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TAXABILITY OF S CORP DISTRIBUTIONS
S corporation, unlike a C corporation, generally escapes income tax at the corporate level; instead, its items of income, deduction, credit, etc., flow through to its shareholders, who calculate and pay any tax due.
The treatment of an S corporation distribution depends on the shareholder’s basis in his or her S corporation stock and the S corporation’s earnings and profits (E&P) and accumulated adjustments account (AAA).
An S corporation will have E&P only if it was previously a C corporation or it acquired the assets of a C corporation in a Sec. 381 transaction. An S corporation distribution from E&P is treated as a dividend.
The treatment of a distribution made by an S corporation without accumulated E&P depends only on the shareholder’s basis in the S corporation stock.
Under Sec. 1368, an S corporation’s distribution of cash or property may give rise to three possible tax consequences to the recipient shareholder: a tax-free reduction of the shareholder’s basis in the corporation’s stock, 1 a taxable dividend, 2 or gain from the sale of the stock (generally resulting in capital gain). 3 These options are not mutually exclusive; a single distribution may result in two or even all three of those consequences.
Integral to determining the taxability of an S corporation’s distributions are two shareholder-level attributes—stock basis and previously taxed income—and two corporate-level attributes—earnings and profits (E&P) and the accumulated adjustments account (AAA). Failure to fully grasp the role each plays in determining the taxability of a distribution adds needless complexity to the process and often results in an incorrect conclusion.
The purpose of this two-part article is to provide a comprehensive review of the rules for determining the taxability of an S corporation’s distributions to its recipient shareholders. Part I provides an overview of the intent of Sec. 1368 and the related regulations, the shareholder- and corporate-level attributes that drive a distribution’s taxability, and the rules for determining the tax consequences of distributions made from an S corporation without accumulated earnings and profits. Part II of the article, in the February issue, will examine the taxability of distributions made from an S corporation with accumulated earnings and profits, while also addressing ancillary considerations and planning opportunities.
Understanding the Intent of the S Corporation Distribution Rules
Before embarking on an in-depth discussion of the taxability of S corporation distributions, it is helpful to first understand precisely why distributions made by an S corporation are afforded different treatment than those made by C corporations.
The hallmark of subchapter C is the concept of “double taxation.” When a C corporation earns taxable income, the income is taxed at the corporate level. When the corporation subsequently distributes that income, the distribution is generally taxed to the shareholder as a dividend. 4 Thus, the same dollars of income the corporation earned are taxed twice, once at the entity level and again at the shareholder level.
S corporations, however, are generally subject to a single level of taxation. When an S corporation generates income, that income is typically not taxed at the entity level; 5 rather, the income is allocated among the shareholders, who report and pay tax on their share of the S corporation’s income on their individual income tax returns. When the S corporation subsequently distributes that income, under the single level of taxation specific to S corporations, the distribution is nottaxed a second time.
The purpose of Sec. 1368 and the underlying regulations is to preserve this vital difference between C and S corporations: income—or more specifically, E&P—of a C corporation must be taxed a second time when distributed, while income of an S corporation should not be taxed a second time.
At first blush, the multiple attributes and distribution tiers that litter Sec. 1368 appear complicated and confusing; however, by focusing on the intent of the governing authority—to preserve the difference between distributions of C corporation income and S corporation income—the process of determining the taxation of S corporation distributions becomes much clearer.
The interplay between two shareholder-level attributes—stock basis and previously taxed income (PTI)—and two corporate-level attributes—E&P and AAA—determines the taxability of an S corporation’s distributions. PTI has grown increasingly rare after being replaced by the AAA on Jan. 1, 1983, under the Subchapter S Revision Act of 1982. 6 Discussion of PTI will be reserved for Part II of this article in the February issue.
Under Sec. 1367, a shareholder in an S corporation is required to adjust his or her basis in the corporation’s stock annually to reflect the items of income, gain, loss, deduction, and distribution allocated to that shareholder. These annual adjustments are necessary to preserve the single level of taxation afforded to S corporations.Example 1: A forms S Co., an S corporation, by contributing $500 to the corporation in exchange for 100% of S Co.’s stock. Under Sec. 358, A ’s initial basis in his stock is $500. In year 1, S Co. generates $100 of taxable income, which is not taxed at the entity level, but is allocated to A , who reports the income on his individual income tax return.