At the beginning of the current year, Paul and John each own 50% of Apple Corpor

Question

At the beginning of the current year, Paul and John each own 50% of Apple Corporation. In July, Paul sold his stock to Sarah for $110,000. At the beginning of the year, Apple Corporation had accumulated E & P of $200,000 and its current E & P is $250,000 (prior to any distributions). Apple distributed $260,000 on March 1 ($130,000 to Paul and $130,000 to John) and distributed another $260,000 on October 1 ($130,000 to Sarah and $130,000 to John). What are the tax implications of the $130,000 distribution to Sarah?

Explanation / Answer

As current E & P is allocated on a pro rata basis to distributions made during the year, one-half, or $125,000 ($250,000 ´ $260,000/$520,000), is allocated to the March 1 distribution and one-half ($125,000) is allocated to the October 1 distribution.

The $200,000 of accumulated E & P is allocated chronologically. As a result, on March 1, Apple has $325,000 of dividend-paying capacity ($125,000 of current E & P and $200,000 of accumulated E & P). Therefore, the March 1 distribution is entirely treated as a dividend and Apple has $65,000 of accumulated E & P remaining after the distribution.

On October 1, Apple has $190,000 of dividend-paying capacity ($125,000 of current E & P and $65,000 of accumulated E & P). So of the $260,000 distribution, $190,000 is treated as a dividend and, as a 50% shareholder, Sarah’s share of this is $95,000.

Thus, of the $130,000 received by Sarah, $95,000 is a dividend distributed from E & P ($62,500 current E & P + $32,500 accumulated E & P), while the remaining $35,000 is a nontaxable recovery of capital. Consequently, her stock basis is reduced to $75,000 ($110,000 – $35,000).

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