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JLK Corporation was formed in 1981 and elected a calendar tax year. It elected S corporation status in 1982. On December 31 of the current year, JLK made a $50,000 distribution to its founder and sole shareholder, John. JLK had a previously taxed income account of $9,000 and $1,000 of accumulated earnings and profits at the time of the distribution. The accumulated E&P was earned in 1981 while a C corporation. The accumulated adjustments account balance on January 1 of the current year was zero. During the year, JLK earned $12,000 of ordinary income. John’s basis in his JLK stock on January 1 of the current year was $10,000. How much income will John report from this S corporation investment in the current year, and what is its character?
Ordinary Income Capital Gain
A. $50,00 $10,000
B. $13,000 $27,000
C. $12,000 $0
the Answer is B.
Distributions by S corporations with accumulated earnings and profits (E&P) are governed by Sec. 1368(c). The portion of the distribution not in excess of the accumulated adjustments account reduces the shareholder’s basis. Money distributions then come from previously taxed income after the accumulated adjustments account has been exhausted. These distributions reduce the shareholder’s basis. Distributions next come out of accumulated E&P and are taxable as dividends. Any remaining distribution is treated as a capital gain to the extent it exceeds the shareholder’s remaining stock basis.
At the end of the year, JLK’s accumulated adjustments account balance is $12,000. John’s basis in the stock will be $22,000. The first $12,000 of the distribution comes out of the accumulated adjustments account and reduces the stock basis to $10,000. The next $9,000 comes out of previously taxed income and reduces the stock basis to $1,000. The next $1,000 comes out of accumulated E&P and is taxable as a dividend (thereby resulting in $13,000 of ordinary income). The next $1,000 reduces the stock basis to zero and causes the last $27,000 of the distribution to be a capital gain.
Author’s note: All pre-1983 earnings and profits earned while an S corporation are eliminated for post-1996 tax years.