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, it distributes $40,000 cash to its sole shareholder. The shareholder's stock basis is $50,000. What is the tax treatment of the distribution?

Answer options:

$40,000 Tax-free Return of Capital

$10,000 Dividend; $30,000 Return of Capital

$10,000 Tax-free (AAA); $20,000 Dividend (AEP); $10,000 Return of Capital

$30,000 Dividend; $10,000 Return of Capital

How to approach this question

Ordering Rules: 1. AAA (Tax free). 2. AEP (Taxable Dividend). 3. Return of Capital (Tax free). 4. Capital Gain.

Full Answer

C.$10,000 Tax-free (AAA); $20,000 Dividend (AEP); $10,000 Return of Capital✓ Correct

IRC §1368(c). <br/>1. From AAA: $10,000 (Tax-free, reduces basis to $40k). <br/>2. From AEP: $20,000 (Taxable Dividend). <br/>3. Remainder ($10,000): Return of Capital (Tax-free, reduces basis to $30k).

Common mistakes

Ignoring AEP or swapping the order of AAA and AEP.

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