While there are some differences, the S corporation basis system is similar to the rules that apply to partnerships.
The tax consequences of distributions by an S corporation to a shareholder depend on the shareholder’s basis in the S corporation stock.
S corporations with accumulated earnings and profits should take advantage of this distinction by clearly identifying liquidating distributions in the documents authorizing the liquidation.
This allows partners to defer recognition of gain in appreciated property that they receive from the partnership.
Like C corporations, S corporations do not recognize any gain or loss on a distribution of cash to its shareholders.
If the S corporation distributes appreciated property to a shareholder, the corporation must recognize gain as if the property were sold to the shareholder at fair market value.
By contrast, liquidating distributions are treated as though the shareholder had sold her S corporation stock to the S corporation in exchange for the distribution from the S corporation. Note: Since the ordinary distribution rules do not apply, the S corporation’s accumulated earnings and profits or accumulated adjustments accounts do not determine the character of the distribution.
But for tax purposes, the defining line can make a big difference.
Witness the situation described in recent letter from the Internal Revenue Service (LTR 200806006, November 7, 2007), which addresses a seeming anomaly related to the tax code.
The shareholder will recognize gain or loss equal to the difference between the amount of the distribution and the shareholder’s basis in the S corporation stock.
Note that these rules differ from the ordinary rules applicable to distributions from S corporations.