ExpertMedium1 markMultiple Choice
CPA · Question 33 · Area II: Entity Tax Compliance
An S Corporation (formerly a C Corp) has Accumulated E&P (AEP) of $20,000. At year-end, its Accumulated Adjustments Account (AAA) is $15,000. The corporation distributes $40,000 cash to its sole shareholder. The shareholder's stock basis (before distribution) is $100,000. How is the distribution taxed?
An S Corporation (formerly a C Corp) has Accumulated E&P (AEP) of $20,000. At year-end, its Accumulated Adjustments Account (AAA) is $15,000. The corporation distributes $40,000 cash to its sole shareholder. The shareholder's stock basis (before distribution) is $100,000. How is the distribution taxed?
Answer options:
A.
$40,000 tax-free return of capital.
B.
$15,000 tax-free, $20,000 dividend, $5,000 return of capital.
C.
$20,000 dividend, $20,000 return of capital.
D.
$40,000 dividend.
How to approach this question
Distribution Ordering Rules (IRC §1368): 1. AAA (Tax-free to extent of basis). 2. AEP (Taxable Dividend). 3. Return of Capital (Tax-free to extent of remaining basis). 4. Capital Gain. Distribution $40k: First $15k from AAA. Next $20k from AEP. Remaining $5k from Basis.
Full Answer
B.$15,000 tax-free, $20,000 dividend, $5,000 return of capital.✓ Correct
B
IRC §1368(c). 1. $15,000 from AAA (Tax-free, reduces basis). 2. $20,000 from AEP (Taxable Dividend). 3. Remaining $5,000 is Return of Capital (Tax-free, reduces basis).
Common mistakes
Mixing up the order of AAA and AEP.
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