CPA Exam — REG (Regulation)Federal Taxation of EntitiesMedium
A client, an S corporation, made a cash distribution of $50,000 to its sole shareholder. At the time of the distribution, the corporation had no accumulated earnings and profits (AE&P) and an accumulated adjustments account (AAA) balance of $30,000. The shareholder's adjusted basis in the S corporation stock was $45,000 prior to the distribution. What is the shareholder's basis in the S corporation stock after the distribution?
- A$45,000
- B$0
- C$25,000
- D$30,000
Show answer & explanationAnswer & explanation
Correct answer: C. $25,000
Since there is no AE&P, the distribution first reduces AAA to zero ($30,000). The remaining distribution of $20,000 ($50,000 - $30,000) then reduces the shareholder's basis. The shareholder's basis was $45,000, so after reduction, it is $45,000 - $20,000 = $25,000. No capital gain is recognized because the distribution did not exceed basis.
Why the other options are wrong
- A. This is incorrect. This is the pre-distribution basis, which is reduced.
- B. This is incorrect. The basis is not reduced to zero in this scenario.
- D. This is incorrect. This is the AAA balance, not the post-distribution basis.
S Corp Distribution (No AE&P)
When an S corporation has no accumulated earnings and profits (AE&P), distributions are first sourced from AAA, then from shareholder basis, and any excess is treated as capital gain.
- AAA distributions are tax-free and reduce AAA.
- Distributions exceeding AAA reduce shareholder basis (tax-free).
- Distributions exceeding basis result in capital gain.
Memory trick: No AE&P, just AAA and basis, then capital gain, that's the S Corp distribution lane.