Question

Escobar Corporation, an accrual basis taxpayer, has struggled to survive since its formation, six years ago. As a result, it has a deficit in accumulated E & P at the beginning of the year of $340,000. This year, however, Pebble earned a significant profit; taxable income was $240,000. Consequently, Pebble made two cash distributions to Martha, its sole shareholder: $150,000 on July 1 and $200,000 December 31. The following information might be relevant to determining the tax treatment of the distributions.

-This year’s taxable income included a net operating loss carryover of $50,000.

-The corporation’s Federal income tax liability is $72,000 for the year.

-Escobar paid nondeductible fines and kickbacks of $10,000. The company also paid nondeductible life insurance premiums of $22,000.

-The cash surrender value of the corporate-owned life insurance policies increased by $11,000 during the year.

-The company sold a piece of equipment during the year and reported a § 1231 gain of $105,000 and recapture income under § 1245 of $35,000. There were no other § 1231 transactions during the year, but the corporation did have a capital loss carryforward of $30,000.

-MACRS depreciation exceeds E & P depreciation by $14,000. In addition, an election under § 179 was made this year for $18,000 of assets.

a. Compute Escobars's E & P for the year.

b. What are the tax consequences of the two distributions made during the year to Martha (her stock basis is $74,000)?

Answer 1

a) Taxable income $2,40,000

Net operating loss carry over $50,000

Federal income tax -$72,000

Life insurance premium - $22,000

Non deductible fines and kickbacks of - $10,000

cash surrender value of the corporate-owned life insurance policies increased $11,000

capital loss carryforward $30,000

Excess of MACRS depreciation over E & P depreciation $14,000

Section 179 expense (80% ´ $18,000) $14,400

Current Earnings and Profits (E&P) = $2,55,400

Martha has a dividend of $255,400 (the amount of the current E & P). The distributions during the year exceed current E & P by $94,600 ($350,000 – $255,400). Consequently, Martha’s stock basis is reduced to $0 and she has a capital gain equal to the extent to which the $94,600 exceeds her stock basis ($74,000), or $20,600.

a) Taxable income $2,40,000

Net operating loss carry over $50,000

Federal income tax -$72,000

Life insurance premium - $22,000

Non deductible fines and kickbacks of - $10,000

cash surrender value of the corporate-owned life insurance policies increased $11,000

capital loss carryforward $30,000

Excess of MACRS depreciation over E & P depreciation $14,000

Section 179 expense (80% ´ $18,000) $14,400

Current Earnings and Profits (E&P) = $2,55,400

Martha has a dividend of $255,400 (the amount of the current E & P). The distributions during the year exceed current E & P by $94,600 ($350,000 – $255,400). Consequently, Martha’s stock basis is reduced to $0 and she has a capital gain equal to the extent to which the $94,600 exceeds her stock basis ($74,000), or $20,600.