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Liquidating vs nonliquidating distributions

Shareholders in an S corporation must keep careful track of their tax basis.

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.

This mainly occurs during voluntary liquidations of solvent corporations.

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.

Distribution source and shareholders' basis for their corporate investment determine the tax consequences of distributions from S corporations.

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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.

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The amount that a shareholder receives in a liquidating distribution is treated as full payment in exchange for the shareholder’s S corporation stock.Note that these rules differ from the ordinary rules applicable to distributions from S corporations.To the extent that the shareholder has basis in the S corporation stock, distributions to the shareholder are tax free.By contrast, liquidating distributions are treated as though the shareholder had sold her S corporation stock to the S corporation in exchange for the distribution from the S corporation. Note: Since the ordinary distribution rules do not apply, the S corporation’s accumulated earnings and profits or accumulated adjustments accounts do not determine the character of the distribution.S corporations with accumulated earnings and profits should take advantage of this distinction by clearly identifying liquidating distributions in the documents authorizing the liquidation.The consequences of distributions to the shareholders and the corporation are discussed further.