Disproportionate S Corp Distributions: What Happens Next?

An S corporation provides the liability protection of a corporation with the pass-through tax benefits of a partnership, meaning income and losses are passed to the shareholders’ personal returns. This structure avoids the double taxation found in C corporations. A principle of S corporations is the requirement for pro-rata distributions, meaning any distributed profits must be allocated in proportion to each shareholder’s ownership percentage. For instance, if one owner has a 70% stake and another has a 30% stake, any distribution must follow that same 70/30 split to ensure equitable treatment.

The One Class of Stock Requirement

A defining rule for an S corporation is having only one class of stock, a regulation found in Internal Revenue Code (IRC) Section 1361. This means all outstanding shares must confer identical rights to both distribution and liquidation proceeds. Every share must be equal in its economic rights, with no share receiving preferential treatment.

The Internal Revenue Service (IRS) interprets this rule by examining the corporation’s “governing provisions,” which include the corporate charter, articles of incorporation, bylaws, and binding shareholder agreements. If these documents establish that all shares have the same rights, the corporation is considered to have a single class of stock. An S corporation can have both voting and non-voting common stock without violating the rule, as long as the economic rights remain identical.

Making distributions that are not proportional to ownership can be viewed by the IRS as evidence that a second class of stock has been created. For example, if a corporation with two equal 50/50 shareholders distributes $7,000 to the first shareholder and only $3,000 to the second, it suggests the first shareholder’s stock carries more favorable distribution rights. This action creates a de facto second class of stock, violating the requirement.

Interpretations by the Tax Court have emphasized the governing provisions over the actual distributions made. According to Treasury Regulation 1.1361-1, as long as the corporation’s official documents provide for identical rights, the entity is not treated as having more than one class of stock. A disproportionate distribution, while problematic and needing correction, may not automatically terminate the S election if the legal documents are structured correctly.

Tax Consequences of S Corporation Termination

Violating the one class of stock requirement can terminate a company’s S corporation status, which carries significant tax consequences. The termination is retroactive to the first day of the tax year in which the disqualifying event occurred. This means the business’s tax status changes for the entire year.

Once the S election is terminated, the business is reclassified and taxed as a C corporation, which introduces double taxation. The business must first pay corporate income tax on its profits. Then, when those after-tax profits are distributed as dividends, shareholders must pay personal income tax on that same income.

The termination also creates a short S corporation tax year and a short C corporation tax year within the same calendar year. This requires complex allocations of income and expenses between the two periods and complicates tax preparation.

Another consequence is a five-year waiting period. Once a corporation’s S election is terminated, it is prohibited from re-electing S status for five taxable years. This rule prevents companies from switching between tax statuses to gain short-term advantages.

Common Scenarios Creating Disproportionate Distributions

Disproportionate distributions often happen unintentionally through common business activities. Business owners may not recognize that certain payments constitute a distribution, such as:

• The direct payment of a shareholder’s personal expenses from the corporate bank account, which creates an unequal distribution of corporate funds if not done for all owners.
• Unequal cash payments to shareholders that are not correctly documented as a loan. Such a payment must be classified as a bona fide loan, complete with a promissory note and a reasonable interest rate, or as salary subject to payroll taxes.
• The forgiveness of a loan to one shareholder. If the corporation has loaned money to multiple shareholders but only forgives the debt for one, the forgiven amount is treated as a distribution to that specific shareholder.
• Distributing property instead of cash if not handled carefully. If an S corporation distributes assets, the fair market value of those assets must be proportional to each shareholder’s ownership stake.

Seeking Relief for Inadvertent Terminations

The IRS recognizes that S corporations can accidentally violate the rules and provides a path for relief for an “inadvertent termination.” Outlined in IRC Section 1362, this relief allows a corporation to maintain its S status despite a terminating event, provided certain conditions are met. The process is not automatic and requires the corporation to seek a ruling from the IRS.

To qualify for relief, the corporation must demonstrate to the IRS that the termination was inadvertent, meaning the disqualifying event was not intentional or motivated by tax avoidance. The corporation has the burden of proof and must provide a detailed explanation of the circumstances that led to the error. The IRS is more likely to grant relief when the event was outside the corporation’s reasonable control.

A second condition is that the corporation must take steps to correct the issue within a reasonable period after its discovery. Corrective actions could involve shareholders repaying excess distributions or the corporation recharacterizing the payments as documented loans or compensation. The goal is to restore the corporation to a state of compliance.

Finally, the corporation and all of its shareholders must agree to any adjustments required by the IRS for the period of the termination. All shareholders must consent to be treated as if the S election had been in effect continuously and make necessary changes to their personal tax returns. Meeting these requirements allows a business to avoid the negative tax consequences of converting to a C corporation.