Question

AB Corp has 1,000 shares outstanding and two equal shareholders, Allison and Bella. Bella has a basis of $5,000 in her 500 shares and Allison has a basis of $2,500 in her 500 shares, both owners purchased their shares 3 years ago. Determine the tax consequences of the following distributions to the shareholders and to AB Corp.

A. AB Corp has accumulated E&P of $5,000 and current E&P of $3,000 and makes a distribution of $10,000 on December 31^st of the tax year ($5K to each shareholder).

B. Disregarding A above, assume AB Corp has accumulated E&P of $5,000 and current E&P of $3,000 for the year and makes a distribution of $5,000 on July 1 of the tax year and another distribution of $10,000 on December 31^st of the tax year. Bella sells her shares to Bob on October 15^th for $10,000.

C. Disregarding A and B above, assume AB Corp has a deficit in accumulated E&P of $5,000 and current E&P of $3,000 and makes a distribution of $9,000 on December 31^st of the tax year ($4,500 to each shareholder).

D. Disregarding A through C above, assume AB Corp has accumulated E&P of $5,000 and a current E&P deficit of $4,000 for the year and makes a distribution of $5,000 on July 1 of the tax year.

Answer Question "D" only

Answer 1

Answer :

If a deficit exists in Current E&P and a positive balance exists in accumulated E&P, then two accounts are netted as on the date of the distribution.

a) If the resulting balance is zero or negative, the distribution is a return of capital.

b) If the balance is positive, distributions are treated as dividends to the extent of a positive net balance.

c) If the distribution exceeds the positive net balance, then the excess is treated as a return of capital, which is not taxable to the shareholders. Any such return of capital does not affect accumulated E&P. Although such return of capital is not taxed, the tax basis in the stock is reduced by such amount. If a return of capital exceeds the shareholders basis in the stock, then the excess must be treated as a capital gain.

In this question, since there is a deficit in Current E&P on the date of distribution, accumulated E&P and current E&P has to be netted. Since the resulting balance is positive ($5,000-$4,000=$1,000), distributions are treated as dividends to the extent of $1,000. Allison and Bella must pay tax on $500 each, received as dividends (assuming the distribution is made equally since they are two equal shareholders)

Since the total distribution is $5,000 , the excess $4,000 is treated as return of capital, which is not taxable to the shareholders. However such amount is reduced from the basis in Allison’s and Bella‘s stock.

Particulars	Allison	Bella
Existing Basis	$2,500	$5,000
Return of Capital (assuming equal distribution is made)	$2,000	$2,000
Revised Basis	$500	$3,000