Rules: Distributions from corporations to shareholders are
taxable to such shareholders if the distributions are classified as dividends. A
dividend is defined by the IRC as a distribution of property by a corporation
out if its earnings and profits. An individual shareholder will be taxed on
dividends in cash for the amount received and on dividends of property for the
fair market value of the property received. Distributions are deemed to come
from earnings and profits first. Any distribution in excess of earnings and
profits ("E&P," accumulated and current) is treated as a nontaxable return
of capital that reduces the shareholder's basis in the stock. Distributions in
excess of basis are capital gain distributions taxable as capital gains instead
of dividends.
Choice "d" is correct. Per the above rules, an individual shareholder will be
taxed on dividends in cash for the amount received and on dividends of property
for the fair market value of the property received, but any distribution in
excess of earnings and profits (accumulated and current) is treated as a
nontaxable return of capital that reduces the shareholder's basis in the stock.
The corporation has $70,000 in current and accumulated earnings and profits.
Therefore, the shareholders will be taxed on the $20,000 in cash received plus
the $60,000 in FMV of the property received ($80,000), but only to the extent
there is E&P, and that means a taxable amount of dividends of
$70,000. The remaining $10,000 will either be a nontaxable return of capital
(assuming basis exists), a taxable capital gain (assuming no basis exists), or
something in between (assuming basis is positive but less than $10,000).
[Note: The question indicates that the basis of the property equals the
fair market value. This avoids the impact on the E&P on the corporation's
books for the gain on the dividend to the shareholders and keeps the E&P at
$70,000.]
Choice "a" is incorrect. This answer option includes both the $20,000 cash
received and the $60,000 fair market value of the property received [$20,000 +
$60,000 = $80,000], but it (incorrectly) does not limit the dividend income to
the total amount of corporate E&P, which is $70,000.
