By: John S. Morlu II, CPA
Distributions from an S corporation can have tax consequences depending on whether they exceed the shareholder’s stock basis. Let’s explore this concept using the example of ABC, an S corporation, and Brianne, one of its shareholders.
The Setup
ABC, an S corporation, had the same facts as the earlier case:
- Nonseparately stated income: $30,000 (Brianne’s share is 50%, or $15,000).
- Tax-exempt income: $10,000 (Brianne’s share is 50%, or $5,000).
- Capital losses: $10,000 (Brianne’s share is 50%, or $5,000).
- Distributions: $150,000, made equally among shareholders (Brianne’s share is $60,000).
Brianne’s beginning stock basis in the S corporation was $35,000, and distributions were made pro rata (equal shares for each owner).
Calculating Brianne’s Stock Basis
To determine Brianne’s ending stock basis after the year’s activities, follow these steps:
1. Start with her beginning balance: $35,000.
2. Add her share of nonseparately stated income: +$15,000.
3. Add her share of tax-exempt income: +$5,000.
4. Subtract her share of distributions: -$60,000.
5. Ending Stock Basis: $0
What Happens When Distributions Exceed Basis?
Here’s where the tax implications come into play:
1. Nontaxable Portion: The first $35,000 of Brianne’s distributions reduces her stock basis to zero and is nontaxable.
2. Dividend Portion: The next $15,000 of her distributions comes from the AE&P layer, which is treated as a taxable dividend (50% of the total $30,000 allocated to AE&P).
3. Excess Distributions: The remaining $10,000 of her distributions exceeds her stock basis, resulting in a taxable gain under IRC Section 1368(b)(2).
Impact on Other Items
Brianne’s share of the capital losses ($5,000) would be suspended because her stock basis is zero. These losses can only be used in future years when her stock basis is increased by new income or contributions.
Key Takeaways
1. Stock Basis Determines Taxability: Distributions are nontaxable as long as they don’t exceed a shareholder’s stock basis. Once the basis reaches zero, additional distributions may result in dividends or taxable gains.
2. AE&P Distributions Are Dividends: Distributions from accumulated earnings and profits (AE&P) are always treated as taxable dividends and do not reduce stock basis.
3. Excess Distributions Create Gains: Any portion of a distribution exceeding both the stock basis and AE&P layer is taxable as a gain.
4. Suspended Losses: When stock basis is zero, losses are suspended and carried forward to future years.
Summary
In this case, Brianne faced three tax outcomes from her $60,000 distribution:
- $35,000 was nontaxable, as it matched her stock basis.
- $15,000 was taxable as a dividend from AE&P.
- $10,000 was taxable as a gain, since it exceeded her stock basis.
Understanding how stock basis, AE&P, and excess distributions interact is crucial for shareholders in S corporations. These rules ensure that income and losses are correctly accounted for and that distributions are properly taxed.
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:
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