CPA Exam — REG (Regulation)Federal Taxation of EntitiesHard
A client, an S corporation, made a distribution of $20,000 to its sole shareholder, whose basis in the stock was $15,000. The S corporation has no accumulated adjustments account (AAA) balance and no accumulated E&P. What is the shareholder's taxable gain from this distribution?
- A$5,000
- B$0
- C$20,000
- D$15,000
Show answer & explanationAnswer & explanation
Correct answer: A. $5,000
Since there is no AAA or E&P, the distribution is first a tax-free return of capital, reducing the shareholder's basis. The distribution ($20,000) exceeds the basis ($15,000) by $5,000. This excess is treated as a capital gain to the shareholder. So, $20,000 (distribution) - $15,000 (basis) = $5,000 taxable gain.
Why the other options are wrong
- B. This is incorrect; distributions exceeding basis result in a capital gain.
- C. This is the total distribution, not the taxable gain.
- D. This is the initial basis, not the gain recognized.
S Corp Distribution Rules
Distributions from an S corporation are generally tax-free to the extent of the Accumulated Adjustments Account (AAA) and then basis, with any excess treated as capital gain or dividend if E&P exists.
- Distributions first from AAA (tax-free).
- Then from accumulated E&P (taxable dividend).
- Then from basis (tax-free return of capital).
- Finally, excess over basis is capital gain.
Memory trick: AAA, E&P, Basis, Gain: The S Corp Distribution Train!