Understanding S Corp Distributions in Excess of Basis

Key Takeaways

• Distributions in excess of basis result in taxable capital gains to S corporation shareholders.
• Stock basis is critical for determining the tax treatment of S corp distributions.
• Distributions are first applied against stock basis and only taxed once that basis is exhausted.
• Former C corporations or those with C corp assets may have accumulated earnings and profits, changing how distributions are taxed.
• Shareholder loans and repayments must be properly documented and understood in relation to basis.
• The order and classification of basis adjustments impact the timing and amount of gain recognition.
• Recourse vs. nonrecourse debt does not increase basis in an S corp, unlike partnerships.

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.

Impact of Corporate-Level Attributes on Distribution Taxability

An S corporation’s history and structure significantly influence the taxability of its distributions. If the S corp has never been a C corporation and has not acquired C corp assets in a tax-free transfer, it typically will not have accumulated earnings and profits (E&P). Without E&P, most distributions are non-taxable up to the shareholder's basis and only become taxable once that basis is exhausted.

However, if the S corp has accumulated E&P, distributions follow a three-tier structure under IRC §1368(c), being:

1. A tax-free return of basis (to the extent of stock basis),
2. A taxable dividend (to the extent of E&P), and
3. Capital gain (for any distribution in excess of both basis and E&P).

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.

When Earnings and Profits Come Into Play

The presence of accumulated earnings and profits (E&P) creates an added layer of complexity. Distributions must first be applied to the shareholder's stock basis, and then to the E&P balance before any excess is treated as a capital gain.

To manage this properly, S corps should track:

• The accumulated adjustments account (AAA),
• Accumulated earnings and profits (from any prior C corp years), and
• Each shareholder's stock basis annually.

If distributions are made in a year where the S corp has both AAA and E&P, and distributions exceed AAA, they are treated as dividends to the extent of E&P—even if the shareholder has basis.

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.

How Basis Is Adjusted and Ordered Annually

Annual basis adjustments follow a specific order that affects the amount of tax-free distributions a shareholder can receive. Basis is adjusted as follows:

1. Increased by:
   • Income items (including tax-exempt income),
   • Separately stated income,
   • Nonseparately stated income.
2. Decreased (but not below zero) by:
   • Nondeductible expenses,
   • Non-capital losses,
   • Distributions of cash or property,
   • Separately stated losses and deductions.

This order ensures that income items increase basis before losses or distributions reduce it, impacting whether a distribution becomes taxable.

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.

Tax Implications of Distributions in Excess of Basis

Distributions in excess of basis are not subject to self-employment or payroll taxes but are reported as capital gains. They are generally considered long-term capital gains if the shareholder has held the stock for more than one year.

Tax planning is essential because:

• Overlooking basis limitations can trigger unexpected tax liabilities.
• Improperly documented distributions might be reclassified as dividends or wages.
• Timing distributions after confirming adequate basis can help avoid taxable gain.

If distributions are incorrectly treated (for example, when basis has already been reduced), the IRS may recharacterize the income, potentially subjecting it to penalties and interest.

The Role of Shareholder Loans in Basis Calculation

Unlike partnerships, shareholder loans to an S corporation do not increase stock basis but instead create a separate debt basis. Distributions cannot reduce loan basis, only stock basis. However, losses may be deducted to the extent of the shareholder’s combined stock and loan basis.

Importantly, repayments of shareholder loans do not create gain, but if a loan is repaid after losses have been deducted against it, the shareholder must restore that basis before claiming new losses.

Frequently Asked Questions

1. What happens if an S corp distribution exceeds my basis?
   You’ll recognize a capital gain on the excess amount, generally taxed as long-term capital gain if you held the stock for over one year.
2. Can shareholder loans increase my basis in an S corp?
   Only debt basis is created from loans, not stock basis. Losses can be deducted against debt basis, but distributions cannot reduce it.
3. Do distributions from an S corp count as income?
   Not always. They are tax-free to the extent of stock basis. Only distributions in excess of basis or from accumulated earnings and profits are taxable.
4. How can I avoid excess distributions?
   Keep accurate annual records of your stock basis, understand the corporation’s E&P, and consult a tax advisor before large distributions.
5. Does the IRS track my basis or do I?
   The IRS does not track your basis—you are responsible for maintaining those records and calculating the impact of distributions.

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