A client, an S corporation, has $70,000 in its Accumulated Adjustments Account (AAA) and $20,000 in Accumulated Earnings and Profits (AE&P) from its prior C corporation years. The sole shareholder's stock basis is $100,000. The S corporation distributes $110,000 cash to its sole shareholder in the current year. What is the shareholder's taxable dividend income from this distribution?
- A$20,000
- B$40,000
- C$0
- D$110,000
Show answer & explanationAnswer & explanation
Correct answer: A. $20,000
S corporation distributions are ordered as follows: first from AAA (nontaxable, reduces basis), then from AE&P (taxable dividend, no basis reduction), then from stock basis (nontaxable, reduces basis), and finally as gain from the sale of stock (taxable capital gain). The $110,000 distribution first depletes the $70,000 AAA (nontaxable), then the $20,000 AE&P (taxable dividend), leaving $20,000 to reduce stock basis.
Why the other options are wrong
- B. Incorrect. This amount would be correct if AE&P was $40,000.
- C. Incorrect. The distribution exceeds AAA, triggering dividend income from AE&P.
- D. Incorrect. Only the portion attributed to AE&P is taxable as a dividend.
S Corp Distribution Hierarchy (with AE&P)
When an S corporation with Accumulated Earnings and Profits (AE&P) from prior C corporation years makes a distribution, it follows a specific ordering: first from AAA (nontaxable), then from AE&P (taxable dividend), then from stock basis (nontaxable), and finally as capital gain.
- AAA (Accumulated Adjustments Account) is distributed first.
- AE&P (Accumulated Earnings and Profits) is distributed second.
- Stock basis is reduced third.
- Any excess is treated as capital gain.
Memory trick: Always Acknowledge Every Penny – AAA, AE&P, Basis, then Gain.