Question

Joe owns 75% and Ethan owns 25% of JH Corporation, a calendar year taxpayer. JH makes a $600,000 distribution to Joe on April 1 and a $200,000 distribution to Ethan on May 1. JH’s current E & P is $120,000, and its accumulated E & P is $500,000. What are the tax implications of the distributions to Joe and Ethan?

A. Both Joe and Ethan will face tax liabilities on their distributions as the total distributions exceed the accumulated E & P.
B. Joe will face tax liabilities, but Ethan will not because the distribution is less than the accumulated E & P.
C. Both Joe and Ethan will not face tax liabilities as their distributions are less than the current E & P.
D. Neither Joe nor Ethan will face tax liabilities as the total distributions are less than the current E & P

Answer 1

Both Joe and Ethan will face tax liabilities on their distributions as the total distributions ($800,000) exceed the current E & P ($120,000) but are less than the accumulated E & P ($500,000), resulting in both distributions being fully treated as taxable dividends.

Step-by-step explanation:

The tax implications of the distributions to Joe and Ethan from JH Corporation depend on how the distributions compare to the company's current and accumulated Earnings and profits (E & P). Joe received a $600,000 distribution and Ethan received a $200,000 distribution. The total distribution of $800,000 exceeds the current E & P of $120,000 but is less than the accumulated E & P of $500,000. Distributions are treated as dividends to the extent of the current E & P first, then the accumulated E & P.

Because Joe's distribution alone exceeds the current E & P, part of his distribution will be treated as a dividend and thus subject to tax. Any distribution above would draw from the accumulated E & P until it is depleted. Accordingly, Ethan's entire distribution is covered by the remaining portion of the accumulated E & P after Joe's distribution is accounted for and therefore is also considered a dividend and subject to tax. Consequently, both distributions are treated as taxable dividends and not a return of capital or capital gain to Joe and Ethan.

The correct answer to the question is: Both Joe and Ethan will face tax liabilities on their distributions as the total distributions exceed the current E & P but not the accumulated E & P.