A client, an S corporation, has an accumulated adjustments account (AAA) balance of $60,000 and accumulated earnings and profits (AE&P) of $30,000. Its sole shareholder, whose stock basis is $120,000, receives a cash distribution of $100,000. What is the amount of the distribution that is considered a taxable dividend?
- A$0
- B$40,000
- C$60,000
- D$30,000
Show answer & explanationAnswer & explanation
Correct answer: D. $30,000
S corporation distributions follow a specific hierarchy when AE&P exists. First, distributions come from AAA, which is tax-free up to the shareholder's basis. Here, $60,000 comes from AAA, reducing it to $0 and the shareholder's basis to $60,000 ($120,000 - $60,000). Next, distributions come from AE&P, which are taxable dividends. The remaining distribution is $100,000 - $60,000 = $40,000. This $40,000 comes from AE&P, but only $30,000 is available as AE&P. Thus, $30,000 is a taxable dividend. The remaining $10,000 ($40,000 - $30,000) reduces the shareholder's basis further. So, the taxable dividend is $30,000.
Why the other options are wrong
- A. Incorrect. When AE&P exists, distributions exceeding AAA are taxable dividends.
- B. Incorrect. This would be the amount remaining after AAA, but before considering the limit of AE&P.
- C. Incorrect. This is the amount from AAA, which is tax-free to the extent of basis.
S Corp Distribution Order (with AE&P)
When an S corporation has accumulated earnings and profits (AE&P), distributions are sourced in a specific order: first from AAA (tax-free up to basis), then from AE&P (taxable dividend), then from basis (tax-free return of capital), finally as capital gain.
- AAA distributions are tax-free up to shareholder basis.
- AE&P distributions are taxable dividends.
- Distributions reduce basis after AAA and AE&P are exhausted.
- Distributions exceeding basis after AAA and AE&P are capital gains.
Memory trick: AAA First, E&P Second, Basis Then Gain.