Question

5) Olivia is the sole shareholder in Western Corporation and has owned the stock for five years. The basis in her stock is $50,000. Western distributes $35,000 to Olivia. Accumulated earnings and profits at the beginning of the year equal $25,000 and current earnings and profits equal $5,000.

Required:

1. What are the tax consequences of this information?

2. What are the tax consequences of this information if, instead of distributing $35,000 to Olivia, Western

distributes $100,000 to Olivia?

Answer 1

As per the IRS Topic No. 404

Return of Capital

Distributions that qualify as a return of capital aren't dividends. A return of capital is a return of some or all of your investment in the stock of the company. A return of capital reduces the adjusted cost basis of your stock. A distribution generally qualifies as a return of capital if the corporation making the distribution doesn't have any accumulated or current year earnings and profits. Once the adjusted cost basis of your stock has been reduced to zero, any further nondividend distribution is a taxable capital gain that you report on Form 8949, Sales and Other Dispositions of Capital Assets (PDF) and Schedule D (Form 1040 or 1040-SR), Capital Gains and Losses (PDF).

i) In first case $30,000 is treated and taxed as dividend and $5,000 reduces the adjusted cost basis of shares.

ii) In second case $30,000 is treated and taxed as dividend , $50,000 reduces the adjusted cost basis of shares to zero.And the balance $20,000 are taxed as Non dividend Distributions (i.e. capital gains)