S corporations have grown in popularity over the last few decades and for good reason. One of the most widely known being it offers the shareholder a way to not have all the earnings subject to self-employment tax. But there are tax traps associated with S corporations that are sometimes overlooked. One of those traps is how distribution of property, other than cash, from an S corporation is treated for tax purposes. Here’s what you need to know about distributions from an S corporation.
Typically, distributions from an S corporation are made in cash. For example, a shareholder receives a $50,000 cash distribution. This distribution of cash in and of itself is not necessarily taxable income since it is likely that the distribution is based entirely on the actual profitability of the company. This may not necessarily be the case but most of the time there is a strong relationship between company profits and the cash distributed.
What happens if a shareholder distributes land from an S corporation? Let’s say the land was purchased 30 years ago for $50,000 when the corporation was initially created. The shareholder now simply wants to remove the land from the S corporation as a distribution to himself personally. The thinking is that there is not a taxable event since there is no sale of the property. Is this truly a $50,000 distribution? Does any gain have to be recognized?
The answer is that it is not a $50,000 distribution. If the land was purchased many years ago like in this case, and given the rate of inflation and general run up in the real estate market over the years, this land is likely to be worth much more than the original price. The actual amount of the distribution is considered to be the property’s fair market value. For this illustration, let us assume that the fair market value is $400,000. In such a scenario, the S corporation would recognize a gain of $350,000 ($400,000 fair market value minus the original cost of $50,000). This transaction, called a “deemed sale”, comes into play because the shareholder is now paying tax on this gain flowing through from the S corporation on their personal tax return as if the property was sold. If a shareholder is not aware of this treatment, they may not have the cash to pay the tax when due. Paying tax on a gain when the property is still owned by the shareholder is not a desirable result under the tax laws.
This is a simplified example outlining a potential hazard under the S corporation tax laws. Many transactions involving property distributions may be much more complex so as always please consult your Henry+Horne tax advisor for your specific situation prior to completing the transaction.
Ron Greenfield, CPA