Distribution source and shareholders' basis for their corporate investment determine the tax consequences of distributions from S corporations.The regulations being proposed under IRC Secs 13 provide the particulars of adjustments to stock basis and distributions to S corporation stockholders.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.
The amount of the tax basis determines the tax treatment of such items as flow-through losses and corporate distributions.
Many S shareholders have two investments in the corporation - the investment in corporate stock and loans made to the corporation.
A common motivation for structuring a transaction as an asset sale is so that the buyer can acquire the business and enjoy a step-up in tax basis in the depreciable/amortizable assets, while leaving the seller’s operating history (and potential legal liabilities) behind.
In this case (where outside tax basis is significantly higher than inside tax basis), it is critically important that the asset sale AND the liquidation of the S corporation both occur in the same tax year (generally the same calendar year).
The consequences of distributions to the shareholders and the corporation are discussed further.
Shareholders in an S corporation must keep careful track of their tax basis.
While there are some differences, the S corporation basis system is similar to the rules that apply to partnerships.
The tax consequences of distributions by an S corporation to a shareholder depend on the shareholder’s basis in the S corporation stock.
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.