A Journey Through Subchapter S / A Review of The Not So Obvious & The Many Traps That Exist For The Unwary: Part IX – Taking the Mystery Out of the S Corporation Distribution Rules

Unlike the rules contained in Subchapter K surrounding partnership distributions, which tend to be somewhat complex, the distribution rules contained in Subchapter S are fairly straightforward.  Nevertheless, from time to time, taxpayers and tax advisers appear to experience difficulty navigating through the applicable S corporation distribution rules.  This Part IX of my multi-part blog series on S corporations is designed to take some of the mystery out of the S corporation distribution rules.  The following is a brief overview of the S corporation distribution rules.

Background

The purpose of pass-thru taxation under Subchapter S is to avoid the imposition of an entity-level tax.  Shareholders of S corporations are taxed on their proportionate share of the corporation’s income, regardless of whether it is actually received; therefore, distributions from S corporation income should not be taxed again, otherwise there would be a second tax on such income, undercutting the purpose of pass-thru taxation.  IRC §1368 allows for shareholder distributions in a manner that avoids double-taxation of S corporation income, but it still imposes an entity-level tax on the earnings and profits (“E&P”) remaining from any prior operations as a C corporation. Much of the complexity within the Subchapter S distribution rules is due to these latter rules, which are designed to prevent C corporations from avoiding double-taxation on C corporation earnings by simply electing S corporation status.

At a fundamental level, distributions from S corporations must be analyzed in one of two categories: S corporations without E&P and S corporations with E&P.