Key Takeaways:

  • Capital Gains in S Corporations: Shareholder distributions exceeding stock basis are taxed as capital gains. Non-dividend distributions below the stock basis are tax-free.
  • Income Characterization: Income types (e.g., long-term gains) retain their nature when passing through to shareholders' personal tax returns.
  • Shareholder Basis Calculations: Shareholders must calculate and track stock and loan basis annually to determine tax liabilities accurately.
  • Sale of S Corporation Stock: The capital gains tax liability on stock sales depends on the shareholder’s stock basis and allocation of the sale price.
  • Goodwill and Asset Sales: Goodwill and certain asset sales may have distinct tax treatments, offering opportunities for tax optimization.

S corp capital gains refer to increases in the value of an S corporation's capital assets, such as stocks, bonds, or properties. An S corp is an entity that allows its earnings, deductions, and credits to pass through to its shareholders to be taxed at an individual level. When a non-dividend distribution is given to a shareholder, it is tax-free as long as it does not exceed his or her stock basis. If it exceeds the stock basis, the excess amount will be regarded as a capital gain.

S Corp Income and Expense Accounting

S corp accounting is somewhat similar to C corp accounting. An S corporation's earnings and expenses are reported at the company level. They will keep their character as they pass through to the personal income tax returns of the shareholders. For instance, long-term capital gains will remain long-term capital gains after they reach the individual level. In order to help its shareholders report their taxes correctly, an S corporation must be able to identify different types of incomes and expenses.

Differentiating Ordinary Income and Capital Gains

For S corporations, distinguishing between ordinary income and capital gains is crucial for proper tax reporting. Ordinary income typically includes revenue generated from the corporation’s primary business activities. In contrast, capital gains arise from the sale of long-term assets like property or stock. Misclassification can lead to errors in shareholder tax filings. Proper record-keeping and consultation with tax professionals are recommended to avoid compliance issues.

S Corp Accounting for Shareholder Capital

One of the main problems that an S corporation faces is accounting for each shareholder's capital account. It must maintain detailed and accurate records of its shareholders' equity investments of property and cash and the loans they advance to the company. Shareholders of an S corp are required to divide the company's net income in exact proportion to their ownership shares. For instance, if a shareholder's investment makes up one-third of the S corporation's capital, he or she will receive exactly one-third of the corporation's net profit or loss.

The capital accounts play a significant role in two crucial aspects of an S corp's financial and tax reporting. First, they are reported as shareholder equity or loans from shareholders on the balance sheets. Second, the capital account of each shareholder may be summarized on IRS Form 1120S Schedule K-1. If there is a lack of capital investments, shareholders may fail to comply with the At-Risk rules for S corp losses, and losses may then become non-deductible.

Tax Implications of Shareholder Distributions

Distributions to shareholders can significantly affect their tax obligations. Non-dividend distributions are generally tax-free until they exceed the shareholder's stock basis. If a distribution surpasses the stock basis, the excess amount is treated as a capital gain and taxed accordingly. Shareholders must accurately track their stock basis to determine how distributions will be taxed and avoid potential penalties.

Investing Cash and Property

Shareholders can invest property or cash in their S corporation. They may also contribute the following items in addition to their investments:

  • Furniture
  • Computers
  • Software programs
  • Reference books
  • Other items

The value of a shareholder's property is the lower of either the property's fair market value or the adjusted basis in the property.

Impact of Goodwill on S Corp Sales

When an S corporation is sold, goodwill often plays a critical role in determining the tax implications. Goodwill refers to the value attributed to the business's reputation, customer relationships, and brand. It is classified as an intangible asset, and its sale can result in capital gains for shareholders. Allocating a portion of the sale price to goodwill may provide tax benefits, as it is often taxed at a lower rate than ordinary income.

What Is Shareholder's Basis?

According to the IRS, stock basis is the sum of a shareholder's capital investment. Typically, it is the amount a shareholder paid in cash, property, services, or debt obligations. The stock basis can fluctuate yearly dollar-for-dollar based on the allocation of undrawn profits.

The capital account of a shareholder must reflect his or her investments and basis in the company's equity and liabilities for the current year. A shareholder is invested in an S corp to the extent that he or she has contributed equity or offered a loan to the company. The value of the property and the amount of cash investments donated to the corporation will be shown in the capital account.

Adjusting Basis for Losses and Deductions

A shareholder’s basis is not static and must be adjusted annually. Additions to basis include allocated income and additional equity contributions. Conversely, basis is reduced by distributions, losses, and deductions. Shareholders can only claim losses up to the extent of their stock and loan basis. Losses exceeding the basis cannot be deducted but may be carried forward to offset future gains or income.

What Is Adjusted Basis?

The capital account is occasionally adjusted to show additional equity investments. Also, it undergoes adjustment at the end of the year to show the pro-rata income and expense share of each shareholder.

What Is Loan Basis?

A shareholder can advance loans to an S corporation. For instance, a shareholder can use his or her personal credit card to pay for company expenses and then submit an expense report for repayment. A loan to an S corp can be a short-term loan that has to be repaid in a year or less or a long-term loan that can be repaid in more than a year. A shareholder who makes a loan to an S corporation is eligible for a tax deduction for losses that exceed his or her stock basis.

Capital Gains Tax on Stock Sale

The stock basis of an S corp shareholder determines the capital gains tax on stock sale. In a straight stock sale, the capital gains tax liability is equal to each shareholder's allocation of the company's purchase price minus his or her current stock basis and the sale's transaction costs. Since a shareholder's stock basis can fluctuate frequently, he or she should hire financial consultants to recalculate the basis yearly to prevent errors.

Strategies to Minimize Tax Liability


When selling S corporation stock, shareholders can adopt several strategies to minimize their tax liability:

  • Installment Sales: Spreading payments over multiple years allows shareholders to recognize gains gradually, potentially keeping them in lower tax brackets.
  • Section 338(h)(10) Elections: This election enables the sale of stock to be treated as an asset sale for tax purposes, allowing shareholders to benefit from capital gains rates on certain portions.
  • Consulting with Tax Advisors: A tailored strategy based on the shareholder’s financial situation and tax bracket is essential to optimizing tax outcomes.

FAQ Section

1. What are S corp capital gains?
S corp capital gains are profits from selling the corporation's capital assets, such as property or stock, taxed at the individual level for shareholders.

2. How is the stock basis in an S corporation calculated?
Stock basis starts with the shareholder’s investment in the corporation and adjusts annually for income, losses, distributions, and additional contributions.

3. Are non-dividend distributions always tax-free?
Non-dividend distributions are tax-free up to the shareholder’s stock basis. Any amount exceeding this is treated as taxable capital gains.

4. What is goodwill in an S corporation sale?
Goodwill is the intangible value of the business, such as brand reputation and customer relationships, often taxed at favorable capital gains rates when sold.

5. How can I reduce my capital gains tax liability when selling S corp stock?
Using strategies like installment sales or making a Section 338(h)(10) election can help minimize tax burdens. Consult a tax advisor for personalized advice.

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