Question

If Karen's basis in her S Corporation stock is $30,000 and she receives a cash distribution of $40,000, she will report $_______ of ordinary income and $__________ of capital gain income from the distribution.

a. $0; $40,000
b. $10,000; $30,000
c. $30,000; $10,000
d. $40,000; $0

Answer 1

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.