An S Corporation has an Accumulated Adjustments Account (AAA) of ,000 and Accumulated E&P (from C Corp years) of ,000. It makes a cash distribution of ,000 to its sole shareholder. The shareholder's stock basis is ,000. What is the tax treatment of the distribution?

Answer options:

,000 Tax-free

,000 Tax-free; ,000 Capital Gain

,000 Tax-free; ,000 Dividend Income

,000 Dividend Income

How to approach this question

Distribution Source Order: 1. AAA (Tax Free). 2. E&P (Taxable Dividend). 3. Stock Basis (Tax Free). 4. Excess (Capital Gain).

Full Answer

C.,000 Tax-free; ,000 Dividend Income✓ Correct

Distributions come first from AAA (tax-free return of capital). ,000 is from AAA. The remaining ,000 comes from Accumulated E&P and is taxable as a dividend.

Common mistakes

Thinking distributions are taxable dividends first.

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