Sam, Dean, Bobby and Cass are the shareholders of a C-corporation named Winchester 4'Ever, Inc. Throughout the current tax year (payment dates provided below), Winchester distributed $70,000 cash to its shareholders (25% to each shareholder):

February 1 - $15,000

May 31 - $15,000

November 30 - $20,000

December 31 - $20,000

The beginning stock basis for each shareholder was as follows:

Sam - $11,000

Dean - $3,000

Bobby - $35,000

Cass - $0

Assume Winchester distributed the $70,000 in a year when its current E&P was a negative ($50,000) and its accumulated E&P at the beginning of the year was a positive $50,000.

The company had historically rarely operated above the break-even level, as evidenced by the 0 balance in E&P at the end of the year the $70,000 was distributed, but Winchester's business really took off the first quarter of the subsequent year - in fact, within three months after year-end, Winchester's earnings and profits had soared to nearly $1,000,000. All four of Winchester's shareholders filed their individual tax returns on April 15 of the following year.

Which of the following is a correct statement?

1.- Corporations can only make dividend distributions to the extent of their positive E&P balance. Since Winchester's combined E&P balance is 0, the entire $70,000 distribution amount will result in a return-of-capitaland/orcapital gain for each shareholder.

2.- Corporations are not allowed to net E&P when determining the character of distributions; therefore, Winchester would characterize $50,000 as a dividend distribution, and the remaining $20,000 distribution amount would represent a return-of-capitaland/orcapital gain for each shareholder.

3.- Companies must not forget to consider the impact to E&P of subsequent events - to the extent the company's E&P balance is materially altered after year-end, and if the shareholders have not yet filed their individual tax returns, the company must revise the character of the prior year distributions. Since the company became aware in March that its cumulative E&P balance far exceeded the $70,000 distribution amount and the shareholders didn't file their individual tax returns until April, Winchester would need to retroactively report the full $70,000 distribution as dividend income, and the shareholders would update their individual tax returns accordingly prior to filing.

4.- Accumulated E&P is considered to be in existence on January 1, but current E&P is generally considered to be earned evenly throughout the year. Therefore, the combined E&P balance of 0 didn't technically happen until December 31, so a portion of the distributions made earlier in the year would actually be characterized dividend distributions. In contrast, if Winchester had waited until December 31 to distribute the full $70,000, the total amount distributed would represent a return-of-capitaland/orcapital gain for each shareholder since total E&P as of December 31 was 0.