Question

At the beginning of year 1, Bill and Cindy form an S-corp and are equal shareholders, each gave $5,000 in exchange for stock. Cindy loaned the corp another $5,000 on June 30th of year. The corporation had an ordinary loss in its first year of $12,000 and ordinary income in its second year of $15,000. Assume that all parties use a calendar based taxable year and that neither the passive nor at-risk limitations are applicable. If the S-corporation also made a $12,000 distribution on Oct 30th of year 1 (split equally between the shareholders as generally required by the one-class of stock rule), then what are the tax impacts of the distribution?

                A.            Both will recognize a short-term capital gain of $1,000 on the distribution and each of their bases in the S-corporation’s stock is reduced to $0. Bill may not deduct any of the first year loss while Cindy may deduct $5,000 of it.

                B.            Bill recognizes a short-term capital gain of $1,000 on the distribution, his basis in stock is reduced to $0, and he cannot recognize any of the first year loss. Cindy recognizes no gain on the distribution, which reduces her basis in stock to $0 and her basis in debt to $4,000. She may then deduct $4,000 of the first year loss, which reduces her debt basis to $0.

                C.            Bill recognizes $5,000 of the first year loss, which reduces his basis to $0. He then recognizes a $6,000 short-term capital gain on the distribution. Cindy recognizes $6,000 of the first year loss, which reduces her stock basis to $0 and her debt basis to $4,000. She then recognizes a $2,000 capital gain on the distribution in excess of her debt basis.

                D.            Bill recognizes $5,000 of the first year loss, which reduces his basis to $0. He then recognizes a $6,000 short-term capital gain on the distribution. Cindyl recognizes $6,000 of the first year loss, which reduces her stock basis to $0 and her debt basis to $4,000. She then recognizes a $6,000 capital gain on the distribution, because debt basis cannot be reduced for distributions with respect to the stock of the S-corporation.

Answer 1

Answer is option C

Bill recognizes $5,000 of the first year loss, which reduces his basis to $0. He then recognizes a $6,000 short-term capital gain on the distribution. Cindy recognizes $6,000 of the first year loss, which reduces her stock basis to $0 and her debt basis to $4,000. She then recognizes a $2,000 capital gain on the distribution in excess of her debt basis.

Unlike with C corporation stock basis, which stays the same each year, annual income, distributions and loans can all affect an S corporation shareholder’s basis.