CPA Exam — REG (Regulation)Federal Taxation of EntitiesMedium
A client, an S corporation, has accumulated adjustments account (AAA) of $50,000 and accumulated earnings and profits (AE&P) of $30,000. Its sole shareholder, whose basis in the stock is $80,000, receives a cash distribution of $70,000. What is the shareholder's taxable dividend income from this distribution?
- A$20,000
- B$30,000
- C$10,000
- D$0
Show answer & explanationAnswer & explanation
Correct answer: A. $20,000
S corporation distributions are first from AAA, then from AE&P, then return of capital. The first $50,000 is from AAA (tax-free, reduces basis). The next portion is from AE&P, which is taxable as a dividend. Since $70,000 was distributed, $50,000 is from AAA, leaving $20,000 to come from AE&P. This $20,000 is taxable as a dividend.
Why the other options are wrong
- B. This would be the case if the entire AE&P was distributed and exceeded the AAA, but only $20,000 of AE&P was distributed.
- C. This would be the case if the distribution exceeded AAA and AE&P by $10,000, which is not true here.
- D. This is incorrect as a portion of the distribution will be from AE&P, which is taxable as a dividend.
S Corp Distribution Priority (with AE&P)
When an S corporation has both AAA and Accumulated E&P, distributions follow a specific ordering: first from AAA (tax-free to basis), then from AE&P (taxable dividend), then return of capital (tax-free to basis), then capital gain.
- AAA distributions are tax-free up to basis.
- AE&P distributions are taxable as dividends.
- Basis is reduced by tax-free distributions.
Memory trick: AAA, E&P, Basis Back: The S Corp Cash Flow Track!