Owners of an S Corporation needs to carefully monitor distributions to shareholders to be certain that there are no disproportionate distributions. Failure to make distributions in proportion to ownership interests can void the S Corporation election.
Distributions to shareholders must be made in proportion to the ownership interests of the shareholders or a disproportionate distribution has occurred. For example, if an S Corporation has three shareholders owning 50%, 35% and 15% of the corporate stock, all distributions to shareholders should be in this ratio. These are distributions of profits, if the shareholders are also employees, amounts paid to them in salary are not distributions for this purpose.
A disproportionate distribution can occur inadvertently. A loan to a shareholder that is not properly documented as a loan can be a distribution. The distribution of non-cash property can be a distribution. A sale of corporate property at less than fair market value can be a distribution.
Under IRS regulations, disproportionate distributions are viewed as evidence of a second class of stock. Since one of the requirements of an S Corporation is that it only have one class of stock, a disproportionate distribution can invalidate the S Corporation election.
If a disproportionate distribution has occurred, the corporation must take immediate action to correct the error by equalizing the distributions. The first step in this regard is to determine the actual distribution per share to each shareholder.
Secondly, identify the shareholder who received the highest distribution per share. Then, determine the amount that each shareholder should have received at that per share level. Next, subtract the amount each shareholder received to determine the amount of equalizing distributions that must be paid to each shareholder. This must be done separately for each distribution that the corporation makes – each distribution stands on its own.
It should then be determined if the distributions to each shareholder can be paid tax-free out of profits and do not violate corporate distribution limitations. If this requirement cannot be met, other actions must be taken. This can get complicated and is beyond the scope of this article. You should consult with your tax professional if you find yourself in this situation. Assuming this hurdle is overcome, the Board of Directors should authorize the equalizing distributions. The distributions should be paid promptly.
If the corporation lacks the cash to make the distributions, it may be necessary for the shareholder to make loans back to the corporation. If this is the case, the loans should be properly documented promissory notes with appropriate interest rates included.
Let’s run through a simple example of one disproportionate distribution. Go back to our hypothetical corporation with three shareholders owning 50%, 35%, and 15%, representing 50, 35, and 15 shares. The shareholders receive distributions of $5,000 each. It does not matter if the distributions were paid in cash or other assets. The important factor is the fair market value of assets received by the shareholder.
A – $5,000/50 shares = $100 per share
B – $5,000/35 shares = $142.86 per share
C – $5,000/15 shares = $333.33 per share
C has received the greater amount per share. A must be given $233.33 per share time 50 shares, or $11,667 in additional distributions. B will receive an additional $190.47 per share, or $6,666 total.
If the distribution has occurred in property rather than cash, there is an additional complicating factor. Property distributed as a dividend to a shareholder is considered distributed at current fair market value. If the basis in the property is less than its FMV, the corporation must show it as a sale for fair market value and report the profit on the deemed sale of the asset.
In summary, this brings us to a point that must be emphasized regarding S Corporations. The corporation is an entity separate from its owners. It may not be treated as an extension of the owners and corporate transactions must be maintained separate from personal business. When the corporation is closely held, especially by close family members, there is a tendency to overlook corporate formalities. To do so, however, you run the risk of losing the advantages of the corporate form of organization, as the courts and the IRS may rightfully ignore the corporate form of organization in these cases.
In accordance with Circular 230 Disclosure
Dr. John Stancil (My Bald CPA) is Professor Emeritus of Accounting and Tax at Florida Southern College in Lakeland, FL. He is a CPA, CMA, and CFM and passed all exams on the first attempt. He holds a DBA from the University of Memphis and the MBA from the University of Georgia. He has maintained a CPA practice since 1979 with an emphasis in taxation. His areas of expertise include church and clergy tax issues and the foreign earned income credit. He prepares all types of returns, individual and business.
Dr. Stancil has written for the Polk County Business Journal and has presented a number of papers at academic conferences. He wrote the Instructor’s Manual for the 13th edition of Horngren’s Cost Accounting. He is published in the Global Sustainability as a Business Imperative, Green Issues and Debates, The Encyclopedia of Business in Today’s World, The Palmetto Business Review, The CPA Journal, and in the NATP TaxPro Journal. His paper, “Building Sustainability into the Tax Code” was recognized as the outstanding accounting paper at the annual meeting of the South East InfORMS. He wrote a book entitled “Tax Issues Faced by U. S. Missionary Personnel Abroad ” that will soon be published.
He has recently launched a new endeavor, Church Tax Solutions, which presents online, on demand seminars on various church and clergy tax issues.
Recent Comments