Five years ago,Eleanor transferred property she had used in her sole proprietorship to Blue Corporation for 1,000 shares of Blue Corporation in a transaction that qualified under § 351.The assets had a tax basis to her of $300,000 and a fair market value of $450,000 on the date of the transfer.In the current year,Blue Corporation (E & P of $600,000)redeems 200 shares from Eleanor for $190,000 in a transaction that does not qualify for sale or exchange treatment.With respect to the redemption,Eleanor will have a:
A)$130,000 dividend.
B)$190,000 dividend.
C)$130,000 capital gain.
D)$190,000 capital gain.
E)None of the above.

Question

Quizplus · Accepted Answer

When Blue Corporation redeems 200 shares from Eleanor, she will receive $190,000 in exchange for those shares. Since the redemption does not qualify for sale or exchange treatment, it will be treated as a distribution made by the corporation to the shareholder.

According to the § 302 rules, the distribution will be classified either as a dividend or as a capital gain, depending on the portion of the distribution that is made from the corporation's earnings and profits (E&P) and the portion that is made from the shareholder's basis in the stock.

In this case, the distribution cannot be treated as a return of capital since Eleanor's basis in the 1,000 shares of Blue Corporation is only $150,000 (her original basis of $300,000 divided by the 1,000 shares). Therefore, the entire $190,000 distribution will be treated as a dividend to the extent of the corporation's E&P, which is $600,000.

As a result, Eleanor will have a $190,000 dividend from the redemption of her shares.

Five Years Ago,Eleanor Transferred Property She Had Used in Her