What are S corporation distributions?
Distributions from an S corporation occur when a corporation makes a payment of cash or property to its shareholders based on their stock ownership. Because S corporations serve as conduit (pass-through) entities, distributions from S corporations more closely resemble partnership distributions than C corporation distributions. C corporation distributions, of course, usually take the form of taxable dividends.
To determine the tax consequences of distributions from an S corporation, it is important to know first whether or not the S corporation has accumulated earnings and profit (AE&P). AE&P is important because a distribution from AE&P will result in a taxable dividend to a shareholder. An S corporation does not generate earnings and profit as such and will not have AE&P unless the company existed originally as a C corporation or acquired a C corporation. To simplify matters, this discussion will presume that there is no AE&P. If there is a possibility that your C corporation will make an S election, contact an accountant or tax attorney to learn more about AE&P.
How are these distributions taxed?
Taxed at shareholder level
A primary advantage of an S corporation is that income is generally taxed only once. This income is taxed at the shareholder level in the year the S corporation reports the income, but it is not taxed again when distributed. However, calculation of the amount that can be distributed without current tax consequences is somewhat complicated. It involves an analysis of the relationship between income, basis, and distributions. A distribution from an S corporation that does not have any AE&P generally will be a nontaxable return of the shareholder's basis in the corporate stock. Any distributions that exceed the basis in stock are considered taxable as a long-term or short-term capital gain from the sale or exchange of property.
Taxability determined by shareholder basis
The taxability of distributions to shareholders is determined by reference to each shareholder's stock basis. The shareholder is taxed on pass-through income whether or not the income is taken out of the business. This amount of income increases the shareholder's basis in the S corporation stock while distributions decrease basis.
Example(s): Assume Jack is the sole shareholder of Jack S Corporation. He has a basis of $20,000 in his stock at the time he forms the business. During the first year, the business generates net income of $40,000, and Jack takes no distributions. He pays income tax on the $40,000 of income, and his stock basis increases to $60,000 ($20,000 + $40,000). The following year, the company distributes the Year 1 income of $40,000. The distribution is a nontaxable return of capital and reduces Jack's stock basis back to $20,000.
How do distributions affect stock basis?
Basis computed at tax year-end
A shareholder's basis in the stock of the S corporation is computed at the close of the tax year in which the distributions are made. Basis is adjusted for distributions and pass-through items in the following order:
- Basis is increased by pass-through items of income and gain
- Basis is decreased by distributions
- Basis is decreased by pass-through items of loss and deduction
See list at end for additional items affecting basis.
Tip: It's important to note that basis cannot be reduced below zero. In effect, a distribution in excess of your basis will be taxed as a capital gain.
Example(s): Assume Jill owns all of the stock of Esscorporation. Jill begins the year with a stock basis of $5,000. She draws $8,000 of cash out of the corporation early in the year when cash flow is strong. Unfortunately, by year-end, Esscorporation has an ordinary business loss of $4,000. Of her $8,000 distribution, $3,000 is taxable to her as a capital gain.
The taxability is determined as follows:
Basis at beginning of year = $5,000
Income and gain items less distributions (cannot reduce basis below zero) = ($5,000)
Pass-through loss of $4,000 (limited to stock basis).
Ending stock basis = $0
Taxation of Distribution:
Nontaxable to extent of basis = $5,000
Remaining amount is capital gain = $3,000
Total = $8,000
Jill's unused loss of $4,000, which is limited by her lack of basis, can be carried forward to future years until Jill has sufficient basis to utilize the loss.
What about property distributions?
When property other than cash is distributed to a shareholder, the shareholder uses the fair market value of the property as the amount distributed. Distributions up to the shareholder's basis are nontaxable returns of basis. Distributions in excess of basis are taxable as capital gains.
If the property is appreciated property, the S corporation is considered to have sold the property to the shareholder at fair market value, received cash as consideration, and then distributed the cash to the shareholder.
Common items affecting stock basis of S corporation shareholders
Basis is increased by:
- Separately and nonseparately stated items of income
- Tax-exempt income
- Capital contributions and stock purchases
- Depletion in excess of the basis in the property
Basis is decreased by:
- Separately and nonseparately stated items of loss or deduction
- Deductions relating to tax-exempt income
- Corporate expenses that are not deductible
- Income in respect of a decedent
- Distributions that were not included in the shareholder's income
- Depletion (to the extent it does not exceed basis in the property)
For additional details about the aforementioned items and their effect on stock basis, contact an accountant or tax attorney.