Updated October 15, 2020: 

S corp distributions in excess of basis are distributions that exceed the stock basis of shareholders in an S corporation. Unlike a C corporation, an S corp enables its shareholders to report corporate income taxes on their personal income tax returns. They are allowed to classify their earnings as distributions instead of salaries to reduce their tax burdens. However, if they overdo this, they may receive more scrutiny from the IRS.

Understanding the Taxability of S Corp Distributions

An S corporation generally escapes corporate income taxes. It passes items of income, credits, and deductions through to its shareholders, who will in turn pay taxes on them at an individual level. The way S corp distributions are made depends on the shareholders' basis in their stocks, as well as the company's earnings and profits, and accumulated adjustment account. A distribution from earnings and profits is regarded as a dividend. Under Section 1368, a distribution of property or cash in an S corporation may result in three possible tax outcomes for the recipient shareholder:

  • A taxable dividend.
  • A gain from selling the stock, which is usually a capital gain.
  • These options become non-mutually exclusive, whereby one distribution may lead to two or three different outcomes.

In order to determine the taxability of an S corp's distributions, it is essential to understand the interrelationship between stock basis, previously-taxed income, earnings and profits, and the accumulated adjustments account. Inability to do so can add unnecessary complication to the process and possibly result in an incorrect conclusion.

Rules for Taxes on S Corp Distributions

The regulations vary depending on whether an S corporation possesses accumulated earnings and profits. It is necessary to identify whether an S corporation has accumulated earnings and profits in the year of distribution when determining the taxability of its distributions. An S corp can only have earnings and profits if it was once a C corp or gained a C corp's assets in a transaction under Section 381.

Taxability of Distributions From an S Corp Without Accumulated Earnings and Profits

According to Section 1.1368-1(c), a two-tier approach has to be used to tax a distribution from an S corp without accumulated earnings and profits. Firstly, the distribution is regarded as a tax-free reduction in the stock basis of the shareholder. Secondly, a distribution that exceeds the stock basis of the shareholder will be regarded as gain from selling or exchanging the underlying stock. In an S corporation without accumulated earnings and profits, the accumulated adjustments account is totally irrelevant in the determination of the taxability of distributions. Instead, the stock basis of the shareholder is the only attribute of consequence.

Understanding Stock Basis in an S Corp

Basis refers to the amount that the owner of a property has invested in the property. At the beginning of the investment, it is the cost of the property. However, in an S corporation, basis can change as the investment of a shareholder changes. Annual earnings, loans, and distributions can all have an impact on the basis of an S corp shareholder.

It is important to correctly calculate the basis of a shareholder because it determines the amount that he or she can receive or withdraw from the S corp without realizing gain or income. Adjustments of basis should be done at the end of every taxable year. They should take into account earnings, distributions, deductions, and losses in the correct order.

Excess Distributions

The IRS specifically states that an S corporation must reasonably compensate a shareholder employee for the services that he or she provides for the company before non-wage distributions are made to him or her. S corp shareholders are required to take wages on the W-2 with proper withholding for taxes on Social Security and Medicare before taking distributions. The IRS has the right to reassign distributions as salaries, making them subject to employment taxes.

Shareholders of an S corporation need to know the consequences of taking excess distributions. Distributions that exceed the stock basis will be generally taxed as long-term capital gains on the personal tax returns of shareholders. Currently, the rate for long-term capital gains is 15 percent.

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