Tom Talks Taxes - April 23, 2022
What are the tax consequences from a corporation distribution of property?
Most of the time, corporations make distributions to shareholders in cash. Those cash distributions have generally no tax effect at the corporate level, but definite tax consequences to the shareholder. Property distributions to a shareholder have added complexity because there are both entity-level and shareholder tax consequences.
Let’s set the table by reviewing the general tax treatment of non-liquidating distributions to corporation shareholders, whether made in cash or property. The distribution amount to the shareholder is the fair market value (FMV) of the cash or property received. The distribution amount received by the shareholder is reduced by any corporation liabilities assumed by the shareholder.
In a C corporation, a distribution, under §301(c), is:
A taxable dividend to the extent of corporation earnings & profits (E&P), then
A return of capital until the shareholder’s stock basis is reduced to $0, then
Capital gain in the amount it exceeds the shareholder’s stock basis.
In a S corporation, a distribution, under §1368(b), is:
Non-taxable until the shareholder’s stock basis is reduced to $0, then
Capital gain in the amount it exceeds the shareholder’s stock basis.
If the S corporation has C corporation E&P from a prior C corporation period, then there are additional considerations. The S corporation will distribute first from the accumulated adjustments account (AAA) tax-free to the extent of the AAA; after AAA is depleted, then distributions will come from C corporation E&P and be taxable dividends. I discussed the AAA in detail in a prior edition.
Now let’s discuss the issues specific to property in a non-liquidating distribution.
If the property has a built-in gain, then the corporation, under §311(b), recognizes gain equal to its FMV less its adjusted basis. In a C corporation, the gain increases corporation E&P. In a S corporation, the gain increases both shareholder stock basis as well as the AAA.
If the property has a built-in loss, then the corporation, under §311(a), does not recognize the loss. In a C corporation, the nondeductible loss decreases corporation E&P. In a S corporation, the nondeductible loss decreases both shareholder stock basis as well as the AAA. See Chief Counsel Advice 201421015.
There is an additional consideration for property distributions to shareholders of certain closely-held corporations. §1239(a) recharacterizes any gain recognized to ordinary if there is a sale or exchange of property between related parties and it is depreciable in the hands of the buyer. This provision applies to property distributions to shareholders since §311(b) states that the “gain shall be recognized to the distributing corporation as if such property were sold to the distributee…”. For purposes of property distributions to shareholders, related parties are a corporation and a shareholder who owns, directly or indirectly, more than 50% of its stock. See §1239(b)(1) and §1239(c)(1)(A).
Here’s an example of how a property distribution to a shareholder, especially that of real estate, can be problematic. Matt is a 100% shareholder of an S corporation and holds a short-term rental property in the S corporation. Assume the following:
The land has a basis of $100,000 and FMV of $150,000,
The building has a basis of $200,000 (original purchase price of $250,000) and a FMV of $350,000, and
The property was held for more than one year.
If Matt distributes the property to himself and continues to use it as a short term rental, then it is a deemed sale of the property to himself to which §1239 applies. The S corporation will recognize (and pass-through to Matt):
$50,000 of §1231 gain from the land, and
$150,000 of ordinary gain from the building.
The simple distribution of appreciated property creates significant taxable gain to Matt, and §1239 makes it worse. The §1231 gain is long-term capital gain provided there is no required recapture of prior §1231 ordinary losses.
If §1239 did not apply, Matt would recognize $50,000 of unrecaptured §1250 gain (capital gain subject to a 25% maximum rate) and $100,000 of §1231 gain, both of which are preferable to ordinary gain. §1239 would not apply in this scenario if the building is not depreciable in Matt’s hands post-distribution; for example, he converts it to personal use property.
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