S Corporation Distributions Rules: Everything You Need to Know
S corporation distributions rules are similar to the rules for partnership distributions; the income becomes taxable the moment it is earned, whether it's distributed or not.3 min read
2. How Distributions Affect the Shareholder Basis
3. How Distributions Affect the S Corporation
4. S Corporation Earnings Distributed by a C Corporation
S corporation distributions rules are similar to the rules for partnership distributions; the income becomes taxable the moment it is earned, whether it's distributed or not.
S Corporation Distributions
When an S corporation distributes cash or property among its shareholders, there can be three possible tax treatments in the hands of the recipient shareholder:
- It may reduce the recipient's basis in the corporation's stock, which would be tax-free.
- It may amount to receiving a taxable dividend.
- It may result in capital gain from the sale of the corporation's stock.
An S corporation is a pass-through entity. When it distributes the earnings by means of dividends, the shareholders are liable to pay tax at the personal level on the amount of dividends they receive. Since the corporation does not pay separate income tax at the corporate level, the income is taxed only once, whether it's reinvested or distributed.
An S corporation accumulates its earnings in a retained earnings account. The balance of this account is not considered as earnings and profits (E&P) because the corporation's income passes through to the individual shareholders, who include their respective shares of income in their individual tax returns.
How Distributions Affect the Shareholder Basis
When an S corporation is formed, the amount of capital a shareholder contributes determines his cost basis in the corporation's stock. However, since an S corporation's income and losses pass through to the shareholders, their basis in the stock changes every year.
While determining the initial basis in the corporation's stock, the amount of cash paid and the market value of the property contributed by the shareholders is taken into account.
Although all shareholders have a stock basis, some of them may have a debt basis as well. A debt basis refers to the amount of money a shareholder has lent to the corporation, adjusted for any repayments.
The debt basis increases if additional loans are given to the corporation or any amount of accumulated interest is capitalized. Similarly, it decreases if any part of the loan is repaid, or there are losses or deductions in excess of the lender's stock basis.
The amount of business losses a shareholder can deduct from his stock basis depends upon whether he has sufficient basis, and it's further regulated by at-risk and passive activity rules.
A shareholder's stock basis increases due to:
- Regular income
- Income from separately stated items
- Income exempt from taxes
- Excess depletion
Similarly, a stock basis decreases due to:
- Regular business loss
- Loss from separately stated items
- Non-deductible expenses
- Distributions other than by way of dividends
- Depletion for oil and gas
However, none of these items can reduce the stock basis below zero.
The tax on the distributed income depends upon a shareholder's stock basis, and so does the deductibility of his share in the corporation's losses. While adjusting the stock basis for flow-through items, you must follow a certain order:
- First, the basis must be increased for income and excess depletion.
- Then it should be decreased for distributions, non-deductible expenses, non-capital expenditure and depletion, and losses and deductible items.
How Distributions Affect the S Corporation
The tax treatment of S corporation distributions is similar to that of partnership distributions. The income becomes taxable the moment it is earned, whether or not the corporation distributes it among its shareholders.
An S corporation keeps its undistributed earnings in the accumulated adjustments account (AAA). When it distributes from this account at a later date, the distributions are tax-free for the shareholders because they have already paid the taxes at the time of income accrual.
S Corporation Earnings Distributed by a C Corporation
Sometimes you may want to convert an S corporation back into a C corporation, such as when you decide to increase the number of shareholders beyond the permissible limit for S corporations or want to issue multiple classes of stock.
Any undistributed earnings at the time of such conversion are treated as:
- A return on investment if the distribution is made within a grace period of one year from the date of conversion
- A taxable dividend (which does not affect the stock basis) if the distribution is made after the initial grace period of one year
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