S Corporation Distributions

As a pass-through entity, S corporations distribute their earnings through the payment of dividends to shareholders, which are only taxed at the shareholder level. Income is taxed only once, when the income is earned by the S corporation, whether the income is reinvested or distributed. Unlike partnerships, S corporations are not subject to either the accumulated earnings tax or the personal holding company tax. Earnings are accumulated in a retained earnings account, but they are not considered earnings and profits (E&P), since the income is taxed on the individual returns of the shareholders. Every share of stock gives the holder an equal right to the retained earnings as any other share. So any rights to the distribution of retained earnings are represented by the number of shares held by a stockholder, not on any agreement, as in a partnership.

How Distributions Affect Shareholder Basis

A shareholder's basis in the stock of an S corporation initially depends on the amount of capital contributed by the shareholder. However, because the S corporation is a pass-through entity, the shareholder's basis changes every year, depending on income, losses, and other separately stated items. Initial basis is determined by the amount  paid to the S corporation for shares and by the fair market value of property contributed to the corporation. If the stock was received as a gift, then the basis is the carryover basis of the donor; if the stock was inherited, then it receives a stepped-up basis. If the S corporation previously operated as a C corporation before the conversion, then the stock basis will equal the basis in the C corporation stock at the time of the conversion.

A shareholder's basis is subsequently modified by income and losses and other items every year. While every shareholder has a stock basis, some shareholders may also have a debt basis, equal to the amount lent to the corporation minus any repayments. A shareholder acquires debt basis by lending money directly to the corporation — personal guarantees do not count nor does any debt acquired by the S corporation from 3^rd parties. If the debt is evidenced by a note, and the note is held longer than 1 year, then any repayment over the debt basis will be apportioned as a return of capital and as a long-term capital gain. So if you lend $10,000 to your corporation, formalized with a note, and your debt basis is reduced to 0, but the corporation pays the loan after 1 year, then you recognize the $10,000 as a long-term capital gain. If, instead, you reduce your debt basis to $5000 and the corporation pays $8000 of the note, then $4000 of that will be treated as a nontaxable return of basis and the remaining $4000 will be treated as a capital gain.

Capital Gain

• = (Note Balance − Debt Basis)

• ÷ Note Balance

• × Repayment Amount

Return of Capital

• = Repayment Amount

• − Portion Treated As Capital Gain

So, to calculate the apportionment of the capital gain and the return of capital for the above example:

• Capital Gain = ($10,000 − $5000) ÷ $10,000 × $8000 = $4000
• Return of Capital = $8000 − $4000 = $4000

Debt basis is increased by any additional loans made to the company, including any capitalized interest (i.e., not paid) and is decreased by loan repayments and by any losses or deductions exceeding the lender's stock basis.

Income and losses and other items pass through to the shareholder, but whether the shareholder can deduct those losses depends on whether the shareholder has sufficient basis, but losses may also be restricted by at-risk and passive activity limitations. Basis will also determine any gain or loss when the stock is finally disposed of.

A shareholder's stock basis is increased by:

• ordinary income
• separately stated income items
• tax-exempt income
• excess depletion.

Stock basis is decreased, but not below 0, by:

• ordinary loss
• separately stated loss items
• nondeductible expenses
• non-dividend distributions
• if applicable, depletion for oil and gas

Dividend distributions do not reduce basis because it is just the distribution of net income, which is taxed to the shareholder, whether distributed or not. Only non-dividend distributions reduce stock basis, which is reported on Form K-1 (Form 1120S), Shareholder's Share of Income, Deductions, Credits, etc.; dividend distributions are reported on Form 1099-DIV, Dividends and Distributions. The Schedule K-1 does not show how much of the distribution is taxable, because only the shareholder can determine that based on his basis.

The tax on the distribution and the deductibility of a loss depends on stock basis. However, the stock basis must be adjusted by flow-through items from the S corporation in a particular order:

• basis is increased for income items and excess depletion
• then decreased for:
  • distributions
  • nondeductible, non-capital expenses and depletion
  • loss and deduction items

The shareholder's basis in stock is always reduced by current year losses, even if such losses would be limited by at-risk or passive activity rules. In contrast to losses and deductions, the tax benefits of tax credits are not limited by basis. However, they may change basis, depending on the type of credit.

Loss and deduction items reduce stock basis 1^st, but cannot reduce the basis below 0. If the shareholder also has a debt basis in the corporation, then that basis is reduced by loss and deduction items that could not be used to reduce the stock basis. However, if the shareholder has no debt basis in the corporation or the debt basis is reduced to 0, then the total of loss and deduction items exceeding the basis is suspended and can be carried forward indefinitely. Moreover, if the S corporation repays the debt when the shareholder has a reduced basis, then the repayment amount exceeding that basis is taxable to the shareholder. Any suspended loss and deduction items can be carried forward indefinitely, but they retain their character. When the shareholder finally disposes of the stock, all suspended loss and deduction items are lost; they cannot be used to reduce any gain on the stock. Additionally:

• Non-dividend distributions exceeding the stock basis is taxed as capital gain, which is treated as long-term if held longer than 1 year.
• Nondeductible expenses reduce basis, but cannot be carried forward.
• Because items carried forward retain their character, any loss and deduction items that exceed basis must be allocated pro rata to those particular items.
• Current year loss and deduction items are combined with suspended losses and deductions, but are listed separately on Schedule E, Supplemental Income and Loss.

  Example: Distribution of S Corporation Earnings

  Stock basis	$200,000
  Pro rata share of annual corporate income	$175,000
  Cash distribution	$125,000
  Stock basis at end of tax year	$250,000	= Stock Basis at Start of Year + Pro Rata Share of Income − Cash Distribution

The change of basis is usually calculated at the end of the tax year. It is the shareholder's duty to track basis. If the shareholder does not track basis every year, then eventually some event will occur, such as selling the stock or terminating the corporation, where the basis will need to be calculated to determine taxable income. If basis is not continually tracked, then reconstructing basis may be a very tedious process, especially if the shareholder held the stock for several years. If the basis must be reconstructed, then the shareholder must review all previous Schedules K-1 + capital contributions to calculate basis. Even if the S corporation maintains records of the stock basis for each shareholder, each shareholder should also maintain their own records to ensure their accuracy.

How Distributions Affect the S Corporation

Distributions from S corporation earnings are identical to the rules governing partnership distributions. Taxes must be paid on income when it is earned, regardless of whether it is distributed to the shareholders. Undistributed S corporation earnings are placed in a special account called the accumulated adjustments account (AAA). Any subsequent distributions from the AAA will be tax-free to the shareholders because the taxes already been paid.

Income retained by the corporation for which the shareholders already paid the tax are held in the AAA. If the S corporation previously operated as a C corporation, then there may have been accumulated earnings and profits (AEP), which is kept in a separate AEP account. Because dividends paid by a C corporation are taxable to the shareholders, any distributions from the AEP account is taxable. However, any distributions paid to shareholders are 1^st deemed distributed from the AAA rather than the AEP, until the AAA is depleted, unless the shareholders choose the AAA bypass election to eliminate the balance in the AEP account. An S corporation will also have an other adjustments account (OAA) that is increased by tax-exempt income and reduced by related nondeductible expenses.

Distributions must 1^st be distributed out of the AAA. When the AAA is depleted, then additional distributions come out of AEP until the AEP is depleted. Any excess over that amount is considered a nontaxable return of paid-in capital.

If the S corporation has a net loss for the year, and it pays a distribution out of AAA, then the distribution is 1^st subtracted from AAA before the losses are subtracted.

A distribution from the AAA reduces the basis in the stock, but a distribution out of E&P as a dividend has no effect on basis. Since the AAA is necessary to segregate undistributed S corporation earnings from accumulated E&P, an S corporation that never operated as C corporation does not have to maintain this account. However, if the corporation ever becomes involved in a corporate merger, then it must segregate its earnings as an S corporation into an AAA.

S Corporation Earnings Distributed by a C Corporation

Sometimes the owners of an S corporation will want to convert to a C corporation, such as when they want to increase the number of shareholders beyond what is allowed for an S corporation or to issue preferred stock. In such a conversion, any undistributed earnings from the S corporation are considered a return of investment during a 1-year grace period from the date of the conversion. Afterwards, any distribution from the S corporation's retained earnings will be treated as a taxable dividend that does not affect the basis of the stock. Distributions from accumulated E&P are treated as taxable dividends.

Property Distributions

Property distributions from an S corporation are treated like those from a C corporation, in that if the fair market value (FMV) exceeds the corporation's tax basis, then the corporation must recognize the gain as if it sold the property to the shareholder. If the FMV exceeds the corporation's basis in the property, then the excess is recognized as a capital gain, but if the basis is less than FMV, then the corporation cannot deduct the loss. In either case, the shareholder recipient's basis in the property = FMV.