S Corporation Income, Loss, Distribution Rules
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CPA Tax Compliance & Planning (TCP) › S Corporation Income, Loss, Distribution Rules
An S corporation's income, loss, deductions, and credits flow through to shareholders based on:
The shareholders' capital account balances at year-end.
Each shareholder's pro-rata daily share of stock ownership - income and loss items are allocated based on the number of shares owned for each day of the year.
The amount of distributions each shareholder received during the year.
Special allocations agreed upon by the shareholders in the operating agreement.
Explanation
S corporation items are allocated strictly pro-rata based on shares owned per day - unlike partnerships, S corps cannot make special allocations. Answer B is correct. Capital accounts (A) determine partnership allocations. Distributions (C) affect basis but not income allocation. Special allocations (D) are not permitted for S corps.
A shareholder's basis in S corporation stock is initially determined by:
The fair market value of the S corporation on the date of purchase.
The S corporation's book value per share on the purchase date.
The S corporation's retained earnings attributable to the shareholder's ownership percentage.
The amount paid for the stock (purchase price or, for founding shareholders, the amount of cash and adjusted basis of property contributed in exchange for the stock).
Explanation
Stock basis in an S corporation is initially the purchase price or contribution amount - the same as for any corporate stock. Answer A is correct. FMV determines amount realized, not initial tax basis (B). Book value (C) and retained earnings (D) are accounting concepts, not tax basis.
A shareholder's basis in S corporation stock is increased by:
The corporation's total debt outstanding.
The shareholder's share of corporate losses.
Distributions received from the corporation.
The shareholder's pro-rata share of S corporation income (including tax-exempt income) and capital contributions to the corporation.
Explanation
Basis increases for income pass-throughs (including tax-exempt income) and additional capital contributions. Answer C is correct. Distributions decrease basis (A). Losses decrease basis (B). S corporation debt generally doesn't increase shareholder stock basis (D).
An S corporation shareholder may deduct their share of S corporation losses only to the extent of:
Their share of the corporation's total assets.
Their pro-rata ownership percentage of total corporate losses.
Their adjusted basis in the S corporation stock plus any basis in loans made to the corporation - losses exceeding this combined basis are suspended until basis is restored.
The amount of their capital contributions during the year.
Explanation
S corp shareholders can deduct losses to the extent of stock basis plus debt basis (loans to the corporation). Excess losses are suspended. Answer B is correct. Loss limitation is based on basis, not ownership percentage (A). Only current-year contributions don't determine the total available basis (C). Asset values are irrelevant to the loss limitation (D).
A non-cash distribution from an S corporation to a shareholder is treated as:
A deductible expense for the S corporation.
A distribution at the fair market value of the property - the S corporation recognizes gain as if it sold the property at FMV, and the shareholder treats the FMV as the distribution amount for basis purposes.
A tax-free exchange with no gain recognized at either level.
Ordinary income to the shareholder equal to the property's adjusted basis.
Explanation
Non-cash distributions trigger gain recognition at the corporate level (as if sold at FMV), and the shareholder receives a distribution at FMV for stock basis purposes. Answer A is correct. Gain is recognized (B). FMV is the measure, not adjusted basis (C). Distributions are not deductible by S corps (D).
An S corporation that was previously a C corporation makes a cash distribution. The distribution ordering rules require:
First from the accumulated adjustments account (AAA), then from accumulated E&P (if any), then as a return of capital, and finally as capital gain - the AAA represents post-S election accumulated undistributed income.
First from paid-in capital, then from AAA.
First from accumulated E&P, then from AAA.
All distributions treated as dividends from E&P as long as any E&P exists.
Explanation
The distribution ordering for S corps with prior C corp history is: AAA first, then AE&P, then return of capital, then capital gain. Answer C is correct. The ordering is AAA then E&P (A - reversed). Paid-in capital is not the first source (B). E&P doesn't override AAA (D).
A shareholder receives a distribution from an S corporation in excess of their stock basis. The tax treatment of the excess is:
Capital gain - distributions in excess of stock basis (after AAA has been exhausted and no AE&P exists) are treated as gain from the sale of the S corporation stock.
Tax-free since the excess represents a return of capital to the shareholder.
Ordinary income since S corporation distributions are not capital transactions.
Ordinary income to the extent of the S corporation's accumulated E&P.
Explanation
After stock basis is reduced to zero, any excess distribution (from AAA or in the absence of AE&P) is capital gain from the deemed sale of stock. Answer B is correct. Excess over basis creates capital gain, not necessarily ordinary income from E&P (A). Capital gain treatment applies (C). Excess over basis is not tax-free (D).
A shareholder has an S corporation stock basis of $20,000 and debt basis (from a loan to the corporation) of $10,000. The S corporation allocates $35,000 of losses to this shareholder. The deductible loss is:
$0 - losses must be separately substantiated before deduction.
$30,000 - the combined stock basis ($20,000) plus debt basis ($10,000). The remaining $5,000 is suspended.
$35,000 - the full loss since the shareholder is an active participant.
$20,000 - only stock basis is available for loss deductions.
Explanation
S corp losses are deductible to the extent of stock basis plus debt basis: $20,000 + $10,000 = $30,000. The $5,000 excess is suspended. Answer A is correct. Full $35,000 (B) exceeds available basis. Debt basis also supports deductions (C). Losses are deductible up to basis (D).
When a shareholder's S corporation debt basis is reduced by losses, subsequent S corporation income:
Has no effect on debt basis - debt basis is fixed at the loan amount.
First restores debt basis to its original amount before increasing stock basis - the income allocation first replenishes the reduced debt basis, then any remaining income increases stock basis.
First restores stock basis, then debt basis.
Increases both stock basis and debt basis proportionally.
Explanation
Income allocations first restore debt basis (reduced by prior losses) before increasing stock basis. Answer C is correct. Stock basis is restored after debt basis (A - reversed). Income doesn't split between them proportionally (B). Debt basis fluctuates with losses and income (D).
The built-in gains (BIG) tax under Section 1374 applies to an S corporation that:
Has passive investment income exceeding 25% of gross receipts for 3 consecutive years.
Converts from an S corporation to a C corporation.
Was formerly a C corporation and sells appreciated assets within the recognition period (5 years after the S election) - the tax is imposed at the highest corporate rate (21%) on net recognized built-in gains.
Has accumulated E&P from its C corporation years and makes distributions.
Explanation
The BIG tax prevents S corporations from avoiding corporate-level tax on pre-conversion appreciation by electing S status. Answer A is correct. AE&P triggers different S corp issues (B). 25% passive income triggers a different provision (C). Conversion from S to C has different rules (D).