By: John S. Morlu II, CPA
For small business owners, distributions represent an essential way to take money out of a company. Understanding the tax rules surrounding distributions is vital to managing business finances efficiently and avoiding unnecessary tax liabilities. This article explores the tax implications of wages, distributions, and expense reimbursements for business owners, focusing on the rules specific to S corporations.
What Are Distributions?
Distributions are payments made by a business to its owners outside the context of wages or salaries. For S corporations, these distributions are often tax-free for the shareholder—provided they do not exceed the shareholder’s stock basis. However, if a nonliquidating cash distribution exceeds an S corporation shareholder’s stock basis, the excess amount is treated as a taxable gain.
Tax Treatment of S Corporation Cash Distributions
S corporation shareholders generally recognize taxable gain on nonliquidating cash distributions only when:
1. The distribution exceeds the shareholder’s stock basis, or
2. The distribution comes from the corporation’s accumulated earnings and profits (AE&P).
To determine the taxability of distributions, S corporations separate their earnings into four distinct layers:
1. Accumulated Adjustments Account (AAA)
- What it is: The AAA consists of earnings generated by the S corporation after 1982, adjusted for nondeductible expenses.
- Tax impact: Distributions from the AAA are typically nontaxable, provided the shareholder has sufficient stock basis.
2. Previously Taxed Income (PTI)
- What it is: This layer represents earnings from before 1983 when the company was already taxed as an S corporation.
- Rarity: PTI is uncommon today, as relatively few S corporations maintain this layer.
- Tax impact: Distributions from PTI are nontaxable and reduce the shareholder’s stock basis.
3. Accumulated Earnings and Profits (AE&P)
- What it is: AE&P consists of earnings from the period when the company was taxed as a C corporation before making the S election.
- Tax impact: Distributions from AE&P are treated as taxable dividends and do not reduce the shareholder’s stock basis.
4. Other Adjustments Account (OAA)
- What it is: The OAA includes income and expenses related to tax-exempt items, such as municipal bond interest.
- Tax impact: Distributions from the OAA are nontaxable and reduce stock basis.
Distributions are first applied to the AAA, PTI, or OAA layers (which are typically tax-free) before any amounts are drawn from the AE&P layer, which is taxable as a dividend.
Increasing Stock Basis to Avoid Taxable Gains
If a shareholder’s distributions exceed their stock basis, the excess becomes taxable as a gain. However, shareholders can increase their stock basis to avoid this situation:
- Stock Contributions: Shareholders can contribute personal funds to the S corporation, increasing their stock basis and allowing for additional tax-free distributions.
- Debt Basis: Unlike stock contributions, increasing debt basis (e.g., by personally guaranteeing the S corporation’s debt) does not allow for additional tax-free distributions.
Key Case Example: Weisberg, TC Memo. 2010-55
In this case, shareholders argued that personally guaranteeing a loan to the S corporation increased their basis, allowing them to claim business losses. The court disagreed, ruling that a personal loan guarantee does not increase stock or debt basis. As a result, the shareholders were denied deductions and penalized under Section 6662 for lacking reasonable authority to support their claim.
Key Takeaways
1. Basis Matters: Shareholders must track their stock basis to determine the tax implications of distributions.
2. Debt Guarantees Do Not Increase Basis: Personal guarantees on loans to the S corporation do not increase stock or debt basis.
3. Plan Ahead: If distributions are likely to exceed stock basis, shareholders should consider contributing personal funds to the S corporation to increase their stock basis.
Understanding these rules can help business owners optimize distributions, manage tax liability, and comply with IRS regulations. By staying informed, small business owners can make smarter financial decisions that support the long-term health of their companies.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a licensed public accounting and management consulting firm. He has more than 20 years of professional experience in auditing and advisory work, including service as Auditor General of Liberia and FAR and DCAA compliance work at Unisys Federal Systems.
The firm’s technology products include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software for financial accuracy and efficiency.
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