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.
On the other hand, individual shareholders often prefer that the distribution be treated as a redemption, for three reasons: A distribution qualifies as a stock redemption only if it significantly reduces the interest of the shareholder in the corporation.
The Internal Revenue Code uses four tests to make this distinction: To prevent gamesmanship among related parties, Congress has added another layer of rules that must be analyzed to determine if a distribution is a redemption.
Cash liquidation distributions are usually considered a nontaxable return of principal.
Credit unions send this sort of distribution to their depositors when they are liquidated as well.
Any amount in excess of the shareholder's stock basis is capital gain (Secs. The amount of the distribution is decreased (but not below zero) by liabilities assumed by the shareholder (e.g., a mortgage on a distributed piece of real estate).
However, only the amount of distribution that is in excess of the recipient's original investment is taxable. The rules governing distributions from C corporations differ from the rules that apply to distributions from S corporations.To the extent that a distribution is made from the corporation’s earnings and profits, it is taxed to the shareholder as a dividend. The portion of the distribution that is not considered a dividend is applied first to reduce the shareholder’s basis in the corporation’s stock. Any remaining portion is treated as gain from the sale or exchange of property (capital gain). Important Note: If a shareholder assumes a liability or takes property subject to a liability, the amount of the distribution is reduced by the amount of the liability. Special rules also apply at the corporate level. Special rules apply to distributions to a shareholder in exchange for the shareholder’s stock (redemptions).A cash distribution to a shareholder is a taxable dividend to the extent of the corporation's current or accumulated E&P. In other words, if there is sufficient current E&P to cover all distributions made during the year, all distributions are taxable dividends.If the current E&P equals or exceeds the amount of the distribution, it is a fully taxable dividend to the shareholder even if the corporation has negative accumulated E&P (Regs. Amounts treated as taxable dividends reduce the corporation's E&P balance, but not below zero.
If the corporation distributes appreciated property, the corporation is taxed on the gain under Code § 311(b).