A client, an S corporation, has accumulated earnings and profits (AE&P) of $30,000 and an accumulated adjustments account (AAA) balance of $40,000 at the beginning of the year. During the year, the S corporation generates $20,000 of ordinary business income and makes a cash distribution of $75,000 to its sole shareholder. What portion of the distribution is considered a tax-free return of capital?
- A$0
- B$60,000
- C$15,000
- D$40,000
Show answer & explanationAnswer & explanation
Correct answer: C. $15,000
S corporation distributions with AE&P follow a specific order: first from AAA, then AE&P, then return of capital (shareholder basis), and finally capital gain. The total AAA available for distribution is $40,000 (beginning) + $20,000 (income) = $60,000. After exhausting AAA ($60,000) and AE&P ($30,000 is more than the remaining $15,000 distribution), the distribution does not reach the return of capital stage in this scenario.
Why the other options are wrong
- A. This is incorrect. A portion of the distribution is a return of capital after AAA and AE&P are exhausted and if shareholder basis exceeds the remaining distribution.
- B. This is incorrect. This is the total AAA available after income, not the return of capital.
- D. This is incorrect. This is the beginning AAA balance, not the return of capital.
S Corp Distribution Order (with AE&P)
Distributions from an S corporation with accumulated earnings and profits (AE&P) are sourced in a specific order: AAA, then AE&P, then return of capital (shareholder basis), then capital gain.
- AAA distributions are tax-free.
- AE&P distributions are taxable dividends.
- Return of capital reduces shareholder basis.
- Capital gain applies after basis is exhausted.
Memory trick: AAA first, then AE&P, then your basis, then capital gain, that's the S Corp distribution chain.