At the beginning of the current year, Penguin Corporation (a calendar year taxpayer) has accumulated E & P of $55,000. During the year, Penguin incurs a $36,000 loss from operations that accrues ratably. On October 1, Penguin distributes $40,000 in cash to Holly, its sole shareholder. How is Holly taxed on the distribution?

Of the $40,000 distribution, $ is taxed as a dividend and $ represents a return of capital.

Of the $40,000 distribution, $28,000 is taxed as a dividend and $12,000represents a return of capital.

Explanation:

we will first compute dividend income for Holly

Loss  from  operations in the year =$36,000

Loss accrued till October 1st, since it accrues ratably  

January - September= 9 months

36,000 x 9/12 = $27,000                                                

But E&P at start of the year = $55,000

Therefore, E&P at October 1st = $55,000- $27,000 = $28,000

The remaining balance. $28,000 after the losses accrued have been deducted will be treated as dividend income

From the statement, the total cash distributed to Holly is $40,000,

$28,000 as calculated from above Is taxed as a dividend and $12,000 ( $40,000- $28,000) represents a return of capital.

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