Form 1099-DIV Compliance Reminder & How to Determine Taxable Dividends
As the cannabis industry matures in Massachusetts, and investors begin to reap what they sowed, AAFCPAs reminds clients classified as Subchapter C corporations who paid distributions to shareholders in 2019 of their potential Form 1099-DIV compliance filing due to the Internal Revenue Service (IRS) by February 28, 2020 (or March 31, 2020 if e-filing). In addition, these corporations are reminded to furnish a copy of Form 1099-DIV to shareholders by January 31, 2020.
AAFCPAs has provided guidance below regarding reporting dividends and other distributions to shareholders and to the IRS, including simplified steps to determine taxable dividends. (Note: Distributions treated as redemptions of shareholder stock are not covered herein.)
Who must File a Form 1099-DIV?
Form 1099-DIV is an information return required under Internal Revenue Code (IRC, or the Code) Section 6042 (returns regarding payments of dividends and corporate earnings and profits). Code Section 6042 requires, generally, a corporation that makes payments of dividends of $10 or more during a calendar year to file Form 1099-DIV with the IRS.
Form 1099-DIV extensions
If additional time is needed to file Form 1099-DIV with the IRS or furnish a copy to shareholders, the IRS may approve a 30-day extension. Form 8809 is used to request an extension of time to file with the IRS. No form exists to request an extension of time to furnish a copy to shareholders. To request an extension of time to furnish a copy, a letter should be mailed to the IRS containing information about the corporation (name, taxpayer identification number, and address), the type of information return (i.e. Form 1099-DIV), a statement that the extension request is for providing statements to recipients, the reason for the delay, and the signature of a corporate officer.
Form 1099-DIV penalties
Code Section 6721 imposes a penalty for failing to timely file Form 1099-DIV or failing to provide a complete and accurate Form 1099-DIV to the IRS. Code Section 6722 imposes a penalty for failing to timely furnish a copy of Form 1099-DIV to shareholders. The penalty is based on when Form 1099-DIV is filed with the IRS or furnished to shareholders. For Forms 1099-DIV due in 2020, the penalty is $50 if less than 31 days late or $110 if more than 30 days late. If the failure is due to intentional disregard for the rules, the penalty is the greater of 1) $550 or 2) 10% of the amount underreported. A penalty under Sections 6721 and 6722 can apply to the same transaction (i.e. not filing with IRS and not providing a copy to shareholders).
Penalties will not be imposed if the failure was due to reasonable cause and not willful neglect. Reasonable cause is defined in Treasury Regulation 301.6724-1 as existing if the filer establishes: 1) that there are significant mitigating factors for the failure, or the failure arose from events beyond the filer’s control, and 2) the filer acted in a responsible manner both before and after the failure occurred. The Regulation provides examples of mitigating factors, events beyond the filer’s control, and of acting in a responsible manner.
Overview of shareholder distributions
Code Section 316 governs distributions made with respect to shareholders’ stock and whether a distribution is taxable as a dividend or capital gain or nontaxable as a return of capital. Distributions are taxable as dividends to the extent of the corporation’s earnings and profits (E&P). Distributions in excess of E&P and not in excess of capital contributions are nontaxable as a return of capital and reduce shareholders’ stock basis. Distributions in excess of capital contributions are capital gain distributions. Planning for distributions is critical to avoid unintentionally making taxable distributions.
Overview of corporate E&P
Code Section 312 governs corporate E&P. E&P consists of current E&P (i.e. current tax year) and accumulated E&P (i.e. prior tax years). Current E&P is determined at the end of the corporation’s tax year. If the corporation’s tax year is other than a calendar year, complexity arises in determining the character of distributions under Section 316 required to be reported on a calendar-year basis under Section 6042.
E&P is determined under economic principles resulting in differences between tax and E&P (and between E&P and retained earnings for GAAP purposes). Current E&P is calculated by adjusting taxable income for differences between tax and E&P under the same overall accounting method a corporation uses for tax purposes (e.g. accrual or cash).
In the simplest situations, E&P will be book income adjusted for the difference between tax and E&P depreciation. E&P depreciation is determined under the Alternative Depreciation System (ADS) rather than the “normal” system for tax purposes—General Depreciation System (GDS). ADS results in an increase in E&P in earlier years because cost recovery periods (i.e. useful lives) are longer and the depreciation method is straight-line under ADS compared to shorter lives and declining balance methods (e.g. double declining) depreciation methods under GDS.
Often, the situation is not simple. As with many sections of the Code, AAFCPAs advises clients to look beyond the statutory language in Section 312 and the regulations thereunder to IRS rulings and caselaw.
Steps to determine E&P and distributions
Under a special rule, Code Section 6042 requires all distributions to be characterized as dividends if the portion of the distribution characterized as a dividend is unable to be determined. If unable to determine by the original filing due date, a 30-day extension may be available.
In the simplest situations, the following four steps may result in the correct calculation of E&P and the character of distributions. If the corporation has a non-calendar year tax year, these steps need to be performed for two periods: 1) for the tax year ending in calendar year (Period 1), and 2) the period beginning after Period 1 and ending on December 31st of the calendar year.
Step 1 – Calculate book pre-tax income: The most critical accounts for cannabis companies are inventory and cost of goods sold (COGS) due to the impact on income and income tax expense. Other common accounts to review are fixed assets and the related depreciation or amortization expense. As customer reward programs grow, the liability for customer rewards and revenue are increasingly common accounts that should be reviewed.
Step 2 – Calculate taxable income and income tax expense: If COGS for book purposes is the same for tax purposes, gross profit often equals taxable income for cannabis companies. Here, multiply gross profit (plus any other income) by the combined federal and state income tax rate to determine the income tax expense. Complexity arises for multi-state operators because income tax rules for each state are different, including combined reporting, apportionment factors, and conformity with Code Section 280E.
Step 3 – Calculate E&P: Determine the differences between taxable income and E&P. In the simplest situations, E&P will equal taxable income adjusted for permanent and temporary book-tax differences, including income tax expense, and depreciation for E&P purposes.
Step 4 – Calculate amount and character distributions: Distributions include cash and non-cash property. If property is distributed, the fair market value must be determined, and any gain recognized by the corporation. In the simplest situations, only cash distributions will be made, and the current E&P will exceed the distributions. Here, all distributions will be dividends.