Choice "d" is correct. A dividend to a preferred shareholder is based on that shareholder's fixed percentage at purchase. Preferred shareholders are not common equity owners of a corporation, and they only get paid based on their preferred percentage; therefore, any dividend payments to a preferred shareholder are considered dividend income to the preferred shareholder. Preferred shareholders are paid in full before common shareholders receive dividends.

Common shareholders are residual owners of a corporation and share in the retained earnings ("earnings and profits" is the tax term) of the corporation as well as the net assets. A "dividend" distribution to a common shareholder may or may not be classified as a taxable dividend. A dividend is defined by the Internal Revenue Code as a distribution of property by a corporation out of its earnings and profits (E & P). Dividends come first from current E&P and then from accumulated E&P. Any distributions in excess of current or accumulated E&P are first return of capital (up to the basis of the common stock) and then capital gain distribution.

In this case, the facts tell us that the company has a deficit in accumulated E&P as of the beginning of the year and that current E&P is $25,000. The facts do not tell us the amount of common shareholder capital in the corporation, but none of the answer choices provide for capital gain distributions, so we have to assume that the capital is in excess of the balance of the distribution after the current E&P is allocated. Because preferred shareholders are paid first, the $20,000 paid to them reduces available current E&P to distribute to $5,000 [$25,000 - $20,000]. The preferred shareholders are taxed on $20,000 of dividends. The common shareholders would report $5,000 in dividend income (the remaining amount of current E&P) and would have $5,000 in return of capital [$5,000 + $5,000 = $10,000 paid to the common shareholders].

Choice "c" is incorrect. Please refer to the discussion above for choice "a". $20,000 is taxable to the preferred stockholders as dividend income. However, there is not enough E&P to provide for $10,000 of dividend income to the common shareholders. After the preferred shareholders are paid their $20,000, only $5,000 of E&P is available for distribution as a taxable dividend. The balance of the common shareholder distribution ($5,000) is return of capital.

Choice "b" is incorrect. Please refer to the discussion above for choice "a". As mentioned, preferred shareholders are paid before common shareholders are paid. This answer choice incorrectly assumes that the common shareholders are allocated their $10,000 first as dividend income and the preferred shareholders receive the balance of E&P ($15,000) as dividend income.

Choice "a" is incorrect. Please refer to the discussion above for choice "a". The corporation has $25,000 of available E&P from which to distribute to the shareholders. Distributions are deemed to come from current E&P first and then from accumulated E&P (of which there is zero in this case). Only the excess is allocated to return of capital (to the extent of capital) and then to capital gain distribution, if excess remains.