Choice "B" is correct. The taxability of distributions to shareholders in S corporations with no C corporation earnings and profits is as follows:
To the extent of basis in stock - tax free; treated as return of capital.
Any distributions in excess of the shareholder's basis - taxable; treated as capital gain.
Based upon this rule and the information in the question, Baker's basis is calculated as follows:
| |
|---|
| Beginning basis | $ 25,000 |
| Plus: Ordinary income | 1,000 |
| Less: Long-term capital loss | (3,000) |
| Baker's Basis | $ 23,000 |
Baker's basis should then be compared to the amount distributed to determine how much constitutes return of capital. In this instance, $23,000 would be nontaxable return of basis, and the remaining $7,000 would be taxable capital gain to Baker.Choice "d" is incorrect. Baker's basis is less than the cash distributed so there would be some gain.
Choice "a" is incorrect. This choice does not take into account the current year activity of the S corporation in determining Baker's basis.
Choice "c" is incorrect. Based upon the above rule, amounts distributed to the extent of the shareholder's basis are not taxable. Note: This question is the official released question of the AICPA. The question appears to assume that the S corporation was organized as such and has no prior C corporation earnings and profits. If this were the case (i.e., corporation E&P exist), ordering rules for distributions would apply, and an election would have had to be made to obtain the same tax effects as in the provided choice.
