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Problems 2 and 3 Beginning on Page 435

Problems 2 and 3 Beginning on Page 435. Pg 435 Problem 2(a). Without regard to the distribution, Nancy and Opal each include $2,000 of LTCG (4,000 ÷ 2) and $3,000 ((32,000 – 18,000 – 8,000) ÷ 2)) of ordinary income. Nancy’s pre-distribution stock basis is $6,000 ($1,000 + 2,000 + 3,000).

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Problems 2 and 3 Beginning on Page 435

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  1. Problems 2 and 3Beginning onPage 435

  2. Pg 435 Problem 2(a) • Without regard to the distribution, Nancy and Opal each include $2,000 of LTCG (4,000 ÷ 2) and $3,000 ((32,000 – 18,000 – 8,000) ÷ 2)) of ordinary income. • Nancy’s pre-distribution stock basis is $6,000 ($1,000 + 2,000 + 3,000). • Opal’s pre-distribution stock basis is $10,000 ($5,000 + 2,000 + 3,000).

  3. Pg 435 Problem 2(a) • P Corp’s pre-distribution AAA account is $10,000 (note AAA begins at zero (a new S election) and is increased by the LTCG of $4,000 and ordinary income of $6,000). • Because the $10,000 distribution does not exceed the AAA account (rather it matches the pre-distribution AAA account), no C Corp e&p is distributed (no dividend to the shareholders).

  4. Pg 435 Problem 2(a) -- Sec 1368 • Impact of distribution on Nancy: No gain. • Nancy’s pre-distribution stock basis $6,000 • Distribution of AAA < 5,000> • Nancy’s Ending Stock Basis 1,000 • Impact of distribution on Opal: No gain. • Opal’s pre-distribution stock basis $10,000 • Distribution of AAA < 5,000> • Opal’s Ending Stock Basis 5,000 Year end AAA is zero

  5. Pg 435 Problem 2(b) • P Corp’s pre-distribution AAA account is still $10,000. • Because the $20,000 distribution exceeds the AAA account by $10,000, $6,000 of that excess is a dividend (C Corp e&p of $6,000 is a given).

  6. Pg 435 Problem 2(b) -- Sec 1368 • The $10,000 distribution to Nancy (recall thatNancy’s pre-distribution stock basis is $6,000) • $5,000 from AAA (basis recovery)-§1368(c)(1), (b)(1) • $3,000 is a dividend--§1368(c)(2) • $1,000 is a basis recovery - §1368(c)(3), (b)(1) • $1,000 is LTCG--§1368(c)(3), (b)(2) Nancy’s year end stock basis is zero ($6,000 – 5,000 (from AAA) – 1,000). Note, the $1,000 §1368(c)(3), (b)(2) LTCG will NOT appear on Schedule K-1. The K-1, line 16d will include the distribution of $7,000 to Nancy and the dividend of $3,000 would appear on Nancy’s Form 1099.

  7. Pg 435 Problem 2(b) -- Sec 1368 • The $10,000 distribution to Opal (recall thatOpal’s pre-distribution stock basis is $10,000) • $5,000 from AAA (basis recovery)-§1368(c)(1), (b)(1) • $3,000 is a dividend--§1368(c)(2) • $2,000 is a basis recovery - §1368(c)(3), (b)(1) Opal’s year end stock basis is $3,000 ($10,000 – 5,000 (from AAA) – 2,000). Schedule K-1 will include the distribution of $7,000 to Opal on line 16d and Opal’s Form 1099 will show a dividend of $3,000.

  8. Pg 435 Problem 2(b) -- Sec 1368 • AAA is zero at year end ($10,000 – 10,000). • AAA can be negative from net losses but not from distributions. • Year end C corp e&p is also zero $6,000 - $6,000) because all $6,000 was distributed (a dividend).

  9. Pg 435 Problem 2(c) • Without regard to the distribution, Nancy and Opal each include $2,000 of LTCG (4,000 ÷ 2) and $3,000 ((32,000 – 18,000 – 8,000) ÷ 2)) of ordinary income. • Nancy’s pre-distribution stock basis is $8,000 ($1,000 + 2,000 + 3,000 + 2,000 (tax exempt inc)). • Opal’s pre-distribution stock basis is $12,000 ($5,000 + 2,000 + 3,000 + 2,000 (tax exempt inc)).

  10. Pg 435 Problem 2(c) • P Corp’s pre-distribution AAA account is $10,000 (note AAA begins at zero (a new S election) and is increased by the LTCG of $4,000 and ordinary income of $6,000 but is not increased by tax exempt income). • Because the $14,000 distribution exceeds AAA account by $4,000, all $4,000 is a dividend. • This is the tax exempt income trap if the S Corp has C corp e&p.

  11. Pg 435 Problem 2(c) -- Sec 1368 • The $7,000 distribution to Nancy (recall thatNancy’s pre-distribution stock basis is $8,000) • $5,000 from AAA (basis recovery)-§1368(c)(1), (b)(1) • $2,000 is a dividend--§1368(c)(2) Nancy’s year end stock basis is 3,000 ($8,000 – 5,000 (from AAA)). The K-1, line 16d would include the distribution of $5,000 to Nancy and the dividend of $2,000 would appear on Nancy’s Form 1099

  12. Pg 435 Problem 2(c) -- Sec 1368 • The $7,000 distribution to Opal (recall thatOpal’s pre-distribution stock basis is $12,000) • $5,000 from AAA (basis recovery)-§1368(c)(1), (b)(1) • $2,000 is a dividend--§1368(c)(2) Opal’s year end stock basis is $7,000 ($12,000 – 5,000 (from AAA)). Schedule K-1 will include a distribution of $5,000 to Opal on line 16d and Opal’s Form 1099 will show a dividend of $2,000.

  13. Pg 435 Problem 2(c) -- Sec 1368 • AAA is zero at year end ($10,000 – 10,000). • C corp e&p at year end is $2,000 $6,000 - $4,000) because $4,000 was distributed (a dividend).

  14. Pg 435 Problem 2(d) -- Sec 1368 • The issue here is the extent to which AAA carries over to a transferee (Rose here) in year 2. • AAA does transfer to a transferee of stock (unlike old PTI).

  15. Pg 435 Problem 2(d) – Year 1 • In year 1, Nancy and Opal each include $2,000 of LTCG (4,000 ÷ 2) and $3,000 ((32,000 – 18,000 – 8,000) ÷ 2)) of ordinary income. • Nancy’s year end stock basis is $6,000 ($1,000 + 2,000 + 3,000). • Opal’s year end stock basis is $10,000 ($5,000 + 2,000 + 3,000). • P Corp’s year end AAA account is $10,000 • P Corp’s C corp e&p at year end is $6,000

  16. Pg 435 Problem 2(d) – Year 2 • Nancy sells her stock to Rose for $6,000 on January 1 of year 2 and recognizes zero gain on the sale ($6,000 sales price - $6,000 stock basis). • Rose’s beginning stock basis is $6,000 (cost).

  17. Pg 435 Problem 2(d) – Year 2 • When the $6,000 is distributed to Rose: • $5,000 will come from AAA (income previously reported by Nancy) and be a tax free recovery of basis to Rose. • $1,000 is a dividend to Rose (her share of C Corp e&p.) Rose’s ending stock basis is $1,000 ($6,000 - $5,000).

  18. Pg 435 Problem 2(e) -- Sec 1368 • The issue here is the post-termination transition period (defined in Sec 1377(b)) following the revocation of the S election effective January 1 of year 2. • Note, the S corp becomes a C corp (subject to double tax on earnings) January 1 of year 2.

  19. Pg 435 Problem 2(e) – Year 1 (S corp) • In year 1, Nancy and Opal each include $2,000 of LTCG (4,000 ÷ 2) and $3,000 ((32,000 – 18,000 – 8,000) ÷ 2)) of ordinary income. • Nancy’s year end stock basis is $6,000 ($1,000 + 2,000 + 3,000). • Opal’s year end stock basis is $10,000 ($5,000 + 2,000 + 3,000). • P Corp’s year end AAA account is $10,000 • P Corp’s C corp e&p at year end is $6,000

  20. Pg 435 Problem 2(e) – Year 2 • In year 2, P (now a C corp) has $5,000 of year 2 e&p (in addition to the old C corp e&p of $6,000) and distributes $7,000 each, to Nancy and Opal • Section 1371(e)(1) provides that cash distributions during a post-termination transition period are treated as a recovery of stock basis to the extent the distribution does not exceed the AAA.

  21. Pg 435 Problem 2(e) – Year 2 • For both Nancy and Opal (each receive $7,000 cash), $5,000 of the distribution (share of AAA) is a tax free basis reduction and the other $2,000 is a dividend per Code Sec 301(c)(1). • Notice that during the post-termination transition period even an S corp without any prior (pre-S election) C corp e&p needs to determine AAA for purposes of C corp e&p earned during that (post-S election) post-termination transition period.

  22. Pg 436 Problem 3 • We will discuss this issue in depth after we finish discussing S corporations. • For distributions of cash, the rules are similar for partners. • In general, with a partnership distribution of appreciated property, distributions do not trigger gain (Sec 311(b) does not apply to partnerships). A partner typically takes the same basis that the partnership had in the property. • Code Sec. 751 (applicable only to partnerships) is a complicated exception for partnerships.

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