Rule: Per IRC Section 1368, the amount of any distribution to an S corporation shareholder is equal to the cash plus the fair market value of any other property distributed. How the distribution is taxed depends on whether the S corporation has C corporation accumulated earnings and profits (E&P). If the S corporation has never been a C corporation or if it has no C corporation accumulated E&P, the distribution is a tax-free recovery of capital to the extent it does not exceed the shareholder's adjusted basis in the stock of the S corporation. When the amount of the distribution exceeds the shareholder's adjusted basis of the stock, the excess is treated as a gain from the sale or exchange of property (normally a long-term capital gain).

Choice "a" is correct. In each of the years, Stone made distributions in excess of each shareholder's basis. These distributions will normally be taxed as capital gains.

Choice "d" is incorrect. In each of the years, and not just the first and second years, Stone made distributions in excess of each shareholder's basis. These distributions will normally be taxed as capital gains; they are not tax free.

Choice "b" is incorrect. In each of the years, and not just the first year, Stone made distributions in excess of each shareholder's basis. These distributions will normally be taxed as capital gains.

Choice "c" is incorrect. In each of the years, and not just the third year, Stone made distributions in excess of each shareholder's basis. These distributions will normally be taxed as capital gains.