Because the tax consequences of S corporation distributions depend on the shareholder’s basis, it is important to keep up with changes in the shareholder’s basis over time.
An S corporation’s income, losses, deductions and credit are passed through to the shareholders for Federal tax purposes and taxed directly to them.1 Because the income of S corporations is taxed to the owners when the income is earned, a mechanism is needed to ensure that the shareholder is not taxed again when the earnings are distributed. This is done through a system of rules that track and adjust the shareholder’s stock basis. While there are some differences, the S corporation basis system is similar to the rules that apply to partnerships.
Shareholder Tax Consequences
The tax consequences of distributions by an S corporation to a shareholder depend on the shareholder’s basis in the S corporation stock. Distributions to the shareholder are not included in the shareholder’s gross income to the extent that the distribution does not exceed the shareholder’s basis in the stock.2 If the amount of the distribution exceeds the shareholder’s basis, the excess is taxed to the shareholder as capital gain.3
Because the tax consequences of distributions depend on the shareholder’s basis, it is important to keep up with changes in the shareholder’s basis over time. A shareholder’s basis in his S corporation stock is increased by the share of the S corporation income that is passed through to the shareholder.4 This effectively gives the shareholder a credit to apply against the earned income when it is ultimately distributed to the shareholder, ensuring that the income is only taxed once.
The shareholder’s basis is decreased (but not below zero) by the shareholder’s share of the S corporation’s items of loss and deduction, nondeductible expenses (except expenses that are not chargeable to the capital account), depletion deduction for oil and gas property, and distributions to the shareholder that are not made from accumulated earnings and profits.5 This helps ensure that the shareholder only benefits once from reductions in income earned by the S corporation.
Corporate Tax Consequences
Like C corporations, S corporations do not recognize any gain or loss on a distribution of cash to its shareholders. If the S corporation distributes appreciated property to a shareholder, the corporation must recognize gain as if the property were sold to the shareholder at fair market value.6
Tax Consequences of Liquidation
Liquidating distributions are not governed by the normal S corporation distribution rules. Instead, liquidation of an S corporation is governed by the same rules that apply to liquidation of a C corporation. If the corporation distributes the assets in kind to a shareholder pursuant to a plan of liquidation, it is treated as having sold the assets to the shareholder for fair market value.8 This is essentially the same treatment that would apply if the corporation sold its assets to a third party and distributed the resulting cash to the shareholder.9 Either way, the corporation will recognize gain or loss to the extent that the amount realized (or the property’s value) differs from the corporation’s basis in the distributed asset.
The shareholder will also have tax consequences from the liquidation. First, if the corporation distributes appreciated or depreciated assets as art of the liquidation, the S corporation’s gain or loss from the deemed sale of assets is passed through to the shareholder.10 The shareholder’s basis in her stock will be increased to reflect the gain or loss.11 The shareholder will take a basis in the distributed property that is equal to the property’s fair market value.12
The shareholder will also be taxed on the liquidation itself. The amount that a shareholder receives in a liquidating distribution is treated as full payment in exchange for the shareholder’s S corporation stock.13 In other words, if the S corporation is making a liquidating distribution, the shareholder is treated as having sold her stock for the amount of the distribution. The shareholder will recognize gain or loss equal to the difference between the amount of the distribution and the shareholder’s basis in the S corporation stock.
Note that these rules differ from the ordinary rules applicable to distributions from S corporations.14 To the extent that the shareholder has basis in the S corporation stock, distributions to the shareholder are tax free. By contrast, liquidating distributions are treated as though the shareholder had sold her S corporation stock to the S corporation in exchange for the distribution from the S corporation. This will result in sale treatment.
Liquidating distributions involve a specific sequence of adjustments. A shareholder’s basis in her subchapter S corporation stock is ordinarily determined at the end of the year. 15 But if the shareholder is treated as having sold her stock, the basis adjustment is treated as having occurred immediately prior to the sale. Id. This ensures that the stock is adjusted appropriately before the shareholder computes her gain or loss from the sale.
Comparison to Partnerships and Limited Liability Companies: In the partnership context, no gain or loss is recognized on a distribution of money or property to a partner.17 This allows partners to defer recognition of gain in appreciated property that they receive from the partnership. In contrast, distributions of appreciated property by C corporations and S corporations are treated as though the property were sold to the shareholder at fair market value.18
- I.R.C. §§ 1366(a)(1); 1377(a)(1). ↩
- I.R.C. § 1368(b)(1). ↩
- I.R.C. § 1368(b)(2). ↩
- I.R.C. § 1367(a)(1). ↩
- I.R.C. § 1367(a)(2). ↩
- I.R.C. § 311. ↩
- See I.R.C. § 1368. ↩
- I.R.C. § 336. ↩
- I.R.C. §§ 1001, 61(a)(3). ↩
- I.R.C. § 1366(a). ↩
- I.R.C. § 1367(a). ↩
- I.R.C. § 334. ↩
- I.R.C. § 334. ↩
- Ordinary distributions from a subchapter S corporation are governed by Section 1368, which applies to distributions “to which … section 301(c) would apply.” I.R.C. § 1368(a). But Section 331 provides that Section 301—which would obviously include 301(c)—does not apply to distributions in liquidation. I.R.C. § 331(b). This means that the normal distribution rules of Section 1368 do not apply to liquidating distributions. If the shareholder has multiple bases in her stock, the exact amount of the gain or loss will depend on whether there are single or multiple liquidating distributions. Rev. Rul. 68-348, 1968-2 C.B. 141; Rev. Rul. 85-48, 1985-1 C.B. 126. ↩
- Treas. Reg. § 1367(d)(1). ↩
- See I.R.C. § 336(b). ↩
- I.R.C. § 731(b). ↩
- I.R.C. § 311(a), (b). ↩
About the Author: Jeramie J. Fortenberry, LL.M.
Jeramie Fortenberry is an attorney based in Austin, Texas. He has an LL.M. in taxation from New York University and more than a decade of experience in business, nonprofit, and trusts and estate law. He has a wide range of experience in advising companies and individuals on business matters, including for-profit and nonprofit taxation, mergers and acquisitions, choice of entity and company formation, and corporate governance. Jeramie’s estate planning practice involves maximum use of federal credits and preservation of wealth through the use of trusts, partnerships, closely held businesses, private foundations, and charitable trusts.