BGBC Partners, LLP Tax Update:
S Corp Disproportionate Distributions
If you operate your store as an S corporation with multiple owners, one significant consideration is the timing and amounts of distributions to the owners. In this segment of our tax update, we will focus on the importance of making sure that distributions are proportionate to all owners.
First off, we need to recall the importance of maintaining the “S” status of the corporation. If the S status is terminated, the corporation becomes a double-taxed C corporation which means that all income is subject to an entity-level tax, and then subject to tax again when it is distributed to the shareholders.
So what events can cause the S status to terminate? Glad you asked, the list includes: Having more than 100 shareholders, having an ineligible shareholder (such as a foreign shareholder), and having more than one class of stock. It’s this last item “having more than one class of stock” that is our focus.
In general, when “disproportionate distributions” are made to shareholders, there is a risk that the IRS will interpret this as creating a “second class of stock” and the S corporation may be terminated.
The technical rule is that a corporation has only one class of stock if all the outstanding shares carry identical rights as to distribution and liquidation proceeds. However, by making disproportionate distributions, the IRS can try to make the argument that you are changing the economic balance between shareholders, which in turn results in unequal rights as to distribution and liquidation proceeds.
What if stock is sold during the year? If stock is sold during the year, the one-class-of-stock regulations enable the S corporation to make distributions based on the shareholders’ varying interests in the corporation during the current year or the immediately preceding tax year.
There are certain regulatory exceptions available which allow for disproportionate distributions. For example, disproportionate distributions to allow shareholders to make state tax payments may be allowed under certain situations. Also, disproportionate distributions might be allowed correct earlier disproportionate distributions made in error.
As you can see, these provisions on disproportionate distributions can be a minefield if you are not careful. Therefore, we recommend that you work with an experienced CPA to plan the timing and amounts of future distributions. After all, distributions are one way to reap the benefits of your hard work. The last thing we want is to have the government reap the benefits due to a lack of planning!
BGBC Partners, LLP is a full service certified public accounting and business consulting practice.
For more information, contact Brad Bell, CPA or Steve Reed, CPA/ABV/CFF at BGBC Partners, LLP (317-633-4700).
