SEE - Special Enrollment Exam Quiz: Corporate Formation And Distributions
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Corporate Formation And DistributionsQuestion 1 of 15

Ryan is the sole shareholder of Blake, Inc., a C corporation. In 2025, Blake pays $15,000 directly to a university for tuition for Ryan's daughter. Blake also sells a delivery vehicle to Ryan for $10,000; the vehicle has an adjusted basis of $18,000 to Blake and a fair market value of $26,000. Blake has $60,000 of current earnings and profits, and Ryan does not reimburse Blake for any of these amounts.

Which of the following correctly describes the federal income tax consequences of these transactions?

Ryan has $31,000 of dividend income, and Blake recognizes an $8,000 loss on the vehicle sale.
Ryan has $31,000 of dividend income, and Blake recognizes no gain or loss on the vehicle sale.
Ryan has $15,000 of dividend income, and the $16,000 vehicle discount is a nontaxable reduction in Ryan's basis in the vehicle.
Ryan has $31,000 of dividend income, and Blake recognizes an $8,000 gain on the vehicle sale.
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SEE - Special Enrollment Exam Quiz

SEE - Special Enrollment Exam Quiz: Corporate Formation And Distributions

Practice Corporate Formation And Distributions in SEE - Special Enrollment Exam with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

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Question 1

Ryan is the sole shareholder of Blake, Inc., a C corporation. In 2025, Blake pays $15,000 directly to a university for tuition for Ryan's daughter. Blake also sells a delivery vehicle to Ryan for $10,000; the vehicle has an adjusted basis of $18,000 to Blake and a fair market value of $26,000. Blake has $60,000 of current earnings and profits, and Ryan does not reimburse Blake for any of these amounts.

Which of the following correctly describes the federal income tax consequences of these transactions?

  1. Ryan has $31,000 of dividend income, and Blake recognizes an $8,000 loss on the vehicle sale.
  2. Ryan has $31,000 of dividend income, and Blake recognizes no gain or loss on the vehicle sale.
  3. Ryan has $15,000 of dividend income, and the $16,000 vehicle discount is a nontaxable reduction in Ryan's basis in the vehicle.
  4. Ryan has $31,000 of dividend income, and Blake recognizes an $8,000 gain on the vehicle sale. (correct answer)
Explanation: IRC §§ 301, 311(b), 316(a). A corporation's payment of a shareholder's personal obligation is a constructive distribution, so the $15,000 tuition payment is a distribution to Ryan. When a corporation sells property to a shareholder for less than fair market value, the bargain element is also a distribution: $26,000 - $10,000 = $16,000. Ryan's total distribution is $15,000 + $16,000 = $31,000, which is a dividend because it does not exceed Blake's $60,000 of current earnings and profits. Under § 311(b), Blake recognizes gain on the vehicle as if it had been sold at fair market value, or $26,000 - $18,000 = $8,000, even though the actual sale price was $10,000. Choice D is correct. Choice B ignores the § 311(b) gain on the bargain sale. Choice C treats the bargain element as a nontaxable purchase-price adjustment, but a bargain purchase from a corporation is a distribution taxable under § 301. Choice A measures Blake's result by the actual sale price; § 311(b) requires gain or loss to be measured against fair market value, and at fair market value the vehicle produces an $8,000 gain.

Question 2

In 2025, Alice, Brian, and Carmen form Zeta Corporation. Alice transfers equipment with an adjusted basis of $60,000 and a fair market value of $135,000 in exchange for 45 percent of Zeta's stock. Brian transfers $90,000 cash in exchange for 30 percent of Zeta's stock. Carmen receives the remaining 25 percent of the stock solely in exchange for services she rendered to Zeta; those services have a fair market value of $75,000.

Based on these facts, which of the following correctly describes the federal income tax consequences of the transfers?

  1. Alice recognizes a $75,000 gain, Brian recognizes no gain, Carmen has $75,000 of compensation income, and Zeta's basis in the equipment is $135,000. (correct answer)
  2. Alice recognizes no gain, Brian recognizes no gain, Carmen has $75,000 of compensation income, and Zeta's basis in the equipment is $60,000.
  3. Alice recognizes a $75,000 gain, Brian recognizes no gain, Carmen has $75,000 of compensation income, and Zeta's basis in the equipment is $60,000.
  4. Alice recognizes no gain, Brian recognizes no gain, Carmen has no income, and Zeta's basis in the equipment is $60,000.
Explanation: IRC §§ 351(a), 351(d), 368(c). Under § 351(a), gain is deferred only if the persons transferring property for stock control the corporation immediately after the exchange, and control means ownership of at least 80 percent of the stock under § 368(c). Stock issued for services is not issued in exchange for property under § 351(d), so Carmen is not a transferor and her 25 percent interest does not count toward the control requirement. The only transferors of property, Alice and Brian, together own only 45 + 30 = 75 percent of Zeta, below the 80 percent threshold, so § 351 does not apply. Alice's exchange is taxable: she recognizes $135,000 - $60,000 = $75,000 of gain, and Zeta's basis in the equipment is its $135,000 cost. Brian exchanged cash equal to the value of the stock he received, so he recognizes no gain. Carmen received stock worth $75,000 for services, which is taxable compensation to her under § 83. Choice A is correct. Choice B incorrectly counts Carmen's service stock toward the control test; services are not property, so the transferors' percentage is 75 percent, not 100 percent. Choice C correctly finds Alice's gain but gives Zeta a $60,000 carryover basis, which is available only when § 351 applies and the corporation takes the transferor's basis under § 362(a). Choice D treats stock issued for services as a tax-free § 351 transfer, but services are not property, and the stock is taxable compensation to Carmen.

Question 3

Marta is the sole shareholder of Drake Corporation. In 2025, Drake distributes land to Marta. The land has an adjusted basis of $20,000 to Drake and a fair market value of $65,000 on the date of distribution. Drake's current earnings and profits for 2025, before considering this distribution, are $40,000, and Drake has no accumulated earnings and profits. Marta's basis in her Drake stock is $30,000.

Which of the following correctly describes the federal income tax consequences of the distribution to Drake and Marta?

  1. Drake recognizes a $45,000 gain; Marta has a $65,000 dividend and a $20,000 basis in the land.
  2. Drake recognizes a $45,000 gain; Marta has a $40,000 dividend, a $25,000 reduction in stock basis, and a $65,000 basis in the land.
  3. Drake recognizes no gain; Marta has a $65,000 dividend and a $20,000 basis in the land.
  4. Drake recognizes a $45,000 gain; Marta has a $65,000 dividend and a $65,000 basis in the land. (correct answer)
Explanation: IRC §§ 301(b), 301(d), 311(b), 316(a). On a nonliquidating distribution of appreciated property, the corporation recognizes gain as if it had sold the property at fair market value: $65,000 - $20,000 = $45,000. The distribution to Marta is measured by the property's $65,000 fair market value under § 301(b), and the § 311(b) gain increases Drake's current earnings and profits to $40,000 + $45,000 = $85,000. Because $65,000 does not exceed $85,000 of current E&P, the entire distribution is a dividend under § 316(a). Marta's basis in the land is $65,000 under § 301(d), and her $30,000 stock basis is unchanged because the distribution was fully a dividend. Choice D is correct. Choice B measures the dividend against E&P of $40,000 before adding the § 311(b) gain; the gain increases E&P, so the full $65,000 is a dividend. Choice C omits the § 311(b) gain at the corporate level and gives Marta a carryover basis. Choice A recognizes Drake's gain but gives Marta Drake's $20,000 carryover basis; § 301(d) requires a fair-market-value basis.

Question 4

Ted owns all 1,000 shares of Harlow Corporation. In 2025, Ted gives 200 shares to his son, Sam, as a gift. Later in 2025, Harlow redeems the remaining 800 shares owned by Ted for $150,000 cash. Sam continues to own his 200 shares after the redemption. Harlow has $120,000 of accumulated earnings and profits, Ted's basis in the 800 redeemed shares is $30,000, and Ted does not file any waiver agreement.

Which of the following correctly describes the federal income tax treatment of the $150,000 redemption proceeds to Ted?

  1. Ted has a $120,000 dividend and a $30,000 long-term capital gain.
  2. Ted has a $120,000 long-term capital gain on the redemption.
  3. Ted has a $120,000 dividend, and the remaining $30,000 reduces his stock basis to zero. (correct answer)
  4. Ted has a $150,000 dividend from the redemption proceeds.
Explanation: IRC §§ 302(b), 302(c), 301(c), 316, 318(a)(1). Under § 318(a)(1), stock owned by Sam is attributed to his father, Ted. Before the redemption, Ted constructively owned 100 percent of Harlow (800 shares directly plus Sam's 200 shares attributed to him). After the redemption, he still constructively owns 100 percent of the 200 outstanding shares because Sam's shares remain outstanding and are attributed to him. Because his proportionate interest did not decline, the redemption fails the disproportionate test of § 302(b)(2), fails the complete-termination test of § 302(b)(3), and is essentially equivalent to a dividend under § 302(b)(1). The § 302(c)(2) waiver of family attribution is not automatic; Ted did not file the required agreement, so attribution applies. The proceeds are therefore treated as a § 301 distribution: $120,000 is a dividend to the extent of Harlow's earnings and profits, and the remaining $30,000 is a return of capital that reduces Ted's $30,000 stock basis to zero, producing no gain. Choice C is correct. Choice A treats the excess over E&P as capital gain without first applying the return-of-capital ordering rule of § 301(c)(2). Choice B treats the redemption as a sale, but the complete-termination exception is unavailable because family attribution applies and no waiver was filed. Choice D ignores the E&P limit on dividends.

Question 5

On September 15, 2025, Kite Corporation, a C corporation, distributed a warehouse to its sole shareholder, Liam, an individual, outside of a complete liquidation. The warehouse had a fair market value of $150,000 and an adjusted basis to Kite of $60,000. The warehouse was subject to a $40,000 mortgage, which Liam assumed. Kite had $120,000 of accumulated earnings and profits at the beginning of 2025 and, apart from any gain recognized on this distribution, no current earnings and profits. Liam's adjusted basis in his Kite stock was $50,000.

What is the total amount of income recognized by Kite and Liam as a result of the distribution?

  1. $90,000
  2. $110,000
  3. $200,000 (correct answer)
  4. $240,000
Explanation: Choice C is correct. Under IRC § 311(b), a C corporation recognizes gain on a nonliquidating distribution of appreciated property as if the property had been sold for its fair market value. Kite recognizes $150,000 − $60,000 = $90,000. Under IRC § 301(b)(2), Liam's distribution amount is $150,000 − $40,000 mortgage = $110,000. Because Kite has sufficient earnings and profits, the $110,000 is a dividend includible in gross income. Total income recognized is $90,000 + $110,000 = 200,000.ChoiceA(200,000. Choice A (90,000) omits Liam's dividend. Choice B (110,000)omitsKite′sgain.ChoiceD(110,000) omits Kite's gain. Choice D (240,000) includes Kite's gain but treats Liam's distribution as the full $150,000 fair market value, ignoring the $40,000 mortgage. Liam's $50,000 stock basis is not used because the distribution is fully covered by earnings and profits.

Question 6

In 2025, Maple Corporation, a C corporation, adopted a plan of complete liquidation. At that time, Maple had accumulated earnings and profits of $400,000. Its sole shareholder, Nora, received $100,000 in cash and land with a fair market value of $80,000 and an adjusted basis to Maple of $30,000. The land was subject to a $20,000 mortgage, which Nora assumed. Nora's adjusted basis in her Maple stock was $40,000.

What amount of gain must Nora recognize on the liquidation?

  1. $120,000 (correct answer)
  2. $130,000
  3. $140,000
  4. $160,000
Explanation: Choice A is correct. Under IRC § 331(a), a distribution in complete liquidation is treated as payment in exchange for the shareholder's stock, not as a § 301 dividend. Nora's amount realized is $100,000 cash + $80,000 land fair market value − $20,000 mortgage assumed = $160,000. Her gain is $160,000 − $40,000 stock basis = $120,000. Maple's 400,000earningsandprofitsdonotmakeanypartoftheliquidatingdistributionadividend.ChoiceB(400,000 earnings and profits do not make any part of the liquidating distribution a dividend. Choice B (130,000) uses Maple's $30,000 basis in the land instead of Nora's 40,000basisinherstock.ChoiceC(40,000 basis in her stock. Choice C (140,000) ignores the mortgage when computing amount realized, giving 180,000,andthensubtractsthestockbasis.ChoiceD(180,000, and then subtracts the stock basis. Choice D (160,000) computes the amount realized correctly but fails to subtract Nora's stock basis.

Question 7

On March 3, 2025, Dana and Elena formed Juniper Corporation, a C corporation. Dana transferred equipment with a fair market value of $200,000 and an adjusted basis to her of $90,000. The equipment was subject to a $130,000 mortgage, which Juniper assumed in the exchange. Dana received Juniper stock worth $70,000. Elena transferred $100,000 cash in exchange for Juniper stock worth $100,000. No other stock was issued, and the mortgage assumption was not part of a plan to avoid federal income tax.

What amount of gain must Dana recognize on the transfer?

  1. $0
  2. $40,000 (correct answer)
  3. $70,000
  4. $110,000
Explanation: Choice B is correct. Because Dana and Elena together own all of Juniper immediately after the exchange, the transfer satisfies the control requirement of IRC § 351. Under IRC § 357(a), a liability assumed by the corporation is generally not boot, but IRC § 357(c) requires the transferor to recognize gain to the extent the assumed liabilities exceed her adjusted basis in the transferred property. Here the excess is $130,000 − $90,000 = $40,000, and Dana's realized gain is larger than that, so Dana recognizes 40,000.ChoiceA(40,000. Choice A (0) incorrectly treats the excess liability as fully nonrecognized. Choice C (70,000)isthevalueofthestockDanareceived,notherrecognizedgain.ChoiceD(70,000) is the value of the stock Dana received, not her recognized gain. Choice D (110,000) is Dana's realized gain computed before applying the § 357(c) limit.

Question 8

Vera is the sole shareholder of Quill Corporation. In 2025, Quill adopts a plan of complete liquidation and, in complete cancellation of all of Vera's stock, distributes a commercial building to her. The building has an adjusted basis of $40,000 to Quill and a fair market value of $130,000 on the date of distribution. Vera's basis in her Quill stock is $25,000, and she has held the stock for more than one year.

Which of the following correctly describes the federal income tax consequences of the distribution?

  1. Quill recognizes no gain; Vera has a $105,000 long-term capital gain and a $130,000 basis in the building.
  2. Quill recognizes a $90,000 gain; Vera has a $105,000 long-term capital gain and a $130,000 basis in the building. (correct answer)
  3. Quill recognizes a $90,000 gain; Vera has a $130,000 dividend and a $130,000 basis in the building.
  4. Quill recognizes a $90,000 gain; Vera has a $105,000 long-term capital gain and a $25,000 basis in the building.
Explanation: IRC §§ 331(a), 334(a), 336(a). In a complete liquidation, the corporation recognizes gain on property distributed to a shareholder as if the property had been sold at its fair market value: $130,000 - $40,000 = $90,000. The shareholder, by contrast, treats the distribution as payment in exchange for her stock under § 331(a) rather than as a dividend, so earnings and profits do not apply. Vera's amount realized is the building's $130,000 fair market value, and her gain is $130,000 - $25,000 = $105,000, which is long-term because she held the stock more than one year. Under § 334(a), her basis in the building is the $130,000 fair market value. Choice B is correct. Choice A omits the corporation's § 336(a) gain. Choice C applies the § 301 dividend rules to a complete liquidation, but § 331(a) requires exchange treatment for the shareholder. Choice D gives Vera a substituted basis equal to her $25,000 stock basis, but § 334(a) requires a fair-market-value basis.

Question 9

Petra is the sole shareholder of Nord Corporation, a calendar-year C corporation. On January 1, 2025, Nord had $90,000 of accumulated earnings and profits. Nord had a current-year loss for 2025 of $60,000, creating a $60,000 deficit in current earnings and profits. On June 30, 2025, Nord distributes $80,000 to Petra. Petra's basis in her Nord stock is $50,000.

How is the $80,000 distribution characterized for federal income tax purposes?

  1. The entire $80,000 is a dividend, and Petra's stock basis remains $50,000.
  2. $60,000 is a dividend, and the remaining $20,000 reduces Petra's stock basis to $30,000. (correct answer)
  3. $30,000 is a dividend, and the remaining $50,000 reduces Petra's stock basis to zero.
  4. $60,000 is a dividend, and the remaining $20,000 is a long-term capital gain.
Explanation: IRC § 316(a); Treas. Reg. § 1.316-2(b); IRC § 301(c). When current earnings and profits are a deficit, the deficit is prorated to the date of the distribution and reduces accumulated earnings and profits before the dividend test is applied. The deficit allocable to the period before June 30 is $60,000 × 6/12 = $30,000, leaving $90,000 - $30,000 = $60,000 of accumulated E&P available on the distribution date. The $80,000 distribution is therefore a dividend to the extent of $60,000, and the remaining $20,000 is a return of capital under § 301(c)(2), reducing Petra's basis from $50,000 to $30,000. Because the distribution does not exceed E&P plus stock basis, no gain results. Choice B is correct. Choice A ignores the current-year deficit and treats the accumulated E&P without adjustment. Choice C nets the entire year's $60,000 deficit against accumulated E&P instead of prorating the deficit to the date of the distribution. Choice D treats the excess over E&P as capital gain instead of applying the return-of-capital ordering rule of § 301(c)(2).

Question 10

In 2025, Dan transfers a building to Nimbus Corporation, a corporation he wholly owns, in exchange for all of Nimbus's stock. The building has an adjusted basis of $50,000 and a fair market value of $300,000 and is subject to a $180,000 mortgage, which Nimbus assumes.

What are Dan's recognized gain and his basis in the Nimbus stock?

  1. $130,000 recognized gain; $0 basis in the stock. (correct answer)
  2. $180,000 recognized gain; $50,000 basis in the stock.
  3. $0 recognized gain; $50,000 basis in the stock.
  4. $130,000 recognized gain; $180,000 basis in the stock.
Explanation: IRC §§ 357(a), 357(c), 358(d). Dan's transfer qualifies for nonrecognition under § 351 because he owns all of Nimbus's stock after the exchange. Under § 357(a), the corporation's assumption of his mortgage is generally not treated as boot. However, § 357(c) provides that when the liabilities assumed exceed the total adjusted basis of the property transferred, the excess is recognized gain: $180,000 - $50,000 = $130,000. Section 358(d) then requires Dan's stock basis to be reduced by the liability relief, even though the liability was not currently taxable: $50,000 + $130,000 - $180,000 = $0. Choice A is correct. Choice B treats the $180,000 mortgage as taxable boot; § 357(a) provides that liability relief is not boot in a qualifying § 351 exchange, so the recognized gain is only the § 357(c) excess of $130,000. Choice C applies the general § 357(a) rule but ignores the § 357(c) exception, which is triggered because $180,000 exceeds Dan's $50,000 basis. Choice D computes the gain correctly but omits the § 358(d) reduction of basis by the mortgage.

Question 11

P and P's adult child C each own 50 of the 100 outstanding shares of X Corporation. In 2025, X redeems all of P's shares for $100,000 cash. X's earnings and profits are more than sufficient to cover the distribution. P does not waive family attribution.

Which of the following correctly describes P's treatment of the $100,000 distribution?

  1. P recognizes a $100,000 long-term capital gain because all of P's shares were actually redeemed.
  2. P has a nontaxable return of capital to the extent of P's basis in the redeemed shares, with the excess taxed as capital gain because the redemption completely terminates P's direct interest.
  3. P recognizes a $100,000 taxable dividend because C's shares are attributed to P and P is treated as owning all of X after the redemption. (correct answer)
  4. P recognizes a $50,000 taxable dividend and a $50,000 return of capital because P is treated as owning half of X after the redemption.
Explanation: Choice C is correct. Under IRC §302(d), a redemption that fails every §302(b) sale-or-exchange test is treated as a distribution under §301. Under IRC §318(a)(1), an individual is treated as owning stock owned by his or her children, so P is considered to own C's 50 shares. Immediately after the redemption, P is treated as owning 100% of the only outstanding stock, so the complete-termination exception of §302(b)(3) is not met without the waiver described in §302(c)(2). With ample E&P, the $100,000 is a dividend. Choice A ignores the family attribution rules. Choice B assumes sale treatment despite the absence of a waiver. Choice D misstates the attributed ownership and incorrectly gives return-of-capital treatment to a dividend-equivalent redemption.

Question 12

Which of the following is correct under IRC §351?

  1. If a transferor receives cash as well as stock in an otherwise qualifying exchange, the entire realized gain is recognized because the exchange is no longer solely for stock.
  2. The nonrecognition rule is available only if all transferors are individuals; a corporate transferor must recognize gain on the exchange.
  3. The transferors must own at least 80% of the total fair market value of all classes of stock immediately after the exchange for the nonrecognition rule to apply.
  4. Stock issued for services is not considered issued in exchange for property, so a service provider who receives only stock for services is not counted as a property transferor in applying §351. (correct answer)
Explanation: Choice D is correct. Under IRC §351(d)(1), stock issued for services is not considered issued in exchange for property, so a person who receives only stock for services has not transferred property for §351 purposes. Choice A misstates §351(b): receipt of boot does not destroy the exchange, and gain is recognized only up to the amount of boot received, not the full realized gain. Choice B is wrong because the term person includes corporations, and a corporation can qualify as a transferor under §351. Choice C misstates the control requirement under IRC §368(c): control is measured by voting power of voting stock and the number of shares of nonvoting stock, not by fair market value.

Question 13

In 2025, A, an individual, transfers a single asset with an adjusted basis of $40,000 and a fair market value of $100,000 to a newly formed corporation solely in exchange for all of its stock. The corporation assumes a $60,000 liability of A in connection with the transfer. A receives no other property or money.

Which of the following correctly describes the Federal income tax consequences of A's transfer?

  1. A recognizes a $20,000 gain, A's basis in the stock is $0, and the corporation's basis in the asset is $60,000. (correct answer)
  2. A recognizes a $60,000 gain, A's basis in the stock is $40,000, and the corporation's basis in the asset is $100,000.
  3. A recognizes no gain, A's basis in the stock is $40,000, and the corporation's basis in the asset is $40,000.
  4. A recognizes a $20,000 gain, A's basis in the stock is $20,000, and the corporation's basis in the asset is $80,000.
Explanation: Choice A is correct. Under IRC §357(c), when liabilities assumed in a §351 exchange exceed the adjusted basis of the transferred property, the excess is treated as gain: $60,000 − $40,000 = $20,000. Under IRC §358(a), A's stock basis is the $40,000 basis, reduced by the $60,000 liability treated as money received, and increased by the $20,000 recognized gain, resulting in a $0 basis. Under IRC §362(a), the corporation's basis is A's $40,000 basis plus the $20,000 recognized gain, or $60,000. Choice B treats the entire liability as boot and uses fair market value as the corporation's basis. Choice C ignores §357(c) and treats the exchange as wholly tax free despite the excess liability. Choice D gets the gain amount right but misapplies the stock and corporate basis rules.

Question 14

In 2025, C, a calendar-year C corporation, distributes land to S, its sole shareholder. The land has a $70,000 adjusted basis and a $120,000 fair market value and is subject to a $30,000 mortgage, which S assumes. C's earnings and profits are more than sufficient to make the entire distribution a dividend.

Which of the following correctly describes the tax consequences of the distribution?

  1. S has dividend income of $120,000 and takes a $120,000 basis in the land; C recognizes a $50,000 gain.
  2. S has dividend income of $90,000 and takes a $120,000 basis in the land; C recognizes a $50,000 gain. (correct answer)
  3. S has dividend income of $90,000 and takes a $90,000 basis in the land; C recognizes a $50,000 gain.
  4. S has dividend income of $90,000 and takes a $120,000 basis in the land; C recognizes no gain.
Explanation: Choice B is correct. Under IRC §301(b), the amount of a property distribution is the fair market value reduced by liabilities assumed or taken subject to, so S's distribution amount is $120,000 − $30,000 = $90,000. Because E&P is ample, the entire $90,000 is a dividend. Under IRC §301(d), S's basis in the distributed land is its $120,000 fair market value. Under IRC §311(b), C recognizes gain as if the land had been sold at fair market value: $120,000 − $70,000 = $50,000. Choice A ignores the liability in measuring S's dividend. Choice C incorrectly reduces S's basis by the liability; the liability reduces the amount of the distribution, not the property basis. Choice D incorrectly ignores C's §311(b) gain.

Question 15

Z, a calendar-year C corporation, had an accumulated earnings and profits deficit of $10,000 at the beginning of 2025. During 2025, Z had current earnings and profits of $25,000. On December 15, 2025, Z distributed $40,000 in cash to S, its sole shareholder. S's basis in Z stock was $5,000 immediately before the distribution.

Which of the following correctly describes the treatment of the $40,000 distribution to S?

  1. S has a $15,000 dividend, a $5,000 return of capital, and a $20,000 capital gain.
  2. S has a $25,000 dividend, a $5,000 return of capital, and a $10,000 capital gain. (correct answer)
  3. S has a $40,000 dividend because Z had current earnings and profits for the year.
  4. S has a $25,000 dividend and a $15,000 capital gain.
Explanation: IRC §§ 316(a)(2) and 301(c)(1)-(3). A distribution is a dividend to the extent of current earnings and profits for the year, computed without reduction for distributions made during the year, even when accumulated earnings and profits show a deficit. Z's $25,000 of current E&P makes $25,000 of the distribution a dividend. The remaining $40,000 − $25,000 = $15,000 is applied under IRC § 301(c)(2) as a return of capital against S's $5,000 stock basis, reducing it to zero, and the last $15,000 − $5,000 = $10,000 is gain from the sale or exchange of the stock under IRC § 301(c)(3). Choice B is correct. Choice A is wrong because it nets the 10,000 accumulated deficit against current E&P (25,000 − $10,000 = $15,000); the accumulated deficit does not reduce current E&P. Choice C is wrong because only the distribution up to current E&P of $25,000 is a dividend; having current E&P does not make the whole $40,000 a dividend. Choice D is wrong because it skips the return-of-capital step and treats the full $15,000 excess as gain, ignoring S's $5,000 basis.