Corporate shareholders sometimes receive distributions in the form of property rather than cash. And while there’s nothing wrong with this practice, it’s important to understand the tax implications.
Tax treatment of distributions
The tax rules surrounding corporate distributions are complicated, and a full discussion of them is beyond the scope of this article. In general, a distribution by a C corporation is treated as a dividend (and is taxable to the shareholder) to the extent of the corporation’s accumulated earnings and profits (AEP), also referred to as “E&P.” If a distribution is greater than the corporation’s E&P, the excess is treated as a nontaxable return of capital to the extent of the shareholder’s basis, and then as capital gain.
An S corporation is treated like a C corporation to the extent it has E&P — for example, if it was previously organized as a C corporation or if it acquired a C corporation’s assets. Otherwise, a distribution to an S corporation shareholder is treated as a nontaxable return of capital up to his or her basis.
If a corporation distributes property other than cash to a shareholder, the amount of the distribution is the property’s fair market value (FMV), less any related liabilities the shareholder assumes.
Owners often give little thought to taking distributions of corporate property — a company car or truck, for example. But these distributions may trigger unwelcome tax consequences. Consider this example:
ABC Inc. is an S corporation with no E&P, owned equally by two shareholders, Sam and Dave. ABC gives Sam a van with an FMV of $15,000 that it purchased for $35,000. The company has depreciated the van over several years, so its adjusted basis is $5,000. Assuming Sam’s basis in the company is more than $15,000, he’s not subject to tax on the distribution. But ABC recognizes a $10,000 gain (the van’s FMV less ABC’s basis), all of which is ordinary income. Even though only Sam benefited from the distribution, the income is passed through to both shareholders ($5,000 each) and reported on their individual tax returns.
If ABC was a C corporation, the income would be reported at the corporate level (subject to potential double taxation when distributed to its shareholders). Sam would be subject to tax on the value he receives — a $15,000 dividend, to the extent of ABC’s E&P. Keep in mind that, even if the company has little or no E&P, distributing the van will generate E&P in the amount of the gain ABC recognizes.
Suppose that, in addition to the van, ABC distributes a car worth $15,000 to Dave. The company paid $35,000 for the car, but its adjusted basis is $20,000. The company still recognizes a $10,000 gain on the van, but its $5,000 loss on the car is nondeductible. ABC would be better off selling the van and the car for $15,000 each and distributing the cash to Sam and Dave. The shareholders would receive the same value, but the company would be able to deduct the loss on the car, reducing its net gain to $5,000.
Do your homework
If you’re considering a corporate distribution of property rather than cash, be sure to analyze the tax consequences first. There may be alternatives that can reduce your tax bill.