Nicolette must recognize a gain of $10,000 from the distribution, which consists of $10,000 of ordinary income from the E&P and a $10,000 reduction in her basis in her Bombay stock.
In this case, Bombay has an AAA balance of $15,000 and accumulated E&P of $20,000. Since the E&P balance must be used to reduce the distribution before the AAA balance, the first $20,000 of the distribution will be used to reduce the E&P balance to zero.
The remaining $10,000 of the distribution will be used to reduce the AAA balance to $5,000.
Nicolette's share of the distribution is $20,000, which consists of $10,000 of AAA and $10,000 of E&P.
Since the AAA balance represents the difference between the S corporation's tax basis in its assets and their fair market value, the $10,000 of AAA that Nicolette receives will be treated as a return of capital and will reduce her basis in her Bombay stock.
The $10,000 of E&P that Nicolette receives will be treated as a dividend and will be taxed as ordinary income.
Therefore, Nicolette must recognize a gain of $10,000 from the distribution, which consists of $10,000 of ordinary income from the E&P and a $10,000 reduction in her basis in her Bombay stock. The gain will be taxed at Nicolette's individual tax rate, which will depend on her total income and filing status.
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