Taxes on S corporation distributions depend on several things such as the shareholder's basis in their corporation stock as well as the S corporation's accumulated adjustments account (AAA) and earnings and profits (E&P).

Information About S Corporation Taxability

Unlike a C corporation, an S corporation can avoid income tax at the corporate level. This is possible because of items of income, credit, and deductions flowing through to the shareholders who pay any tax due.

As far as earnings and profits are concerned, an S corporation will only have E & P if was previously structured as a C corporation or acquired a C corporation's assets in a Section 381 transaction. Distributions from an E & P are treated as a dividend. For distributions without accumulated E & P, it depends solely on the shareholder's basis in S corporation stock.

Under Section 1368, the distribution of an S corporation's property or cash may result in one of three tax consequences to the shareholder in receipt of the cash or property. These are: 

  • The shareholder's basis in the corporation's stock receives a tax-free reduction
  • A taxable dividend
  • Capital gains from the sale of stock

These consequences are not exclusive to a single distribution, which can result in two or all the consequences, not just one.

Taxability of an corporations">S corporation is determined by several factors. These are: 

  • Two shareholder attributes, stock basis 
  • Previously taxed income 
  • Two corporate attributes, earnings and profit (E & P) 
  • Accumulated adjustments account (AAA)

Because each of these factors plays an important role in determining taxability, it is important to have a solid understanding of each to avoid confusion that may result in decisions made regarding taxability. 

S Corporation Distribution Rules

Double Taxation

S corporation distributions are treated differently than those made by C corporations. One of the standout points of subchapter C is the concept of "double taxation."

When C corporations earn taxable income, it is taxed at the corporate level. When the income is distributed as a dividend, the tax falls to the shareholder. This means the income earned by the corporation is taxed at the corporate and the shareholder levels, with the result being double taxation.

S corporations, on the other hand, are subject to taxation generally only once. Income generated by an S corporation is allocated among its shareholders. The shareholders are then responsible for reporting and paying the tax due on their share of the income on their federal tax return. The "single filing only" process results in an S corporation not being taxed a second time.

Sec. 1368

The purpose of Sec. 1368 and its regulations is to maintain this significant difference between C corporations and S corporations; double taxation for C corporations and single taxation for S corporations.

While the distribution and attribute tiers involved with Sec. 1368 appear complicated, preserving the difference regarding income between two structures in place, determining tax distributions of S corporations will be clearer.

Key Attributes of Distribution Rules

Stock Basis

Under Sec. 1367, shareholders in S corporations are required annually to adjust their basis in the corporation's stock. The adjustment should address income, deductions, losses, gains, and the distribution allocated to the shareholder.

The basis of S corporation stock must increase for the following items: Capital contributions, Income items stated separately and non-separated computed income, and the excess of the deductions for depletion over the basis of property that is subject to depletion.

Stockholders must decrease basis for these items: distributions other than those being taxes as dividends per Sec. 1368, items state separately of deduction and loss and non-separately computed loss, expenses that are nondeductible and are not properly chargeable to a capital account, depletion deduction for gas and oil property held by the S corporation. The extent of the deduction cannot exceed a shareholder's share of the adjusted basis of the property.

The regulations require the stock basis be adjusted first when working with increases to basis.

Accumulated Adjustments Account

Amendments to S corporation rules resulted in an S corporation no longer generates current E & P. At the time of the S corporation election, any accumulated E & P is taxed to the recipient shareholder(s) as a dividend once it is distributed.

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