Question

Gopher, Inc. has $40,000 of current E&P and $10,000 of accumulated E&P at the start of the year. The sole shareholder, Carl has a basis in his stock of $20,000. If Gopher distributes $100,000 to Carl, it will be treated as a ______.

Answer 1

The $100,000 distribution from Gopher, Inc. to shareholder Carl will be considered a dividend for the first $50,000, a return of capital for the next $20,000 reducing his basis to zero, and a capital gain for the remaining $30,000.

Step-by-step explanation:

If Gopher, Inc. distributes $100,000 to Carl, it will first be treated as a dividend to the extent of the current and accumulated E&P (Earnings and Profits), and thereafter, any excess will be seen as a return of capital, and ultimately, as a capital gain.

With $40,000 of current E&P and $10,000 of accumulated E&P, the first $50,000 of the $100,000 distribution will be classified as a dividend.

The remaining $50,000 will reduce Carl's basis in his stock down from $20,000 to zero, with the remaining $30,000 being treated as a capital gain assuming there are no other adjustments.

When a firm pays out dividends, it provides a rate of return directly to its shareholders. However, investors also earn from any increase in the value of their stock, classified as capital gains. This scenario exemplifies the financial implications of stock ownership and the role of E&P in determining the nature of distributions from corporations to shareholders.