Tax Implications of Distributions from Teal Corporation

How will the shareholder be taxed if Teal made a distribution of $50,000 to its sole shareholder?

A. Dividend income: $0
B. Return of capital: $50,000
C. Capital gain: $0

Answer:

The shareholder will not have any dividend income or capital gain. Instead, the $50,000 distribution will be treated as a return of capital.

The Earnings and Profits (E&P) of Teal Corporation at the beginning of the year was $210,000. However, during the year, Teal incurred a deficit in current E&P of $305,000, which includes the $200,000 loss on the sale of the asset. This means that the company's earnings were not sufficient to cover its losses, resulting in a deficit in E&P.

When a distribution is made to shareholders, it is generally treated as a dividend to the extent of the company's current and accumulated E&P. However, since Teal Corporation had a deficit in current E&P, there is no E&P available to support a dividend distribution. Therefore, the $50,000 distribution will be considered a return of capital, which is not taxable to the shareholder.

It's important to note that the shareholder's basis in her stock is $72,000. The distribution of $50,000 will reduce her basis to $22,000 ($72,000 - $50,000). This reduction in basis will have tax implications when the shareholder eventually sells her stock.