Key Takeaways
- Distributions are generally tax-free to the extent of stock basis and AAA.
- Unlike C corps, S corp distributions are NOT taxed as dividends if no E&P.
- Distributions exceeding basis are capital gains.
- Former C corps with E&P follow special ordering rules.
- Disproportionate distributions can create a second class of stock.
- Property distributions are treated as sales at FMV.
S Corporation Distributions
Why This Matters for the Exam
S corp distributions are a major advantage over C corps—generally tax-free. The exam tests the basic rule and the special rules for former C corps.
Expect at least 2-3 questions on distributions.
The Basic Rule: Tax-Free to Extent of Basis
For S corps that have always been S corps (no accumulated E&P):
| Distribution Amount | Tax Treatment |
|---|---|
| Up to stock basis | Tax-free (reduces basis) |
| Exceeds stock basis | Capital gain |
Distribution Example (No E&P)
| Scenario | Amount |
|---|---|
| Shareholder stock basis | $50,000 |
| S corp distributes | $70,000 |
| Tax-free portion | $50,000 |
| Capital gain | $20,000 |
| Ending basis | $0 |
Why S Corp Distributions Avoid Dividends
| Entity | E&P? | Distribution Treatment |
|---|---|---|
| C Corporation | Yes | Dividends (taxable) |
| S Corporation (always S) | No E&P | Not dividends |
| S Corporation (former C) | May have E&P | Special rules |
Key Point: S corporations do not generate E&P. Distributions from pure S corps are never dividends.
Former C Corporations: Special Rules
If an S corp was formerly a C corp with accumulated E&P:
| Order | Source | Tax Treatment |
|---|---|---|
| 1st | AAA | Tax-free (reduces basis) |
| 2nd | E&P | Dividend (taxable) |
| 3rd | Stock basis | Tax-free |
| 4th | Excess | Capital gain |
AAA (Accumulated Adjustments Account)
AAA tracks undistributed S corp earnings since the S election.
| AAA Adjustment | Effect |
|---|---|
| + Income | Increases AAA |
| - Losses | Decreases AAA |
| - Distributions | Decreases AAA |
| - Non-deductible expenses | Decreases AAA |
Key Point: AAA can go negative, but distributions are only tax-free to the extent of positive AAA.
Property Distributions
When an S corp distributes property (not cash):
| Step | Treatment |
|---|---|
| Recognize gain | S corp recognizes gain as if sold at FMV |
| Shareholder basis | Distribution = FMV of property |
| Tax consequence | Gain flows through to shareholders |
Example:
- S corp distributes land with basis $10,000, FMV $25,000.
- S corp recognizes $15,000 gain (flows through to shareholders).
- Shareholder receives property with basis = $25,000.
Disproportionate Distributions: Second Class of Stock Risk
| Situation | Risk |
|---|---|
| Unequal distributions | May create second class of stock |
| Second class of stock | Terminates S election |
| Safe harbor | Distributions consistent with ownership percentage |
Best Practice: Always distribute proportionally to ownership unless you have clear documentation that it's a loan or compensation.
Real-World Scenario
Scenario: An S corp (always S, no E&P) has two 50% shareholders. The corp distributes $100,000 total ($50,000 each). Shareholder A has $60,000 basis; Shareholder B has $40,000 basis.
- Shareholder A: $50,000 tax-free (basis reduces to $10,000).
- Shareholder B: $40,000 tax-free, $10,000 capital gain (basis to $0).
On the Exam
Expect 2-3 questions on distributions, typically:
- Basic Rule Questions: "Are S corp distributions taxable?"
- Basis Questions: "What happens when distributions exceed basis?"
- E&P Questions: "How are distributions treated for a former C corp?"
The key is to remember: Tax-free to extent of basis. Excess = capital gain. Former C corps: AAA first, then E&P (dividend), then basis.
An S corp shareholder has $40,000 stock basis. The S corp (no E&P) distributes $50,000. How is this taxed?
Why are S corporation distributions not taxed as dividends?
For a former C corp with E&P, in what order are distributions sourced?