Chapter 8: Distributions to Business Owners
Questions and Problems for Discussion
1. Midland’s payments for life insurance premiums, meals, and entertainment reduce its financial
capacity to pay a return on invested capital. Therefore, these payments reduce Midland’s current
E&P.
2. Retained earnings is a financial accounting term that refers to a corporation’s undistributed aftertax book income. Accumulated E&P is a tax term that refers to a corporation’s undistributed E&P
for all taxable years. Because after-tax book income and E&P are measured differently, retained
earnings and accumulated E&P are different amounts.
3. Current E&P is computed only at the end of the taxable year without taking into account any
distributions made during the year. Thus, Noland’s $15,000 distribution had no effect on the
computation of current E&P for its first taxable year. The distribution did reduce Noland’s
accumulated E&P as it began its second taxable year.
4. If KPL distributes the devalued land to its shareholders, it cannot recognize a loss for the $83,000
excess of basis over FMV. Assuming that KPL has sufficient E&P, its shareholders will recognize
the $200,000 FMV of the land as a dividend and will take a $200,000 basis in the land. If KPL
sells the land to an unrelated party, it can recognize its $83,000 loss. The shareholders will
recognize the $200,000 distribution of the sales proceeds as a dividend.
5. A pro rata stock dividend would simply increase the number of shares outstanding. Each share
would represent a smaller equity interest in the corporation and would have less value. The
increased number of shares will give the shareholders more flexibility because they can transfer
ownership to the grandchildren in smaller incremental units.
6. The revenue agent will be more interested in the corporation’s balance sheet because it reveals
the extent to which the corporation used accumulated E&P to finance the purchase of operating
assets or nonbusiness investment assets. The presence of operating assets is evidence of the
corporation’s reasonable need to accumulate rather than distribute earnings.
7. Theoretically, the accumulated earnings tax is imposed on corporations used by shareholders for
a specific purpose: avoidance of shareholder-level tax on dividends. Thus, the shareholders must
control the corporation’s dividend-paying policy for this forbidden purpose to exist. As a general
rule, shareholders of publicly held corporations have no influence over corporate dividend-paying
policy, which does not take into account the desire of any particular shareholder to avoid paying
tax on dividend income.
8. A family might form a personal holding company to allow each family member to own an interest
in a diversified investment portfolio, to permit one or more family members with investment
expertise to manage the family wealth, or to concentrate the voting power of each family
member’s individual stock into a voting block.
9. Both the accumulated earnings tax rate and the personal holding company tax rate equal the 15
percent preferential individual rate on dividend income. Thus, the corporate penalty tax is as least
as much as the individual tax that shareholders would pay on dividends from the corporation.
10. The fact that a partnership never recognizes gain or loss on property distributions to partners
reflects the aggregate theory of partnerships. Under this theory, a partnership is nothing more
than a collection of partners, and a property distribution represents only a change in the form of
property ownership. In other words, the partners are merely moving the property from one
balance sheet (partnership balance sheet) to another (recipient partner’s balance sheet).
8-1
11. An S corporation’s AAA is a record of retained earnings on which the shareholders have paid
individual tax and which should not be taxed a second time. The purpose of the AAA is to
segregate undistributed S corporation earnings from undistributed C corporation earnings
(accumulated E&P), which should be taxed a second time (as a dividend) if distributed to the
shareholders. If an S corporation has no history as a C corporation, all its retained earnings are
undistributed S corporation earnings, and all distributions are nontaxable. Therefore, S
corporations with no C corporation history (and no accumulated E&P) do not have to maintain a
AAA.
Application Problems
2. a. Only $897,600 (amount paid out of current and accumulated E&P) of the $1 million
distribution was a dividend.
b. Magruder’s accumulated E&P on January 1 of the following year is zero.
Accumulated E&P on January 1
Current E&P
Dividend paid out of current E&P
Dividend paid out of accumulated E&P
Accumulated E&P
642,000
255,600
(255,600)
(642,000)
0
3. a. Only $90,000 (amount paid out of current E&P) of the $140,000 distribution was a dividend.
b. Sansoni’s accumulated E&P on January 1 of the following year is a $489,000 deficit.
Accumulated E&P on January 1
Current E&P
Dividend paid out of current E&P
Addition to accumulated E&P
Accumulated E&P
(489,000)
90,000
(90,000)
0
(489,000)
4. a. Mr. Vojas recognizes a $65,000 dividend (distribution paid out of current and accumulated
E&P). The $35,000 remainder of the distribution is a nontaxable return of capital.
b. Mr. Vojas’s stock basis on next January 1 is $37,000 ($72,000 initial basis  $35,000 return
of capital).
c.
Vantage’s accumulated E&P on January 1 of the next year is zero.
8. a. Herzig must recognize a $25,000 gain ($75,000 FMV  $50,000 basis) on the distribution of
the appreciated property to Mr. Morton. Here is the computation of Herzig’s current E&P and
accumulated E&P on next January 1.
Taxable income
Federal income tax ($525,000 taxable income  34%)
Current E&P
Accumulated E&P on January 1
Current E&P
346,500
Reduction for FMV of property distribution
(75,000)
Addition to accumulated E&P
Accumulated E&P on January 1 of the following year
525,000
(178,500)
346,500
369,100
271,500
640,600
b. Mr. Morton recognizes $75,000 dividend income (FMV of property distribution). His tax basis
in the property is $75,000.
8-2
c.
Herzig cannot recognize a loss on the distribution of devalued property to Mr. Morton. Here is
the computation of Herzig’s current E&P and accumulated E&P on next January 1.
Taxable income
Federal income tax ($500,000 taxable income  34%)
Current E&P
500,000
(170,000)
330,000
Accumulated E&P on January 1
Current E&P
330,000
Reduction for basis of property distribution
(90,000)
Addition to accumulated E&P
Accumulated E&P on January 1 of the following year
369,100
240,000
609,100
Mr. Morton recognizes $75,000 dividend income (FMV of property distribution). His tax basis
in the property is $75,000.
12. a. Energex is entitled to a minimum accumulated earnings credit of $131,000 ($250,000 
$119,000 accumulated E&P at beginning of year). Here is the computation of the
corporation’s accumulated earnings tax.
Taxable income
Federal income tax ($367,000 taxable income  34%)
Dividends paid during the year
Minimum accumulated earnings credit
Accumulated taxable income
367,000
(124,780)
(35,000)
(131,000)
76,220
.15
11,433
Accumulated earnings tax
b. Energex has no minimum accumulated earnings credit because its $588,200 accumulated
E&P at the beginning of the year exceeded $250,000. Here is the computation of the
corporation’s accumulated earnings tax.
Taxable income
Federal income tax ($367,000 taxable income  34%)
Dividends paid during the year
Minimum accumulated earnings credit
Accumulated taxable income
367,000
(124,780)
(35,000)
0
207,220
.15
31,083
Accumulated earnings tax
13. a. EastBay’s personal holding company income is only 55.16 percent of its ordinary gross
income ($5,185,000 dividends and interest/[$4,215,000 ordinary gross business income +
$5,185,000 dividends and interest]). Therefore, EastBay is not a personal holding company
this year.
b. If EastBay is a personal holding company, its personal holding company tax is $845,108.
Ordinary taxable income
Federal income tax ($5,590,000 taxable income  34%)
Dividends paid during the year
Undistributed personal holding company income
Personal holding company tax
5,590,000
(1,900,600)
(1,500,000)
2,189,400
.15
328,410
15. a. The cash distribution is a nontaxable return of Mr. Kidd’s investment.
Beginning outside basis
Distributive share: ordinary business income
tax-exempt interest income
Section 1231 loss
8-3
50,000
80,200
4,100
(7,600)
Cash distribution
Adjusted basis
(112,500)
14,200
b. Mr. Kidd must recognize the $18,200 cash distribution in excess of adjusted basis as capital
gain. For purposes of determining gain, basis is increased by his share of income items but
not decreased for his share of loss items.
Beginning outside basis
Distributive share: ordinary business income
tax-exempt interest income
Adjusted basis
Cash distribution not in excess of basis
Adjusted basis
c.
10,000
80,200
4,100
94,300
(94,300)
0
If Mr. Kidd’s beginning outside basis was $50,000, he can deduct his entire share of Section
1231 loss. If his beginning outside basis was only $10,000, he cannot deduct any of his share
of Section 1231 loss but can carry it forward to deduct in future years in which he restores
basis to his KLN interest.
16. a. Duran realizes a $13,000 book gain ($35,000 FMV  $22,000 book basis) but does not
recognize any taxable gain on the distribution.
b. Mr. Rehr does not recognize any taxable income on receipt of the distribution.
c.
Mr. Rehr’s tax basis in the distributed asset is a $22,000 carryover basis.
d. Here is the computation of Mr. Rehr’s capital account and outside basis.
Capital Account
Balance before distribution
Allocation of $13,000 book gain
Reduction for distribution
Balance after distribution
86,000
5,200
(35,000)
56,200
Outside Basis
93,200
NA
(22,000)
71,200
17. a. Duran realizes a $13,000 book gain ($35,000 FMV  $22,000 book basis) but does not
recognize any taxable gain on the distribution.
b. Mr. Rehr does not recognize any taxable income on receipt of the distribution.
c.
Mr. Rehr’s tax basis in the distributed asset is $15,000 (limited to the outside basis in his LLC
interest immediately before the distribution).
d. Here is the computation of Mr. Rehr’s capital account and outside basis.
Capital Account
Balance before distribution
Allocation of $13,000 book gain
Reduction for distribution
Balance after distribution
86,000
5,200
(35,000)
56,200
Outside Basis
15,000
NA
(15,000)
0
18. a. Mrs. Dunbar does not recognize any income on receipt of the cash distribution.
b. Here is the computation of Mrs. Dunbar’s basis in her Skylark stock on next January 1.
Beginning stock basis
Pro rata share:
ordinary business income
dividend income
capital gain
8-4
24,800
35,400
2,000
8,690
Cash distribution
Adjusted basis
c.
(55,000)
15,890
If Mrs. Dunbar’s stock basis was $6,000, she must recognize the $2,910 excess of the cash
distribution over adjusted basis as a capital gain and reduce the basis to zero.
Beginning stock basis
Pro rata share:
ordinary business income
dividend income
capital gain
Adjusted basis
Cash distribution not in excess of basis
Adjusted basis
6,000
35,400
2,000
8,690
52,090
(52,090)
0
20. a. The entire $25,000 distribution was a taxable dividend to Mishra’s shareholders.
b. Here is the computation of Mishra’s accumulated E&P and AAA on next January 1.
Accumulated E&P
Balance at beginning of year
Operating loss
Reduction for distribution
Balance on January of next year
161,000
NA
(25,000)
136,000
AAA
0
(11,000)
0
(11,000)
21. a. Because Mishra could make distributions from its positive AAA (as computed at the end of
the year) before making distributions from its accumulated E&P, only $7,000 of the
distribution was a taxable dividend to its shareholders.
b. Here is the computation of Mishra’s accumulated E&P and AAA on next January 1.
Accumulated E&P
Balance at beginning of year
Taxable income
Reduction for distribution
Balance on January of next year
136,000
NA
(7,000)
129,000
8-5
AAA
(11,000)
64,000
(53,000)
0