1. Tornado, an S corporation, has no earnings and profits. In 2017, Tornado dist
ID: 2530900 • Letter: 1
Question
1. Tornado, an S corporation, has no earnings and profits. In 2017, Tornado distributed property with a fair market value of $32,500 and an adjusted basis of $26,000 to Dorothy, its sole shareholder. After Dorothy’s share of any corporate gain or loss was recognized, her adjusted basis in Tornado’s stock at year end was $25,000. How should Dorothy handle the distribution?
A.
$25,000 as return of capital and $7,500 as nontaxable distributions.
B.
$25,000 as return of capital and $7,500 as taxable capital gain.
C.
$50,000 as return of capital and $1,000 as taxable capital gain.
D.
$25,000 as nontaxable distributions.
2. Rap, Inc., was organized in January 2017 and immediately made an S election. Rap, Inc.’s stock is entirely owned by Howard, who contributed $40,000 to start the business. Rap reported the following results for the 2017 year:
Ordinary income
$36,000
Short-term capital loss
4,000
Charitable contributions
1,000
Tax-exempt income
1,000
Sec. 179 deduction
10,000
On April 12, 2017, Howard received a $30,000 cash distribution from the corporation. What is the adjusted basis of his stock on January 1, 2018?
A.
$41,000
B.
$32,000
C.
$31,000
D.
$10,000
A.
$25,000 as return of capital and $7,500 as nontaxable distributions.
B.
$25,000 as return of capital and $7,500 as taxable capital gain.
Explanation / Answer
1. A. $25,000 as return of capital and $7500 as non taxable distributions
Dorothy has to distribute $7500 as non taxable distribution out of $ 25000 adjusted basis and $17500 as return of capital ($25000 - $7500). As non taxable distributions are distributions not out of dividends but out of return of capital.
B. $25000 as return of capital and $ 7500 as taxable capital gain.
Dorothy has to distribute $ 25000 as return of capital and $ 7500 as capital gain both separately, as taxable capital gain means earnings & profits and hence it is not a part of return of capital. Both to be distributed.
C.$50,000 as return of capital and $ 1000 taxable capital gain.
Dorothy has to distribute $ 25000 as return of capital (the availability is only that much to distribute and $ 1000 as taxable capital gain separately as taxable capital gain means earnings & profits which is not a part of return of capital.
D.$25000 as non taxable distributions.
Dorothy has to distribute fully $25000 as non taxable distributions but there will not be any return of capital balance. As non taxable distributions are itself part of return of capital.
2. Computation of adjusted basis of Rap, Inc. stock's on January 1, 2018
Answer is D - $ 10,000
Working Note Adjusted basis is the difference between the cost of investment and current market value of investment.
Current market value of investment = $36000 - $4000-$1000-$1000-$10000 = $20000
Cost of investment = Initial investment - nontaxable Distribution or cash distribution etc = $40000 - $30000=$10000
therefore, adjusted basis = $20000 - $10000= $10000 (increase in the adjusted basis ie gain).
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