How to Get Appreciated Property Out of an S Corp

Distributing appreciated property from an S corporation requires understanding tax implications. S corporations offer pass-through taxation, where income and losses are reported on owners’ personal tax returns, avoiding C corporation double taxation. However, distributing appreciated property introduces specific tax considerations requiring careful planning. This process requires understanding tax principles for a compliant and tax-efficient outcome for the corporation and shareholders.

Understanding Core Tax Principles

S corporation property distributions involve Fair Market Value (FMV) and Adjusted Basis. The adjusted basis represents the original cost of an asset, plus improvements, minus depreciation. FMV is the price a willing buyer and seller would agree upon. When an S corporation distributes appreciated property, it must recognize gain as if sold at FMV, even without an actual sale. This gain flows to shareholders, increasing their S corporation share basis.

Shareholder basis determines the taxability of distributions. It represents investment in the S corporation, adjusted annually by income, losses, and distributions. Distributions reduce basis and are tax-free up to stock basis. Excess distributions are taxed as capital gain.

The Accumulated Adjustments Account (AAA) is important for S corporations, especially those previously C corporations or with accumulated earnings. AAA tracks the S corporation’s cumulative undistributed net income and gains passed through to shareholders. AAA distributions are tax-free to shareholders, as this income was already taxed. AAA starts at zero upon S election, increasing with income and decreasing with losses and distributions.

The Built-in Gains (BIG) tax applies if an S corporation was a C corporation and distributes appreciated property within five years of its S election. This tax prevents C corporations from avoiding corporate-level tax on appreciated assets by converting to S status before distribution. BIG tax is imposed on gain accrued while a C corporation, levied at the highest corporate income tax rate (21%). It applies to gains on assets owned by the corporation at S election.

Distribution Strategies and Tax Outcomes

Several strategies exist for S corporations distributing appreciated property, each with different tax consequences for the corporation and shareholders. The method chosen depends on circumstances and objectives, leveraging S corporation tax principles to impact gain recognition, shareholder basis, and AAA.

Direct distribution of appreciated property to shareholders results in the S corporation recognizing gain as if sold at fair market value. This gain flows to shareholders, increasing their stock basis and taxed at individual rates. The distribution reduces the corporation’s AAA and shareholders’ stock basis. If the distribution does not exceed shareholder basis (including recognized gain), it is a tax-free return of capital. Excess distributions are taxed as capital gain.

An S corporation can sell appreciated property directly to a shareholder at fair market value. The corporation recognizes gain, which passes to all shareholders proportionally, increasing their basis. The purchasing shareholder acquires it at fair market value, establishing a new cost basis. This is a sale, not a distribution; the purchase price does not reduce AAA or shareholder basis. The S corporation receives cash or other consideration, usable for operations or cash distribution, subject to AAA and basis rules.

Selling appreciated property to a third party, then distributing cash to shareholders, is another strategy. The S corporation recognizes gain on the sale, which flows to shareholders, increasing their stock basis and taxed at individual rates.

Cash proceeds from the sale can be distributed to shareholders. These distributions reduce the corporation’s AAA and shareholders’ stock basis. They are tax-free up to adjusted basis; excess is taxed as capital gain.

Corporate liquidation involves formally dissolving the S corporation and distributing all assets, including appreciated property, to shareholders. In liquidation, the S corporation is treated as if it sold all assets at fair market value, recognizing built-in gains. This “deemed sale” gain passes to shareholders, increasing their stock basis. Shareholders treat the liquidating distribution as payment for their stock. The difference between the property’s fair market value and their adjusted stock basis (after passed-through gain) results in a capital gain or loss.

Unlike C corporations, S corporations avoid a second corporate-level tax during liquidation, as deemed sale gain flows to shareholders, and distributions are treated as a stock sale.

Executing the Distribution

Executing an appreciated property distribution from an S corporation requires corporate formalities and accurate tax reporting. The process begins with internal corporate approvals, including formal board meetings and shareholder consent through resolutions, ensuring alignment with bylaws and state law.

Accurate valuation of appreciated property is important, especially for non-cash distributions. A professional appraisal to determine FMV is recommended. This valuation establishes the gain the S corporation must recognize and the basis shareholders take in the distributed property. FMV is the reported distribution amount.

Legal documentation is necessary to transfer property ownership. For real estate, this involves executing and recording deeds. Vehicle transfers require updating titles. For other tangible personal property, a bill of sale documents ownership transfer. If the property has outstanding debt, consider if the corporation or shareholder will satisfy it, as this impacts distribution amount and tax consequences.

Tax reporting is important. The S corporation must report recognized gain on Form 1120-S. This gain, capital or ordinary, flows to shareholders and is reported on Schedule K-1. Property distribution is also reported on Schedule K-1, reducing shareholder stock basis. Shareholders use Schedule K-1 information to report income and distributions on Form 1040, on Schedule D if distribution exceeds stock basis.

Given complex tax rules and potential liabilities, consulting qualified tax advisors and legal counsel is advisable before distributing appreciated property. These professionals provide guidance tailored to situations, ensure compliance with federal and state regulations, and help structure tax-efficient transactions. Their expertise prevents unintended tax consequences and ensures smooth asset transfer.