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S-Corp Nondividend Distributions

Technical topics regarding tax preparation.
#1
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Husband and wife own shares of an S corp 50/50.

Under normal circumstances, I know distributions must be commensurate with the percentage ownership to avoid having two classes of stock.

However, in a community property state, and with the rules of attribution, do husband and wife shareholders have to take the same amount of distributions?

It seems that they would both be deemed to have taken the same amount regardless of whether or not the husband, say, took $10,000 and the wife took $2,000. They would both be deemed to have taken $6,000 each and basis calculations would reflect that.

Is my thinking correct?

Thanks for any replies...
 

#2
Nilodop  
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I don't know. The regs. count the spouses as one in determining the number of shareholders, but I think only for that purpose. Maybe you'd have to argue something like an equal distribution was made combined with a spousal gift.

THe regs. mainly look to to the legal rights to distributions and liquidation proceeds. But they also look to facts and circumstances, like so:
... any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.


It seems that they would both be deemed to have taken the same amount regardless of whether or not the husband, say, took $10,000 and the wife took $2,000. They would both be deemed to have taken $6,000 each and basis calculations would reflect that.. As I said, I don't know. What do you base that on? The regs. on basis say to reduce basis by a pro rata share of distributions, but in your facts that's not the actual distributions.

I'd bet there's a case or ruling on point. Have you looked?

You seem concerned about basis. What about termination?
 

#3
Chay  
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Let's try coming at this from another angle. If the ownership of the shares were 80/20, would the presence of community property laws force the distribution ratio to 50/50 no matter what, thus giving rise to two classes of stock?
 

#4
JR1  
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I don't know the answer other than for sure state law isn't going to overcome Fed law.
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#5
EADave  
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I can tell you this, in the Texas Court of Appeals, Thomas v Thomas, where the husband was the S Corp shareholder of a family owned S Corp, and the wife was not, the Court ruled:
"A partner, like a shareholder or LLC member, does not own any interest in partnership property. The retained earnings of a partnership, corporation, or LLC belong to the entity, not to the persons who own interests in the entity. Thus the undistributed income of a pass-through entity organized under state law as an S Corporation, partnership, or LLC, is not the property of the person who owns the interest in the entity."

I take the Court's position/explanation to mean the profits are not community property income, until distributed by resolution of the members of the LLC. This would mean the members, following Federal Law, would be required to adhere to the pro-rata, distribution rules of the S Corp; oddly enough, profits should be distributed 50/50 in this case but only because they are 50/50 shareholders. If the members have unequal distributions, I would have a plan in place to make the 80% member whole again within the near future, and I would recommend the client not do this again in the future (A), or change the ownership structure to suit the needs of the clients.
 

#6
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Thanks, EADave. This was done early on before me and why their CPA didn't mention this at the time, I'm not sure. I'm just trying to move forward and right now working on basis. Because they both contributed equal capital in year 1, the lopsided distributions to the husband vs. the wife took his basis negative which would have triggered the recognition of income as basis can't go negative. This does not appear to have been done. My thought was to just treat all distributions early on as equal. I understand the issues, but if it isn't done this way then their basis will forever be quite different, which is a source of consternation since they hold the same ownership percentage. The last five years or so, they have been quite diligent about making sure all distributions are equal.
 

#7
EADave  
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Boy, cleaning up after someone else's mess is akin to watching your co-workers get promoted for all the hard work you did! Hang in there TT.
 

#8
Chay  
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taxtried wrote:if it isn't done this way then their basis will forever be quite different

So, the wife is going to have to take corrective distributions to equalize the total distributions and prevent a second class of stock. Then you'll then have a situation where the husband's basis is permanently higher than the wife's — is that what you're getting at?

In this scenario, I can easily imagine the IRS finding a way to push the basis down to what it "should" be. If the K-1's during the uneven distribution year(s) were filed showing the correct amount of distributions to each shareholder, then no capital gain on the personal return strikes me as a clear representation of a fact that there was sufficient basis at the time, requiring a downward adjustment under the duty of consistency. Failing that, the income exclusion + higher basis combo smacks of the "equivalent" of a double deduction which would be eliminated with a basis adjustment under § 1.1016-6(a).

Taking this into consideration, I'm sure no one would complain if you went ahead and made the downward basis adjustment yourself.
 


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