Question

Sparrow Corporation is a calendar year taxpayer. At the beginning of the current year, Sparrow has accumulated E & P of $33,000. The corporation incurs a deficit in current E & P of $46,000 that accrues ratably throughout the year. On June 30, Sparrow distributes $20,000 to its sole shareholder, Libby. If Libby's stock has a basis of $4,000, how is she taxed on the distribution?

Answer 1

Answer: The Dividend income is $10,000 whereas tax free recovery of basis is $4,000, and capital gain is $6,000.

Explanation: The accumulated and current E & P must be totaled because one half of the loss is incurred in June 30 ($46,000/2 = $23,000). So now you would reduce the accumulated E & P $33,000 with $23,000 which equals to $10,000. This is the balance in E & P which is the dividend income that would be distributed.

The other $10,000 of the distribution is first recovery of the capital which is $4000 and then a $6,000 capital gain.