Tax Consequences of a Section 311b Distribution

Section 311(b) of the Internal Revenue Code governs the tax consequences when a corporation distributes appreciated property to its shareholders. This rule prevents corporations from avoiding tax on an asset’s appreciation by giving it to shareholders instead of selling it. The provision ensures that any gain is recognized and taxed at the corporate level before the property is transferred.

Triggering a Section 311b Gain

A gain under Section 311(b) is triggered when a corporation makes a “non-liquidating distribution” of “appreciated property” to a shareholder. A non-liquidating distribution is a payment made during a company’s normal course of business, not as part of a formal process to end the corporation’s existence.

The distribution must also involve “appreciated property,” which is any corporate asset with a fair market value (FMV) higher than its adjusted basis. The adjusted basis is typically the original cost of the asset, adjusted for factors like depreciation. For instance, if a corporation distributes land worth $250,000 with an adjusted basis of $100,000, the land is appreciated property, and the distribution triggers a taxable event for the corporation.

Calculating the Corporate-Level Tax

The corporate-level tax is calculated as if the corporation sold the property to the shareholder for its fair market value. The recognized gain equals the property’s FMV minus the corporation’s adjusted basis. This gain is then subject to the corporation’s regular income tax rate.

For example, if a corporation distributes equipment with an FMV of $50,000 and an adjusted basis of $10,000, it must recognize a $40,000 gain. This gain is reported on the corporation’s tax return and taxed accordingly. While gains are recognized under this rule, losses on distributed property are not.

A special rule applies if the property is subject to a liability that the shareholder assumes. If the liability is greater than the property’s FMV, the FMV is treated as being equal to the liability amount for calculating the gain. For instance, if a building with an FMV of $500,000 and a basis of $300,000 is distributed subject to a $550,000 mortgage, the corporation’s gain is calculated using the liability amount. The gain would be $250,000 ($550,000 liability minus the $300,000 basis).

Tax Impact on the Shareholder

The tax consequences for the shareholder are determined under Section 301. The amount of the distribution is the property’s fair market value, and its tax treatment follows a three-tier system based on the corporation’s “Earnings & Profits” (E&P), a measure of its ability to pay dividends.

First, the distribution is treated as a taxable dividend to the extent of the corporation’s current and accumulated E&P. This portion is taxed at the shareholder’s applicable dividend tax rate. If the value of the property distributed exceeds the corporation’s E&P, the excess amount moves to the second tier.

Under the second tier, the excess distribution is considered a non-taxable return of capital. This amount is not immediately taxed but instead reduces the shareholder’s basis in their corporate stock. For example, if a shareholder’s stock basis is $50,000 and they receive a $10,000 return of capital, their new stock basis becomes $40,000.

Once the shareholder’s stock basis has been reduced to zero, any further excess distribution is treated as a capital gain, typically a long-term capital gain if the stock has been held for more than one year. The shareholder’s basis in the property they received is its fair market value at the time of the distribution.

Application to S Corporations

Section 311(b) applies differently to S corporations. An S corporation recognizes gain on the distribution of appreciated property, but as a pass-through entity, it does not pay tax on the gain itself. Instead, the S corporation’s income, losses, deductions, and credits flow through to its shareholders.

The recognized gain is passed through to its shareholders and reported on their individual tax returns, which increases each shareholder’s basis in their S corporation stock. For example, if an S corporation recognizes a $100,000 gain and there are two equal shareholders, each shareholder reports $50,000 of gain and increases their stock basis by that amount.

The fair market value of the distributed property is then treated as a distribution to the receiving shareholder, which reduces their newly increased stock basis. This two-step process of a basis increase from the gain followed by a basis decrease from the distribution ensures that the appreciation is taxed once at the shareholder level. This structure avoids the double taxation found in C corporations.