Tax Consequences of Distributions in a Business
When you decide to start a business venture, there are a myriad of things to consider. We regularly assist small business owners, especially start-up businesses, walking them through the steps that need to be taken in order to make the business official and legal. There are many ways a business can be organized and there are both non-tax and tax factors as well as state and local statutory requirements that need to be taken into consideration when embarking on this exciting journey of starting a business.
I previously wrote an article regarding the non-tax factors that should be considered when starting a business. This article is one of a series of articles that focuses on the tax implications of certain business activities and things you should consider when choosing your business entity. The most prominent federal tax considerations in choosing a business entity include:
- Capital Contributions
- Ownership Restrictions
- Business Income and Loss
- Allocations of Income or Loss
- Basis Limitations and the Deductibility of Losses
- Employment Tax Considerations
- Tax Rates on Ordinary Income
This article will focus on the tax consequences of distributions in a business.
A liquidating or nonliquidating distribution from a partnership to a partner generally is treated as a nontaxable return of the partner’s capital. The partner recognizes no gain until he receives cash exceeding the basis of his partnership interest. On non-cash property distributions, a partner does not recognize any gain, but defers any gain not recognized when the distribution occurs and recognizes it when he subsequently disposes of the distributed property. Gain or loss may be recognized under §751(b) of the Internal Revenue Code if the distribution changes the partner’s share of certain partnership ordinary income property. A partner may recognize a loss on a liquidating distribution if the only property he receives consists of cash, unrealized receivables, or inventory. These rules also apply to LLCs.
Cash distributions from an S corporation generally are considered a nontaxable return of capital up to the shareholder’s basis for his stock. The excess is considered capital gain. Certain cash distributions may be taxable if they are attributable to earnings and profits accumulated under Subchapter C before the corporation elected to be taxed under Subchapter S. An S corporation is deemed to sell any distributed property to the shareholder, and the corporation recognizes any gain or loss inherent in the property when the distribution occurs. That gain passes through to the shareholders and is taxable to them in the year the distribution occurs. Gain “built-in” to corporate assets when it converts from a C to an S corporation is taxable at the corporate level.
Cash distributions from C corporations are taxable to shareholders as dividends to the extent of the corporation’s earnings and profits. Corporate earnings are subject to double taxation: they are taxable for the corporation when earned, and taxable again for the shareholder when distributed. A similar double tax is imposed when a C corporation distributes appreciated property; the transaction is treated as if the corporation sold the property for its value and distributed the cash proceeds to the shareholder.
For a complete analysis of the tax implications of C Corporations, Partnerships, and S Corporations click here for the Joint Committee on Taxation’s publication entitled “Choice of Business Entity: Present Law and Data Relating to C Corporations, Partnerships, and S Corporations.”
Attorney Angel Oliver / McGrath and Spielberger, PLLC assists clients with all sorts of tax matters, both federal and state (including but not limited to North Carolina and South Carolina). Click here to contact Ms. Oliver about your tax matter.
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