CPA Exam — REG (Regulation)Federal Taxation of EntitiesMedium
A client, an S corporation, made a cash distribution of $40,000 to its sole shareholder. At the time of the distribution, the S corporation had an accumulated adjustments account (AAA) balance of $25,000, accumulated earnings and profits (AE&P) of $10,000, and the shareholder's stock basis was $60,000. How much of this distribution is treated as a return of capital?
- A$10,000
- B$5,000
- C$0
- D$15,000
Show answer & explanationAnswer & explanation
Correct answer: B. $5,000
Distributions from S corporations with AE&P follow a specific order: first from AAA ($25,000), then from AE&P ($10,000), then return of capital (reducing basis), and finally capital gain. Total distribution is $40,000. $25,000 (AAA) + $10,000 (AE&P) = $35,000 as dividends. The remaining $5,000 ($40,000 - $35,000) is a return of capital.
Why the other options are wrong
- A. This represents the AE&P portion, not the return of capital.
- C. Incorrect; a portion of the distribution exceeds AAA and AE&P, making it a return of capital.
- D. Incorrect calculation of the return of capital portion.
S Corp Distribution Hierarchy (with AE&P)
S corporation distributions with accumulated earnings and profits (AE&P) follow a specific order: first from Accumulated Adjustments Account (AAA), then from AE&P, then return of capital, and finally capital gain.
- AAA distributions are tax-free to the extent of basis.
- AE&P distributions are taxable dividends.
- Return of capital reduces stock basis.
- Distributions exceeding basis after all other categories are capital gains.
Memory trick: AAA Always Answers, AE&P Adds Earnings, Basis Becomes Balance, Gain Goes Last.