ExpertMedium1 markMultiple Choice
CPA · Question 17 · Area II: Entity Tax Compliance
An S Corporation was formerly a C Corporation and has Accumulated Earnings and Profits (AEP) of $20,000. It has an Accumulated Adjustments Account (AAA) of $10,000. In Year 1, the S Corp distributes $40,000 cash to its sole shareholder. The shareholder's stock basis before the distribution is $50,000. What is the tax treatment of the distribution?
An S Corporation was formerly a C Corporation and has Accumulated Earnings and Profits (AEP) of $20,000. It has an Accumulated Adjustments Account (AAA) of $10,000. In Year 1, the S Corp distributes $40,000 cash to its sole shareholder. The shareholder's stock basis before the distribution is $50,000. What is the tax treatment of the distribution?
Answer options:
A.
$40,000 tax-free return of capital.
B.
$10,000 tax-free return of capital; $20,000 taxable dividend; $10,000 tax-free return of capital.
C.
$30,000 tax-free return of capital; $10,000 capital gain.
D.
$10,000 tax-free return of capital; $30,000 taxable dividend.
How to approach this question
Follow the S Corp distribution waterfall: 1. AAA (Tax-free to extent of basis), 2. AEP (Taxable Dividend), 3. OAA (if any), 4. Return of Capital (Tax-free to extent of remaining basis), 5. Capital Gain.
Full Answer
B.$10,000 tax-free return of capital; $20,000 taxable dividend; $10,000 tax-free return of capital.✓ Correct
$10,000 tax-free return of capital; $20,000 taxable dividend; $10,000 tax-free return of capital.
IRC §1368(c) dictates the ordering rules for S Corps with AEP. Distributions come first from AAA (tax-free reduction of basis), then from AEP (taxable dividend), then from basis (tax-free return of capital). Here: $10k from AAA, then $20k from AEP, then remaining $10k from basis.
Common mistakes
Skipping the AEP layer or treating the entire distribution as tax-free because basis is high.
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