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 "C" 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 "d" is incorrect. This answer option incorrectly includes only the cash received ($20,000) as the dividend and excludes the property received.
Choice "b" is incorrect. This answer option incorrectly includes only the fair market value of the property received ($60,000) as the dividend and excludes the cash received.
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.