S Corporation Distributions

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IRS code and regulations stipulate the following items concerning tax treatment of S Corporations and their shareholders distributions:

No Earnings and Profits

For S Corporations with no earnings and profits, distributions are applied against basis of the shareholder’s stock. If the distribution exceeds the adjusted basis of the stock, the amount in excess is treated as gain from the sale or exchange of property. Sec. 1368. Distributions

With Earnings and Profits

For S Corporations with earnings and profits, that portion of the distribution that does not exceed the accumulated adjustments account (AAA) is treated the same as an S Corporation having no earnings and profits. The remainder is treated as a dividend to the extent it does not exceed the accumulated earnings and profits. Any remaining distribution is treated the same as the S Corporation having no earnings and profits. Sec. 1368. Distributions

For more information about the accumulated adjustments account, see Distributions from AAA.

Distributions to Officers

Distributions to a corporate officer that are for services rendered should be characterized as compensation. The instructions for Line 7 of Form 1120S read, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.“ Wages are subject to employment taxes. The following article gives more detail about the tax law pertaining to officer compensation.

Those interested in this topic should take special note of the Watson v. U.S. [(DC IA 5/27/2010)105 AFTR 2d 2010-908] case against an accounting firm that was quite aggressive by paying $24k wages when the full-time officer/owner was getting another $200k plus from the company each year. It seems the IRS wants to use this as an example of being too aggressive and if the government prevails, they will likely proceed on other taxpayers with similar aggressive positions.

(And, of course, keep an eye on HR 4213, which is in reconciliation between house and senate as of late May, 2010.)

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