CaseStudy: distributing property to S corporation shareholders.

• Author: Ellentuck, Albert B.

AN S CORPORATION CAN DISTRIBUTE property (as well as cash) to its shareholders. If property is distributed, the amount of the distribution is considered to be the property's fair market value (FMV) (Sec. 301(b)). The tax attributes of the distribution are generally determined as if the distribution had been made in cash.

When appreciated property (property that has an FMV in excess of its adjusted basis) is distributed, gain is recognized in the same manner as if the S corporation had sold the property to the shareholders at its FMV (Sec. 311(b) via Sec. 1371(a)). The gain passes through to the shareholders and increases their basis in their stock. No loss is allowed, however, if the distributed property has an FMV that is less than the corporation's tax basis in such property. (Under Sec. 336, a loss can be recognized if the distribution is in liquidation of the corporation.) The shareholder's basis in the distributed property is its FMV (Sec. 301(d)).

Example 1: A and B each own 50% of A&B Inc.'s stock. Each shareholder wants to receive a distribution of $20,000, but the corporation does not have the cash available to make the distributions. A suggests that A&B distribute $20,000 cash to him and a fully depreciated piece of equipment worth $20,000 to B. (The equipment originally cost $50,000.) A&B has been an S corporation, and A and B have been shareholders, for 12 years. A&B has not previously merged with another corporation.

[ILLUSTRATION OMITTED]

If the equipment is distributed to B, a gain of $20,000 (FMV of $20,000 less basis of zero) will be recognized at the corporate level. All of the gain will be subject to tax as ordinary income due to depreciation recapture (Sec. 1245). It will be passed through so that A and B each will report $10,000 of income from the deemed sale. B will be considered to have received a $20,000 distribution, and the tax attributes of the distribution will be determined as if the distribution had been made in cash. B's basis in the equipment will be its $20,000 FMV, so if she sold it for $20,000, she would recognize no gain or loss from the sale (Sec. 301(d)).

If the shareholders do not want to report gain from the distribution, they could distribute equipment to B that had a basis higher than its FMV so that corporate-level gain could be reduced or eliminated. As a general rule, however, assets that have basis in excess of FMV should not be distributed to a shareholder because the potential loss cannot be...