Aaron and Michele, equal shareholders in Cavalier Corporation, receive $25,000 each in distributions on December 31 of the current year. During the current year, Cavalier sold an appreciated asset for $60,000 (basis of $15,000). Payment for the sale of the asset will be made as follows: 50% next year and 50% in the following year, with interest payable at a rate of 6 percent. Before considering
the effect of the asset sale, Cavalier's current year E & P is $40,000 and it has no accumulated E & P. How much of Aaron's distribution will be taxed as a dividend?
a. $0
b. $20,000
c. $25,000
d. $42,500
e. None of the above
c
RATIONALE: Accounting methods used for determining E & P are generally more conservative than those allowed for calculating income tax. As a consequence, the installment method is not permitted for E & P purposes. Thus, an adjustment is required for the deferred gain from property sales made during the year. All principal payments are treated as having been received in the year of the sale. Cavalier's E & P of $40,000 in the current year is thereby increased by the $45,000 of gain on the sale. Since Cavalier now has $85,000 of E & P ($40,000 of current E & P plus $45,000 of deferred gain), Aaron's entire distribution of $25,000 is a dividend.
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