The key advantage of owning S corporation shares is that you are only taxed once on the business income. If you withdraw your taxable income as a distribution, it is a tax-free return of your basis. If you leave your taxable income in the S corporation, it increases your basis in your shares, reducing your gain or increasing your loss on any eventual sale.
C corporations, in contrast, are taxed twice. The corporation pays tax on the earnings; the shareholder pays tax when the after-tax earnings are distributed or when they are recovered by selling the shares.
There's one catch: once you no longer own the shares, you no longer have basis. A California shareholder learned this the hard way in Tax Court this week.
The shareholder had 100,000 shares of S corporation stock with a basis of $866,795 -- all but $200,000 of which was retained S corporation earnings. In 2002 the shareholder gifted 95,000 of the shares to his son. Under the tax law, a gift recipient steps into the donor's basis. That left the donor-father with basis of $42,340.
Even so, the S corporation distributed over $600,000 to the taxpayer in 2003, when his remaining 5% stake generated $19,123 taxable income. The math didn't work.
While the taxpayer didn't report any income from the $600,000 distribution, the IRS saw it differently. When a distribution exceeds a taxpayers basis, capital gain results. The IRS assessed tax on a $548,664 capital gain.
The Moral? If you give shares away, you can't act like you still own them. While the tax law has some flexibility to allow "ex-dividend" distributions based on prior share ownership, that's limited. If your son owns the shares, he gets the basis.
Russ Fox has more.
Cite: Miller, T.C. Memo. 2011-189.
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