporation distribution that may apply in your particular situation. For example, the distribution may have different tax consequences for alternative minimum tax and state tax purposes. Thus, before an actual distribution is made, you may wish to give me a call so we can determine all of the possible tax consequences in your particular situation.

Distribution after Revocation of S Election
Earlier this week, we discussed the consequences of your company revoking its S corporation status. I want to reiterate that revoking S corporation status is a significant tax event. As we discussed, you should understand the tax consequence that will result when your corporation becomes a C corporation, including distributions of the corporation’s accumulated adjustments account (“AAA”). If you decide to revoke S status, we should calculate your expected tax burden comparing retaining S status to the resulting tax burden in becoming a C corporation.
During our discussion, you asked whether your company (which uses a calendar year) will have to distribute its entire AAA before the election is revoked in order to ensure that the entire AAA can be distributed tax free to the company’s shareholders. Since your company plans to revoke its election as of November 1, and will not know the exact amount of its AAA until after that date, the company will not know how much it can distribute tax free before November 1.
We have looked into this question and determined that your company need not know the exact amount of its AAA as of the date of revocation. Rather, the company may distribute less than its estimated AAA before November 1 and distribute the balance of the AAA (as later determined) after the election is revoked on a tax-free basis. The specific results of our research are discussed below.
As you know, S corporations with accumulated earnings and profits must maintain an AAA. The AAA is generally increased by income passed through (and taxed) to shareholders and is decreased both by losses passed through to shareholders and by tax-free distributions. In effect, the AAA represents the net undistributed income of the S corporation that has been previously taxed to shareholders and that can be distributed later on a tax-free basis before earnings and profits must be distributed as a dividend.
Once the corporation’s election is revoked, however, distributions are taxed under the rules applicable to regular C corporations; that is, distributions are taxable as a dividend to the extent of current and accumulated earnings and profits. Thus, if an S corporation’s election is revoked before its entire AAA is distributed, the shareholders risk losing the possibility of receiving tax-free distributions of the company’s income previously taxed to them.
Fortunately, subchapter S contains a special rule to mitigate this potential hardship. This rule provides that former S corporations may make tax-free distributions from their AAA during a limited period after the S corporation election is revoked. This period begins on the day after the last day of the last S corporation year and ends on the later of (1) the day that is one year after the last S corporation year or (2) the extended due date for filing the last S corporation return. In your case, this period would run from November 1, 2016, to October 31, 2017, i.e., the later of October 31, 2017 (one year after the company’s last day as an S corporation), or September 15, 2017 (the due date for filing the final S corporation return, assuming its due date is fully extended). Thus, the company would effectively have one full year to distribute its remaining AAA tax free to shareholders.
In addition, the 2017 tax act made an additional change that potentially extends the period of time post revocation in which you can take out AAA. But in these limited situations, each distribution will need to be a proportionate distribution of AAA and accumulated E&P (which would be taxable as a dividend). We should discuss this alternative if you are interested in moving ahead with a revocation.
Please note that, in addition to the limited period when these distributions can be made, the rule applies only to distributions of money. Moreover, tax-free treatment is permitted only to the extent of the adjusted basis of the shareholders’ stock.
Finally, it is noted that this post-revocation distribution rule applies unless your company (with the consent of its shareholders) elects to apply the normal C corporation distribution rules instead. Normally, former S corporations would not want to make this election. But, it may provide the corporation with an opportunity to bail out some or all of its earnings and profits at no additional tax cost to the shareholders (for example, if the shareholders have excess investment interest expense that would be available to offset the dividend). We can discuss this election further if you think it could be beneficial.

Repayment of Shareholder Debt

There are  federal income tax consequences of the repayment of a loan previously made to an S corporation by one of its shareholders.Below is a summary of the rules applicable in this situation.

In general, no gain or loss is recognized when a loan is made or when it is subsequently repaid. However, if low-basis debt is repaid, gains could be triggered.

Shareholders often lend money to S corporations as a way of establishing basis for purposes of passing through corporate losses to the shareholders. When this happens, however, the shareholder/creditor’s basis in the debt is reduced by the amount of loss passed through and used at the shareholder level. Thus, if such reduced-basis debt is later repaid, gain will be recognized in an amount equal to the excess of the amount repaid over the shareholder/creditor’s basis in the debt.

For example, assume a shareholder lends $500 to an S corporation that passes through a $300 loss to the shareholder, thus reducing his or her basis in the debt to $200. (This assumes that the shareholder’s stock basis has already been reduced to zero.) If the corporation repays the entire debt, the shareholder-creditor would recognize a $300 gain. Whether this gain is taxable as ordinary income or as a capital gain depends upon whether the debt is evidenced by a written debt instrument. If the debt is evidenced by a written debt instrument, such as a term or demand note, then the gain upon repayment is taxable as a capital gain. If the debt is “open account” debt that is not evidenced by a written debt instrument, then the gain generally is considered ordinary income. If the total principal amount of open account debt at the close of an S corporation’s tax year exceeds $25,000, then that open account debt is treated as debt evidenced by a separate written debt instrument in any subsequent tax year. One effect of this rule is that repayments and advances on open account indebtedness that exceeds $25,000 may not be netted to arrive at a net increase or decrease in the debt.

The above rule is slightly more complicated if the corporation pays off less than all of the reduced-basis debt. In this case, the shareholder-creditor generally may not report the repayment on a cost recovery basis; that is, the shareholder-creditor may not claim that no income is recognized until an amount exceeding the shareholder’s basis in the loan (if any) is recovered. Rather, in computing gain on the repayment, the basis in the note must be allocated to each payment on the note. For example, assume the same situation as above except that the corporation repays only $400, or 80%, of the loan. The shareholder must allocate 80%, or $160, of the loan basis to the repayment. Thus, the shareholder would recognize a gain of $240 and would still have $40 of basis in the remaining balance of the note.

If an S corporation has items of income that exceed its items of loss, deductions, and distributions to its shareholders during the year the debt is repaid, then some or all of the debt’s basis may be restored. In this case, the income from debt repayment may be reduced or eliminated.