Chapter 5: Corporations Earnings and Profits and Dividend Distributions

Distributions by a corporation to its shareholders are presumed to be a dividend unless the parties can prove otherwise.

a.

True

b.

False

T

A distribution from a corporation will be taxable to the recipient shareholders only to the extent of the corporation's E & P.

a.

True

b.

False

F

All cash distributions received from a corporation with a positive balance in accumulated E & P at the beginning of the year will be taxed as dividend income.

a.

True

b.

False

F

To determine E & P, some (but not all) previously excluded income items are added back to taxable income.

a.

True

b.

False

F

When computing E & P, taxable income is not adjusted for § 179 expense.

a.

True

b.

False

F

An increase in the LIFO recapture amount must be added to taxable income to determine E & P.

a.

True

b.

False

T

Use of MACRS cost recovery when computing taxable income does not require an E & P adjustment.

a.

True

b.

False

F

Federal income tax paid in the current year must be subtracted from taxable income to determine E & P.

a.

True

b.

False

T

Nondeductible meal expense must be subtracted from taxable income to determine current E & P.

a.

True

b.

False

T

A realized gain from an involuntary conversion under § 1033 that is not recognized for income tax purposes has no effect on E & P.

a.

True

b.

False

T

When current E & P has a deficit and accumulated E & P is positive, the two accounts are netted at the date of the distribution. If a positive balance results, the distribution is a dividend to the extent of the balance.

a.

True

b.

False

T

When current E & P is positive and accumulated E & P has a deficit balance, the two accounts are netted for dividend determination purposes.

a.

True

b.

False

F

Regardless of any deficit in current E & P, distributions during the year are taxed as dividends to the extent of accumulated E & P.

a.

True

b.

False

F

Corporate distributions are presumed to be paid out of E & P and are treated as dividends unless the parties to the transaction can show otherwise.

a.

True

b.

False

T

During the year, Blue Corporation distributes land to its sole shareholder. If the fair market value of the land is less than its adjusted basis, Blue will not be able to recognize a loss on the distribution.

a.

True

b.

False

T

In a property distribution, the amount of dividend income recognized by a shareholder is always reduced by the amount of liability assumed by a shareholder.

a.

True

b.

False

T

Property distributed by a corporation as a dividend is subject to a liability in excess of its basis. For purposes of determining gain on the distribution, the basis of the property is treated as being not less than the amount of liability.

a.

True

b.

False

F

A corporation that distributes a property dividend must reduce its E & P by the adjusted basis of the property less any liability on the property.

a.

True

b.

False

F

Constructive dividends have no effect on a distributing corporation's E & P.

a.

True

b.

False

F

Rose Corporation (a calendar year taxpayer) has taxable income of $300,000, and its financial records reflect the following for the year.

Federal income taxes paid

$110,000

Net operating loss carryforward deducted currently

70,000

Gain recognized this year on an installment sale from a prior year

44,000

Depreciation deducted on tax return (ADS depreciation would have been $10,000)

40,000

Interest income on Iowa state bonds

8,000

​

Rose Corporation's current E & P is:

a.

$254,000.

b.

$214,000.

c.

$194,000.

d.

$104,000.

A

Tern Corporation, a cash basis taxpayer, has taxable income of $500,000 for the current year. Tern elected $25,000 of § 179 expense. It also had a related-party loss of $20,000 and a realized (not recognized) gain from an involuntary conversion of $75,000. It paid Federal income tax of $150,000 and paid a nondeductible fine of $10,000. Tern's current E & P is:

a.

$415,000.

b.

$350,000.

c.

$340,000.

d.

$320,000.

C

Silver Corporation, a calendar year taxpayer, has taxable income of $550,000. Among its transactions for the year are the following:

Collection of proceeds from insurance policy on life of corporate

officer (in excess of cash surrender value)

$82,500

Realized gain (not recognized) on an involuntary conversion

11,000

Nondeductible fines and penalties

44,000

​

Disregarding any provision for Federal income taxes, Silver Corporation's current E & P is:

a.

$500,500.

b.

$588,500.

c.

$599,500.

d.

$687,500.

B

Aaron and Michele, equal shareholders in Cavalier Corporation, receive $25,000 each in distributions on December 31 of the current year. During the current year, Cavalier sold an appreciated asset for $60,000 (basis of $15,000). Payment for the sale of the asset will be made as follows: 50% next year and 50% in the following year with interest payable at a rate of 6 percent. Before considering the effect of the asset sale, Cavalier's current-year E & P is $40,000 and it has no accumulated E & P. How much of Aaron's distribution will be taxed as a dividend?

a.

$0

b.

$20,000

c.

$25,000

d.

$42,500

C

Tracy and Jerome, equal shareholders in Macaw Corporation, receive $600,000 each in distributions on December 31 of the current year. Macaw's current-year taxable income is $1,000,000 and it has no accumulated E & P. Last year, Macaw sold an appreciated asset for $1,200,000 (basis of $400,000). Payment for one-half of the sale of the asset was made this year. How much of Tracy's distribution will be taxed as a dividend?

a.

$0

b.

$300,000

c.

$500,000

d.

$600,000

B

During the current year, Hawk Corporation sold equipment for $600,000 (adjusted basis of $360,000). The equipment was purchased a few years ago for $760,000 and $400,000 in MACRS deductions have been claimed. ADS depreciation would have been $300,000. As a result of the sale, the adjustment to taxable income needed to determine current E & P is:

a.

No adjustment is required.

b.

Subtract $100,000.

c.

Add $100,000.

d.

Add $80,000.

B

On January 2, 2023, Orange Corporation purchased equipment for $300,000 with an ADS recovery period of 10 years and a MACRS useful life of 7 years. Section 179 was not elected. MACRS depreciation properly claimed on the asset, including depreciation in the year of sale, totaled $79,605. The equipment was sold on July 1, 2024, for $290,000. As a result of the sale, the adjustment to taxable income needed to arrive at current E & P is:

a.

No adjustment is required.

b.

Decrease $49,605.

c.

Increase $49,605.

d.

Decrease $79,605.

B

Tungsten Corporation, a calendar year cash basis taxpayer, made estimated tax payments of $800 each quarter in 2023, for a total of $3,200. Tungsten filed its 2023 tax return in 2024 and the return showed a tax liability $4,200. When it filed its tax return in 2024, Tungsten paid an additional $1,000 in Federal income taxes. How does the additional payment of $1,000 impact Tungsten's E & P?

a.

Increase by $1,000 in 2023.

b.

Increase by $1,000 in 2024.

c.

Decrease by $1,000 in 2023.

d.

Decrease by $1,000 in 2024.

D

Inka and Eva each own one-half of the stock in Parakeet Corporation, a calendar year taxpayer. Cash distributions from Parakeet are $350,000 to Inka on April 1 and $150,000 to Eva on May 1. If Parakeet's current E & P is $60,000, how much is allocated to Eva's distribution?

a.

$5,000

b.

$10,000

c.

$18,000

d.

$30,000

C

Maria and Christopher each own 50% of Cockatoo Corporation, a calendar year taxpayer. Distributions from Cockatoo are $750,000 to Maria on April 1 and $250,000 to Christopher on May 1. Cockatoo's current E & P is $300,000 and its accumulated E & P is $600,000. How much of the accumulated E & P is allocated to Christopher's distribution?

a.

$0

b.

$75,000

c.

$150,000

d.

$300,000

B

Robin Corporation, a calendar year taxpayer, has a deficit in current E & P of $200,000 and a $580,000 positive balance in accumulated E & P. If Robin determines that a $700,000 distribution to its shareholders is appropriate at some point during the year, what is the maximum amount of the distribution that could potentially be treated as a dividend?

a.

$0

b.

$380,000

c.

$480,000

d.

$580,000

D

Pheasant Corporation, a calendar year taxpayer, has $400,000 of current E & P and a deficit in accumulated E & P of $180,000. If Pheasant pays a $600,000 distribution to its shareholders on July 1, how much dividend income do the shareholders report?

a.

$0

b.

$20,000

c.

$220,000

d.

$400,000

D

Jasmine is the sole shareholder of Condor Corporation. She sold her stock to Melissa on October 31 for $150,000. Jasmine's basis in Condor stock was $50,000 at the start of the year. Condor distributed land to Jasmine immediately before the sale. Condor's basis in the land was $20,000 (fair market value of $25,000). On December 31, Melissa received a $75,000 cash distribution from Condor. During the year, Condor has $20,000 of current E & P and its accumulated E & P balance on January 1 is $10,000. Which of the following statements is true?

a.

Jasmine recognizes a $110,000 gain on the sale of her stock.

b.

Jasmine recognizes a $100,000 gain on the sale of her stock.

c.

Melissa receives $5,000 of dividend income.

d.

Jasmine receives $20,000 of dividend income.

A

Blue Corporation has a deficit in accumulated E & P of $300,000 and has current E & P of $225,000. On July 1, Blue distributes $250,000 to its sole shareholder, Sam, who has a basis in his stock of $52,500. As a result of the distribution, Sam has:

a.

Dividend income of $225,000 and reduces his stock basis to $27,500.

b.

Dividend income of $52,500 and reduces his stock basis to zero.

c.

Dividend income of $225,000 and no adjustment to stock basis.

d.

No dividend income, reduces his stock basis to zero, and has a capital gain of $250,000.

A

Renee, the sole shareholder of Indigo Corporation, sold her stock to Chad on July 1 for $180,000. Renee's stock basis at the beginning of the year was $120,000. Indigo made a $60,000 cash distribution to Renee immediately before the sale and Chad received a $120,000 cash distribution from Indigo on November 1. As of the beginning of the current year, Indigo had $26,000 in accumulated E & P and current E & P (before distributions) was $90,000. Which of the following statements is correct?

a.

Renee recognizes a $60,000 gain on the sale of the stock.

b.

Renee recognizes a $64,000 gain on the sale of the stock.

c.

Chad recognizes dividend income of $120,000.

d.

Chad recognizes dividend income of $30,000.

B

Tangelo Corporation has an August 31 year-end. Tangelo had $50,000 in accumulated E & P at the beginning of its 2024 fiscal year (September 1, 2023) and during the year, it incurred a $75,000 operating loss. It also distributed $65,000 to its sole shareholder, Cass, on November 30, 2023. If Cass is a calendar year taxpayer, how should she treat the distribution when she files her 2023 income tax return (assuming the return is filed by April 15, 2024)?

a.

$65,000 of dividend income.

b.

$60,000 of dividend income and $5,000 recovery of capital.

c.

$50,000 of dividend income and $15,000 recovery of capital.

d.

The distribution has no effect on Cass in the current year.

A

As of January 1, Cassowary Corporation has a deficit in accumulated E & P of $100,000. For the tax year, current E & P (accrued ratably) is $240,000 (prior to any distributions). On July 1, Cassowary Corporation distributes $275,000 to its sole shareholder. The amount of the distribution that is a dividend is:

a.

$20,000.

b.

$140,000.

c.

$240,000.

d.

$275,000.

C

At the beginning of the current year, both Doug and Amelia each own 50% of Amaryllis Corporation (a calendar year taxpayer). In July, Doug sold his stock to Kevin for $140,000. At the beginning of the year, Amaryllis Corporation had accumulated E & P of $240,000 and its current E & P is $280,000 (prior to any distributions). Amaryllis distributed $300,000 on February 15 ($150,000 to Doug and $150,000 to Amelia) and distributed another $300,000 on November 1 ($150,000 to Kevin and $150,000 to Amelia). Kevin has dividend income of:

a.

$150,000.

b.

$140,000.

c.

$110,000.

d.

$70,000.

C

On January 1, Eagle Corporation (a calendar year taxpayer) has accumulated E & P of $300,000. During the year, Eagle incurs a net loss of $420,000 from operations that accrues ratably. On June 30, Eagle distributes $180,000 to Libby, its sole shareholder, who has a basis in her stock of $112,500. How much of the $180,000 is a dividend to Libby?

a.

$0

b.

$90,000

c.

$112,500

d.

$180,000

B

Purple Corporation makes a property distribution to its sole shareholder, Kyung. The property distributed is a house (fair market value of $189,000; basis of $154,000) that is subject to a $245,000 mortgage that Kyung assumes. Before considering the consequences of the distribution, Purple's current E & P is $35,000 and its accumulated E & P is $140,000. Purple makes no other distributions during the current year. What is Purple's taxable gain on the distribution of the house?

a.

$0

b.

$21,000

c.

$35,000

d.

$91,000

D

Puffin Corporation makes a property distribution to its sole shareholder, Bonnie. The property distributed is a car (basis of $30,000; fair market value of $20,000) that is subject to a $6,000 liability, which Bonnie assumes. Puffin has no accumulated E & P and $30,000 of current E & P from other sources during the year. What is Puffin's E & P after taking into account the distribution of the car?

a.

$4,000

b.

$6,000

c.

$10,000

d.

$14,000

B

Navy Corporation has E & P of $240,000. It distributes land with a fair market value of $70,000 (adjusted basis of $25,000) to its sole shareholder, Troy. The land is subject to a liability of $55,000 that Troy assumes. Troy has:

a.

A taxable dividend of $15,000.

b.

A taxable dividend of $25,000.

c.

A taxable dividend of $70,000.

d.

A basis in the machinery of $55,000.

A

Which one of the following statements about property distributions is false?

a.

When the basis of distributed property is greater than its fair market value, a deficit may be created in E & P.

b.

When the basis of distributed property is less than its fair market value, the distributing corporation recognizes gain.

c.

When the basis of distributed property is greater than its fair market value, the distributing corporation does not recognize loss.

d.

The amount of a distribution received by a shareholder is measured by using the property's fair market value.

A

Brett owns stock in Oriole Corporation (basis of $100,000) as an investment. Oriole distributes property (fair market value of $375,000; basis of $187,500) to him during the year. Oriole has current E & P of $25,000 (which includes the E & P gain on the property distribution), accumulated E & P of $100,000, and makes no other distributions during the year. What is Brett's capital gain on the distribution?

a.

$0

b.

$100,000

c.

$150,000

d.

$187,500

C

Rust Corporation distributes property to its sole shareholder, Andre. The property has a fair market value of $350,000, an adjusted basis of $205,000, and is subject to a liability of $220,000. Current E & P is $500,000. With respect to the distribution, which of the following statements is correct?

a.

Rust has a gain of $15,000 and Andre has dividend income of $350,000.

b.

Rust has a gain of $145,000 and Andre's basis in the distributed property is $130,000.

c.

Rust has a gain of $130,000 and Andre's basis in the distributed property is $350,000.

d.

Rust has a gain of $145,000 and Andre has dividend income of $130,000.

D

Purple Corporation has accumulated E & P of $100,000 on January 1, 2023. In 2023, Purple has current E & P of $130,000 (before any distribution). On December 31, 2023, the corporation distributes $250,000 to its sole shareholder, Cara (an individual). Purple Corporation's E & P as of January 1, 2024 is:

a.

$0.

b.

($20,000).

c.

$100,000.

d.

$130,000.

A

Starling Corporation has accumulated E & P of $60,000 on January 1, 2023. In 2023, Starling Corporation had an operating loss of $80,000. It distributed cash of $40,000 to Zoe, its sole shareholder, on December 31, 2023. Starling Corporation's balance in its E & P account as of January 1, 2024, is:

a.

$60,000 deficit.

b.

$20,000 deficit.

c.

$0.

d.

$60,000.

B

On January 1, Gold Corporation (a calendar year taxpayer) has E & P of $30,000 and generates no additional E & P during the year. On March 31, the corporation distributes $40,000 to its sole shareholder, Ava (basis in stock of $8,000). Determine the effect of the distribution on Ava's taxable income and stock basis.

Ava recognizes dividend income of $30,000 (the amount of E & P distributed). In addition, she reduces her stock basis from $8,000 to zero and recognizes a taxable capital gain of $2,000 (the excess of the distribution over the stock basis).

On January 1, Tulip Corporation (a calendar year taxpayer) has accumulated E & P of $300,000. Its current E & P for the year is $90,000 (before considering dividend distributions). During the year, Tulip distributes $600,000 ($300,000 each) to its equal shareholders, Anne and Tom. Anne has a basis in her stock of $65,000, and Tom's basis is $120,000. What is the effect of the distribution by Tulip Corporation on Anne and Tom?

Anne and Tom each have dividend income of $195,000 {[$300,000 (Tulip's accumulated E & P) + $90,000 (Tulip's current E & P)] ÷ 2}. The remaining $210,000 distributed reduces the basis in Tulip stock with the excess treated as capital gain. Thus, Anne reduces her stock basis to zero and has a capital gain of $40,000 [($210,000 distribution in excess of E & P ÷ 2) - $65,000 basis]. Tom reduces his stock basis to $15,000 [$120,000 basis - ($210,000 distribution in excess of E & P ÷ 2)].

Ashley, the sole shareholder of Hawk Corporation, has a stock basis of $200,000 at the beginning of the year. On July 1, she sells all of her stock to Francisco for $1,000,000. On January 1, Hawk has accumulated E & P of $90,000 and during the year, current E & P of $160,000. Hawk makes the following cash distributions: $270,000 to Ashley on March 31 and $90,000 to Francisco on December 1. How are the distributions to Ashley and Francisco taxed? What is Ashley's recognized gain on the sale to Francisco?

The $160,000 in current E & P is allocated pro rata to the two distributions made during the year; thus, $120,000 is allocated to Ashley and $40,000 is allocated to Francisco. Because accumulated E & P is applied in chronological order, it is allocated entirely to Ashley. Consequently, of the $270,000 distribution to Ashley on March 31, $210,000 is taxed as dividend income [$90,000 (accumulated E & P) + $120,000 (current E & P)] and the remaining $60,000 reduces her stock basis to $140,000. She then recognizes a capital gain of $860,000 on the sale of her stock [$1,000,000 (sales price) - $140,000 (remaining stock basis)]. As to the $90,000 distribution to Francisco, $40,000 is taxed as a dividend (from current E & P) and the remaining $50,000 reduces his basis to $950,000 [$1,000,000 (original basis) - $50,000 (return of capital)].

Brown Corporation, an accrual basis corporation, has taxable income of $150,000 in the current year. Included in its determination of taxable income are the following transactions.

- Brown incurred a $65,000 capital loss from the sale of stock. Because Brown had no capital gains this year, none of the loss is deductible.

- The corporation's Federal income tax liability is $31,500.

- Brown incurred $18,000 in nondeductible meal expenses.

- Brown uses the LIFO method when accounting for inventory. This year, the company's LIFO recapture amount increased by $3,000.

- Brown claimed a dividends received deduction of $1,500.

​

What is Brown's current E & P for the year?

Taxable income

$ 150,000

Current-year capital loss

(65,000)

Federal income tax

(31,500)

Nondeductible meal expenses

(18,000)

LIFO recapture adjustment

3,000

Dividends received deduction

1,500

--------------------------------

Current E & P

$ 40,000

​

​

​

Finch Corporation (E & P of $400,000) distributed machinery ($10,000 adjusted basis, $150,000 fair market value) to its sole shareholder, Kathleen. The property is subject to a $50,000 mortgage, which Kathleen assumed. How much dividend income does Kathleen recognize as a result of the distribution and what is her basis in the machinery?

As a result of the distribution, Kathleen has a taxable dividend of $100,000 [$150,000 (fair market value) - $50,000 (liability)].The basis of the property to Kathleen is its fair market value, or $150,000

Sylvia owns 25% of Cormorant Corporation, which sells diamonds to retail jewelry businesses. While Cormorant has a deficit in accumulated E & P of $56,000 at the beginning of the year, its current E & P is $500,000. Since the company had a successful year, Cormorant pays a $36,000 distribution to each of the company's four shareholders on December 15. Three shareholders receive cash, but Cormorant distributes a diamond (adjusted basis of $40,000 and a fair market value of $36,000) to Sylvia in lieu of cash. Determine the effect of distributing the diamond on Cormorant's and on Sylvia's taxable income. What is Sylvia's basis in the diamond? Was the distribution good tax planning on the part of Cormorant? Why or why not?

Losses on distributed property are not recognized at the corporate level, so there is no impact on Cormorant's taxable income. Because there is sufficient current E & P to cover the distribution, Sylvia has a taxable dividend of $36,000 and her basis in the diamond is also $36,000. The distribution reflects poor tax planning by Cormorant because the built-in $4,000 loss on the diamond ($36,000 fair market value - $40,000 adjusted basis) has been wasted. If Cormorant had sold the diamond for its $36,000 fair market value, it could have recognized the loss. The $36,000 cash received from the sale would be distributed to Sylvia instead.

Thrush, Inc., is a calendar year, accrual basis corporation with Haruki as its sole shareholder (basis in his stock is $90,000). On January 1 of the current year, Thrush has accumulated E & P of $200,000. Before considering the effect of the distribution described below, the corporation's current E & P is $50,000. On November 1, Thrush distributes an office building to Haruki. The office building has an adjusted basis of $80,000 (fair market value of $100,000) and is subject to a mortgage of $110,000. Assume that the building has been depreciated using the ADS method for both income tax and E & P purposes. What are the tax consequences of the distribution to Thrush and to Haruki? (In your answer, be sure to describe the effects on taxable income for both Thrush and Haruki, the impact of the distribution on Thrush's E & P, and Haruki's basis in the building.)

Thrush recognizes gain of $30,000 [$110,000 (liability) - $80,000 (adjusted basis)]. The $30,000 gain increases the corporation's current E & P from $50,000 to $80,000. Because the liability exceeds the fair market value of the property, the distribution itself will not impact E & P. Haruki has no taxable income because the liability exceeds the fair market value of the property received. Further, Haruki's basis in the office building is its deemed fair market value, or $110,000 (the amount of the liability assumed).

Scarlet Corporation is an accrual basis, calendar year corporation. Scarlet distributes inventory (basis of $20,000; fair market value of $40,000) to Frank, its shareholder. Assuming that Scarlet has $500,000 of current E & P, what is the impact of the distribution on Scarlet Corporation and on Frank?

Scarlet's E & P is increased by the $20,000 gain [$40,000 (fair market value) - $20,000 (adjusted basis)] and decreased by the $40,000 fair market value of the distribution. Frank has dividend income of $40,000.

Stephanie is the sole shareholder and president of Hawk Corporation. She feels that she can justify at least a $220,000 bonus this year because of her performance. However, rather than a bonus in the form of a salary, she plans to have Hawk pay her a $220,000 dividend. Because Stephanie's marginal tax rate is 32%, she prefers to receive a dividend taxed at 15%. Her accountant, however, suggests a $275,000 bonus in lieu of the $220,000 dividend since Hawk Corporation is in the 21% tax bracket. Should Stephanie take the $220,000 dividend or the $275,000 bonus? Support your answer by computing the after-tax cost of the two alternatives to Hawk and to Stephanie.

Stephanie should choose the $275,000 bonus instead of the $220,000 dividend because the after-tax benefit to her is the same and the after-tax cost for Hawk is less. Stephanie's after-tax benefit for the bonus is $187,000 [$275,000 × (1 - 0.32)], while her after-tax benefit for the dividend is $187,000 [$220,000 × (1 - 0.15)]. Hawk Corporation's after-tax cost for the bonus is $217,250 [$275,000 bonus - ($275,000 × 0.21) taxes saved], and its after-tax cost for the dividend is $220,000 (the dividend is not deductible).

Maria owns 75% and Christopher owns 25% of Cockatoo Corporation, a calendar year taxpayer. Cockatoo makes a $600,000 distribution to Maria on April 1 and a $200,000 distribution to Christopher on May 1. Cockatoo's current E & P is $120,000 and its accumulated E & P is $500,000. What are the tax implications of the distributions to Maria and Christopher?

Current E & P is allocated on a pro rata basis to each distribution made during the year. Cockatoo Corporation made $800,000 of distributions during the year. Christopher's distribution represents 25% ($200,000/$800,000) of that amount. Consequently, 25% of Cockatoo's current E & P, or $30,000 ($120,000 × 25%), is allocated to Christopher's distribution. Maria's distribution represents 75% ($600,000/$800,000) of total distributions. Consequently, 75% of Cockatoo's current E & P, or $90,000 ($120,000 × 75%), is allocated to Maria's distribution.

Accumulated E & P is applied in chronological order beginning with the earliest distribution.

When Maria's distribution is made, Cockatoo has $590,000 of dividend-paying capacity ($500,000 of accumulated E & P plus $90,000 of current E & P). Therefore, $590,000 of Maria's distribution is treated as a dividend with the balance ($10,000) being a return of capital (to the extent of her stock basis) and then a capital gain. After this distribution, Cockatoo has no accumulated E & P remaining.

When Christopher's distribution is made, Cockatoo has $30,000 remaining in current E & P. Therefore, $30,000 of Christopher's distribution is treated as a dividend with the balance ($170,000) being a return of capital (to the extent of his stock basis) and then a capital gain. After the distribution to Christopher, Cockatoo has no remaining current or accumulated E & P.

Jen, the sole shareholder of Mahogany Corporation, sold her stock to Jason on July 1 for $90,000. Jen's stock basis at the beginning of the year was $60,000. Mahogany made a $30,000 cash distribution to Jen immediately before the sale, and Jason received a $60,000 cash distribution from Mahogany on November 1. As of the beginning of the current year, Mahogany had $16,000 in accumulated E & P, and current E & P (before distributions) is $30,000. What are the tax consequences of these transactions to Jen and Jason?

The $30,000 in current E & P is allocated on a pro rata basis to the two distributions made during the year; thus, $10,000 of current E & P is allocated to Jen ($30,000 × $30,000/$90,000) and $20,000 is allocated to Jason ($30,000 × $60,000/$90,000).

​

Because accumulated E & P is allocated in chronological order, all of Mahogany's $16,000 of accumulated E & P is allocated to Jen's distribution.

​

Therefore, the distribution to Jen is treated as a $26,000 dividend and a $4,000 reduction in stock basis. Jason's distribution consists of a $20,000 dividend and a $40,000 reduction in stock basis. Because Jen sells her stock for $90,000 and her basis immediately after the distribution is $56,000 ($60,000 original basis - $4,000 recovery of capital), she has a $34,000 gain on the sale.

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Discussion Questions:

LO.2: In determining Blue Corporation's current E & P for 2023, how should taxable income be adjusted as a result of the following transactions?

- A capital loss carryover from 2022, fully used in 2023.

- Nondeductible meal expenses in 2023.

- Interest on municipal bonds received in 2023.

- Nondeductible lobbying expenses in 2023.

- Loss on a sale between related parties in 2023.

- Federal income tax refund received in 2023.

Critical Thinking:

LO.1, 2, 3, 4, 5: Orange Corporation distributes $200,000 in cash to each of its three shareholders: Sandy, Byron, and Fuchsia Corporation. What factors must be considered when determining how the distribution is treated for tax purposes by the shareholders?

Computational Exercises:

LO.1: At the beginning of the year, Myrna Corporation (a calendar year taxpayer) has E & P of $32,000. The corporation generates no additional E & P during the year. On December 31, the corporation distributes $50,000 to its sole shareholder, Abby, whose stock basis is $10,000. How is the distribution treated for tax purposes?

LO.3: On January 1 of the current year, Rhondell Corporation has accumulated E & P of $13,000. Current E & P for the year is $84,000, earned evenly throughout the year. Elizabeth and Jonathan are sole equal shareholders of Rhondell from January 1 to April 30. On May 1, Elizabeth sells all of her stock to Marshall. Rhondell makes two distributions to shareholders during the year: a total of $42,000 ($21,000 to Elizabeth and $21,000 to Jonathan) on April 30 and a total of $58,000 ($29,000 to Jonathan and $29,000 to Marshall) on December 31. Determine the allocation of the distributions by completing the table below. Assume that the shareholders have sufficient basis in their stock for any amount that is treated as return of capital.

- From Current E & P

- From Accumulated E & P

- Treated as Return of Capital

LO.4, 8: Rover Corporation would like to transfer excess cash to its sole shareholder, Aleshia, who is also an employee. Aleshia is in the 24% tax bracket, and Rover is subject to a 21% rate. Because Aleshia's contribution to the business is substantial, Rover believes that a $25,000 bonus in the current year is reasonable compensation and should be deductible by the corporation. However, Rover is considering paying Aleshia a $25,000 dividend because the tax rate on dividends is lower than the tax rate on compensation. Is Rover correct in believing that a dividend is the better choice? Why or why not?

Problems:

LO.1, 2: Cardinal Corporation, a calendar year taxpayer, receives dividend income of $250,000 from a corporation in which it holds a 10% interest. Cardinal also receives interest income of $35,000 from municipal bonds. (The municipality used the proceeds from the bond issue to construct a library.) Cardinal borrowed funds to purchase the municipal bonds and pays $20,000 of interest on the loan. Excluding these three items, Cardinal's taxable income is $500,000. Cardinal has $150,000 of accumulated E & P at the end of the prior year, and it paid Federal income taxes of $131,250 during the year.

- What is Cardinal Corporation's taxable income after these three items are taken into account?

- What is Cardinal Corporation's accumulated E & P at the start of next year?

LO.1, 3: At the beginning of the year, Penguin Corporation (a calendar year taxpayer) has accumulated E & P of $55,000. During the year, Penguin incurs a $36,000 loss from operations that accrues ratably. On October 1, Penguin distributes $40,000 in cash to Holly, its sole shareholder. How is Holly taxed on the distribution?