Final answer:
Karen will report $0 of ordinary income and $10,000 of capital gain income. The distribution up to her basis of $30,000 is tax-free, and the remaining $10,000 is a capital gain, as it exceeds her basis.
Step-by-step explanation:
If Karen's basis in her S Corporation stock is $30,000 and she receives a cash distribution of $40,000, she will report $0 of ordinary income and $10,000 of capital gain income from the distribution.
The reason for this is that distributions from an S Corporation to a shareholder are generally treated as a return of capital up to the shareholder's basis in the corporation's stock and not as ordinary income.
Since Karen's basis is $30,000, this portion of the distribution is a tax-free return of her investment. Only the amount that exceeds her basis, which is $10,000 ($40,000 distribution minus $30,000 basis), is taxable.
This taxable portion is treated as a capital gain, which represents the increase in value of the investment between the time it was acquired and when it was distributed. Therefore, the correct answer is b. $0 of ordinary income and $10,000 of capital gain income.