Rocky Corporation, an S corporation, reports the following results for the current year:Ordinary income$70,000Long-term capital gain20,000Municipal bond interest income10,000Domestic corporate dividends6,000Charitable contributions16,000Rocky's AAA and accumulated E&P balances at the beginning of the year are $80,000 and $50,000, respectively. Rocky makes a $100,000 cash distribution to its sole shareholder on June 1 and a second $100,000 cash distribution on December 1. The shareholder's basis for Rocky stock on January 1 was $120,000. Discuss the tax consequences of these transactions.

Question

What will be an ideal response?

Answer 1

The basis of the shareholder's stock is increased to $210,000 ($120,000 + $70,000 + $20,000 + $10,000 + $6,000 - $16,000) by Rocky's current year operations.

Rocky's AAA balance before any current year distributions is $160,000 ($80,000 + $70,000 + $20,000 + $6,000 - $16,000). $80,000 {[$100,000/($100,000 + $100,000)] × $160,000 = $80,000} of each distribution comes from Rocky's AAA and is tax-free because the $160,000 amount coming from AAA is less than the $210,000 basis of the Rocky stock.

The remaining $20,000 of each distribution comes from Rocky's accumulated E&P and is a taxable dividend. This portion of the distribution does not reduce the basis of the stock. The year-end accumulated E&P is $10,000.

In addition, Rocky has a $10,000 balance in its Other Adjustments Account from the current year tax-exempt income. This amount is not a separate earnings pool for distribution purposes, but is reflected in the shareholder's stock basis.

The basis of the Rocky stock is $50,000 at year-end ($210,000 - $160,000).