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 unless it makes a distribution of appreciated property, in which case the corporation must recognize gain as if the property were sold to the shareholder at fair market value.[6]
Tax Consequences of Liquidation
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 to the shareholders in kind pursuant to a plan of liquidation, it is treated as having sold the assets to the shareholder for fair market value.[8] If, on the other hand, the corporation sells the assets and distributes the remaining cash to the shareholder, it is taxed on the sale.[9] In either case, the resulting gain or loss is passed through to the shareholder,[10] and the shareholder receives a corresponding adjustment to basis of S corporation stock.[11] The shareholder’s basis in property received as part of the liquidation equals the property’s fair market value.[12]
[1] I.R.C. §§ 1366(a)(1); 1377(a)(1).
[2] I.R.C. § 1368(b)(1).
[3] I.R.C. § 1368(b)(2).
[4] I.R.C. § 1367(a)(1).
[5] I.R.C. § 1367(a)(2).
[6] I.R.C. § 311(a), (b).
[7] See I.R.C. § 1368.
[8] I.R.C. § 336.
[9] I.R.C. §§ 1001, 61(a)(3).
[10] I.R.C. § 1366(a).
[11] I.R.C. § 1367(a).
[12] I.R.C. § 334.
[13] See I.R.C. § 336(b).
[14] I.R.C. § 731(b).
[15] I.R.C. § 311(a), (b).