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The primary difference between C corporations and S corporations is that C corporations are taxed twice on earned income: : once at the corporate level when the income is earned, and again at the shareholder level when the income is distributed. The rules governing distributions from C corporations differ from the rules that apply to distributions from S corporations.

Shareholder Tax Consequences

To the extent that a distribution is made from the corporation’s earnings and profits, it is taxed to the shareholder as a dividend.[1] The portion of the distribution that is not considered a dividend is applied first to reduce the shareholder’s basis in the corporation’s stock.[2] Any remaining portion is treated as gain from the sale or exchange of property (capital gain).[3]

Important Note: If a shareholder assumes a liability or takes property subject to a liability, the amount of the distribution is reduced by the amount of the liability.[4] Special rules also apply at the corporate level.[5]

Special rules apply to distributions to a shareholder in exchange for the shareholder’s stock (redemptions). Instead of being treated as dividends, redemptions are treated as a sale or exchange of the stock by the shareholder.[6]  The distinction can be important when the long-term capital gains rates (which apply to redemptions) are higher than the tax rates on dividends.

Corporate shareholders may prefer that the distribution be treated as a dividend, allowing the corporation to take advantage of the special dividends-received deduction under Code § 243 (which allows the dividends to only be taxed once at the corporate level). On the other hand, individual shareholders often prefer that the distribution be treated as a redemption, for three reasons:

  1. A redemption allows the shareholder to offset his basis in a way that is not available with ordinary distributions, which only allow a basis offset if the corporation has no accumulated earnings and profits.
  2. If the shareholder’s stock has depreciated, the shareholder can recognize a loss at the time of the redemption. This loss, which is usually a capital loss, can be deducted against capital gains.
  3. A redemption usually results in capital gain treatment, which can be taxed at preferential rates.

A distribution qualifies as a stock redemption only if it significantly reduces the interest of the shareholder in the corporation.  The Internal Revenue Code uses four tests to make this distinction:

  1. Redemptions Not Equivalent to Dividends – A distribution is treated as a stock redemption “if the redemption is not essentially equivalent to a dividend.”[7] Although this murky language has been somewhat clarified by rulings and case law, it is not clear enough to rely upon.
  2. Complete Termination of Interest – If the redemption is “in complete redemption of all of the stock owned by the shareholder,” the distribution is treated as a stock redemption.[8]
  3. Substantially Disproportionate Distribution – If the shareholder’s voting interest is reduced by more than 20 percent and the interest that the shareholder retains after the redemption is not a controlling interest, the distribution is treated as a stock redemption.[9]
  4. Partial Liquidations – This test views the distribution from the corporation’s perspective.  It requires (a) that the distribution is not essentially equivalent to a dividend (when viewed from the corporation’s perspective) and (b) that the distribution is “pursuant to a plan and [occurs] within the taxable year in which the plan is adopted or within the succeeding taxable year.”[10]

To prevent gamesmanship among related parties, Congress has added another layer of rules that must be analyzed to determine if a distribution is a redemption. These attribution rules provide that shares owned by a shareholder’s parents, children, and grandchildren (but not siblings) are considered to be owned by the shareholder.[11] Similarly, shares held by corporations, trusts, and partnerships are deemed to be owned by their shareholders beneficiaries, and partners, and vice versa.[12]  As a result, shares held by these family members and entities are considered to be owned by the shareholder for purposes of determining whether the distribution qualifies as a redemption.

Corporate Tax Consequences

A corporation will not recognize any gain or loss on a distribution of cash to its shareholders.[13]  But if the corporation distributes appreciated property, the corporation must recognize gain as if the property were sold to the shareholder at fair market value.[14]

Important Note: These two rules operate as a loss disallowance system. If the corporation distributes appreciated property, the corporation is taxed on the gain under Code § 311(b).  But that section only covers gain on distributions of appreciated property. If the corporation distributes property that has depreciated (i.e., property with a built-in loss), Code § 311(b) does not apply. Instead, the distribution is governed by the general nonrecognition rule of Code § 311(a), which prevent the corporation from recognizing loss on a transfer of depreciated property.

Tax Consequences of Liquidation

Liquidation is a taxable event for both the shareholder and the corporation. A corporation may liquidate by (a) paying off creditors and distributing the remaining assets in kind to the shareholders or (b) selling assets, paying off creditors, and distributing the remaining cash to the shareholders.

If the corporation distributes the assets to the shareholders in kind pursuant to a plan of liquidation, it is treated as having sold the assets to the shareholder for fair market value.[15] If the corporation instead sells the assets and distributes the remaining cash to the shareholder, it is taxed on the sale.[16]

Likewise, the shareholder is treated as though the shareholders sold their stock to the corporation for the value of the assets or cash received.[17] The shareholder’s basis in property received pursuant to a plan of liquidation is the fair market value of the property at the time of the distribution.[18]

Important Note: Special rules apply to distributions involving liabilities.[19]

 

[1] I.R.C. §§ 301(c)(1), 316.

[2] I.R.C. § 301(c)(2).

[3] I.R.C. § 301(c)(3).

[4] I.R.C. § 301(b)(2).

[5] See I.R.C. §§ 311(b)(2), 336(b).

[6] I.R.C. § 302(a).

[7] I.R.C. § 302(b)(1).

[8] I.R.C. § 302(b)(3).

[9] I.R.C. § 302(b)(2).

[10] I.R.C. § 302(b)(4).  Like the “Redemptions Not Equivalent to Dividends” test of I.R.C. § 302(b)(1), this test is usually used only when the safe harbors of I.R.C. §§ 302(b)(2) and 302(b)(3) are unavailable.

[11] I.R.C. § 318(a)(1).

[12] I.R.C. § 318(a)(3) and 318(a)(4).

[13] I.R.C. § 311(a).

[14] I.R.C. § 311(b).

[15] I.R.C. § 336.

[16] I.R.C. §§ 1001, 61(a)(3).

[17] I.R.C. § 331.

[18] I.R.C. § 334.

[19] See I.R.C. § 336(b).