Question

Larry, the sole shareholder of Brown Corporation, sold his Brown stock to Ed on July 30 for $270,000. Larry’s basis in the stock was $200,000 at the beginning of the year. Brown had accumulated E & P of $120,000 on January 1 and has current E & P of $240,000. During the year, Brown made the following distributions: $450,000 of cash to Larry on July 1 and $150,000 of cash to Ed on December 30. How will Larry and Ed be taxed on the distributions? How much gain will Larry recognize on the sale of his stock to Ed?

Answer 1

Capital Gain arises when any asset like shares of stock, a piece of land, a business etc. are transferred to another person. When the sale price is more than the cost price of the assets, the profit from the sale of the asset is known as the capital gain.

Larry, the sole shareholder of Brown Corporation, sold his Brown stock to Ed on July 30 for $270,000. Larry’s basis in the stock at the beginning of the year was $200,000.

Total Distributions = $450,000 + $150,000 = $600,000

Brown Corporation made the following distributions: $450,000 of cash to Larry on July 1 and $150,000 of cash to Ed on December 30.

Brown Corporation's current E & P = $240,000

Formula for Current E & P allocation = (Current E & P x Distribution) / Total Distributions

1. Current E & P allocated to Larry = ($240,000 x $450,000) / $600,000 = $180,000

2. Current E & P allocated to Ed = ($240,000 x $150,000) / $600,000 = $60,000

Brown Corporation on distribution of $450,000 to Larry on July 1, the dividend-paying capacity will be = Accumulated E & P + current E & P = $120,000 + $180,000 = $300,000. Therefore, $300,000 of Larry's distribution will be treated as Dividend Income and the remaining recovery of capital which is $150,000 ($450,000 - $300,000) will reduce Larry's stock basis = stock at the beginning of the year - recovery of capital = $200,000 - $150,000 = $50,000

Brown Corporation on distribution of $150,000 to Ed on December 30, $60,000 of Ed's distribution will be treated as Dividend Income. The remaining recovery of capital of $90,000 ($150,000 - $60,000) will reduce Ed's stock basis = sales price - stock basis = ($270,000 - $90,000) = $180,000

On the sale of Brown stock for $270,000 to Ed, Larry recognizes that there is a Capital Gain.

Capital Gain = Sale price - Stock basis = $270,000 - $50,000 = $220,000