ExpertHard1 markMultiple Choice
CPA · Question 38 · Area 3: Entity Tax Compliance
An S Corporation has Accumulated Earnings and Profits (AE&P) of $20,000 from C Corp years. It has an Accumulated Adjustments Account (AAA) of $10,000. It distributes $40,000 to its sole shareholder. The shareholder's stock basis is $50,000. What is the tax treatment?
An S Corporation has Accumulated Earnings and Profits (AE&P) of $20,000 from C Corp years. It has an Accumulated Adjustments Account (AAA) of $10,000. It distributes $40,000 to its sole shareholder. The shareholder's stock basis is $50,000. What is the tax treatment?
Answer options:
A.
$40,000 Tax-free Return of Capital
B.
$10,000 Tax-free; $20,000 Dividend; $10,000 Return of Capital
C.
$30,000 Dividend; $10,000 Return of Capital
D.
$10,000 Tax-free; $30,000 Capital Gain
How to approach this question
1. Ordering Rules for S Corp with AE&P:<br/> - Tier 1: AAA (Tax-free to extent of basis).<br/> - Tier 2: AE&P (Taxable Dividend).<br/> - Tier 3: Return of Capital (Tax-free to extent of remaining basis).<br/> - Tier 4: Capital Gain.<br/>2. Apply: <br/> - Distribute $40,000.<br/> - AAA: $10,000 (Tax-free). Remaining Dist: $30,000.<br/> - AE&P: $20,000 (Dividend). Remaining Dist: $10,000.<br/> - ROC: $10,000 (Basis is sufficient). <br/>3. Result: $10k Tax-free, $20k Div, $10k ROC.
Full Answer
B.$10,000 Tax-free; $20,000 Dividend; $10,000 Return of Capital✓ Correct
B
The distribution comes first from AAA ($10,000 tax-free), then from Accumulated E&P ($20,000 taxable dividend), and finally as a return of basis ($10,000 tax-free).
Common mistakes
Skipping the E&P layer.
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