When a C Corporation converts to an S Corporation, understanding the tax implications of distributions from the newly elected S Corporation is crucial. Distributions are payments made to shareholders, and they can have different tax treatments based on various factors, including the corporation’s history, the type of earnings, and whether the distribution is considered a dividend or a return of capital.
Key Considerations for Distributions from a Converted S Corporation:
- Character of Distributions
Distributions made by an S Corporation can be classified into two types: taxable dividends or non-taxable returns of capital.
- Return of Capital (Non-Taxable):
- If the distribution does not exceed the shareholder’s basis in the S corporation, it is typically treated as a return of capital. This means that the distribution is not taxed immediately but reduces the shareholder’s basis in their stock.
- Basis refers to the amount of the shareholder’s investment in the S Corporation. The initial basis is the shareholder’s cost of purchasing the stock, plus any additional investments, and less any distributions or losses passed through to the shareholder.
- Taxable Dividends:
- If the distribution exceeds the shareholder’s basis, the excess amount is generally treated as a capital gain and taxed accordingly (either as long-term or short-term depending on the holding period).
- Tax Treatment of Distributions After a C Corp to S Corp Conversion
For a business converting from a C Corporation to an S Corporation, there are special rules regarding the treatment of distributions:
- Built-in Gains Tax (BIG): If a C Corporation has appreciated assets (assets that have gone up in value since the company acquired them), and those assets are sold by the S Corporation within five years after the conversion, the S Corporation might be subject to the Built-In Gains Tax (BIG). This tax is intended to capture any built-in gains that were not taxed when the assets appreciated while the business was a C Corporation.
- Distributions related to built-in gains may trigger the BIG tax if the distribution is linked to the appreciation of assets that occurred before the conversion. For example, if the S Corporation distributes property that had appreciated during the time it was a C Corporation, the distribution may be subject to BIG tax.
- Accumulated Earnings and Profits (AE&P):
If the S Corporation had any accumulated earnings and profits (AE&P) from its time as a C Corporation, distributions made from these earnings might be treated as taxable dividends. The AE&P represents retained earnings that were not distributed when the business was a C Corporation.- Distributions from AE&P are taxed as ordinary income, and shareholders would be required to report it as dividend income, subject to tax rates on dividends (which may be lower than ordinary income rates, depending on the shareholder’s tax bracket).
- Impact of S Corp Conversion on Distributions
Distributions in an S Corporation after the conversion are generally treated as pass-through income, meaning that they are reported on the shareholders’ personal tax returns, and the corporation itself does not pay taxes on the earnings. However, the specifics of the distribution depend on several factors:
- Distributions from C Corporation to S Corporation: Any distribution of earnings that existed during the time the corporation was a C Corporation (i.e., AE&P) will continue to be treated as dividends, taxed accordingly.
- Distributions from S Corporation Earnings: Earnings after the S Corporation election are generally not subject to double taxation. However, shareholders may need to consider their basis in the S Corporation when determining whether distributions are taxable.
- Shareholder’s Basis in S Corporation Stock
A critical element when handling distributions is the basis in S Corporation stock, which impacts the tax treatment. Here’s how it works:
- Increased Basis: Shareholders can increase their basis by any additional capital contributions or by their share of the corporation’s income.
- Decreased Basis: The shareholder’s basis decreases by any distributions they receive, as well as by their share of any losses the S Corporation passes through.
If the shareholder’s basis reaches zero, further distributions would be taxable as capital gains (as opposed to a return of capital).
- Special Considerations for S Corp Conversions
- S Corporation Election Date: The timing of the S Corporation election can affect the character of the distributions. If the election is made during the tax year, any distributions made before the election will be treated as distributions from a C Corporation and may be subject to the applicable C Corporation tax treatment.
- Built-in Gains (BIG) Tax for S Corps: If the S Corporation sells any appreciated assets within 5 years of the conversion, the BIG tax may apply, which could affect any distributions made from those assets.
- Distributions After 5 Years: Once 5 years have passed since the conversion, the BIG tax generally no longer applies, and the distribution of appreciated assets will not trigger additional tax.
- Examples of Distribution Scenarios
- Scenario 1: Distribution from AE&P
A C Corporation has accumulated $100,000 in earnings and profits (AE&P) before converting to an S Corporation. After converting, the company distributes $50,000 to a shareholder. Since the distribution comes from AE&P, it will be treated as a dividend and taxed as ordinary income to the shareholder. - Scenario 2: Distribution from Post-conversion S Corp Earnings
After the conversion, the S Corporation earns $50,000 in the first year, and a shareholder receives a distribution of $30,000. Since the distribution comes from earnings after the S Corporation election, it would typically be a return of capital (assuming the shareholder’s basis is sufficient). It would not be taxable unless it exceeds the shareholder’s basis in the stock. - Scenario 3: Distribution Exceeding Basis
If a shareholder receives a $60,000 distribution, but their basis in the stock is only $50,000, the first $50,000 will generally be a non-taxable return of capital, and the remaining $10,000 would be treated as a capital gain, taxable to the shareholder.
Conclusion
Distributions from a Converted S Corporation can be complex due to factors such as accumulated earnings and profits (AE&P), built-in gains, and the shareholder’s basis in the company. The tax treatment of distributions depends on the nature of the earnings (C Corp vs. S Corp earnings), and understanding the specific tax rules can help shareholders avoid unexpected tax liabilities. Always consult a tax professional for personalized advice when dealing with distributions in a converted S Corporation.