Small business owners often wonder whether it’s acceptable to make disproportionate distributions to a shareholder of an S Corporation. The following example paints a picture of a situation where business owners may consider this possibility:
Tom and Jeff own an S Corporation called TJ Engineering as equal shareholders (i.e. each shareholder owns 50% of the stock of the S Corporation). TJ Engineering has been profitable for a number of years and has approximately $1,000,000 of retained earnings that can be distributed. When Tom finds himself in hard times financially, he wants to have TJ Engineering make distributions to help him get by. Jeff, on the other hand, doesn’t need the cash and would rather leave the money available to the business to help finance construction of a new office building. Tom and Jeff wonder whether they can make a cash distribution of $125,000 to Tom, but no distribution at all to Jeff, leaving the remaining retained earnings available to the business and thus satisfying the desires of both shareholders.
General Rule for S Corporations
So based on this example, the question really is whether an S Corporation can make distributions to select shareholders that are disproportionate to the shareholders’ ownership interest. Well, the simple answer is no, but there are possibilities for “timing differences” between distributions. First, let’s explain why disproportionate distributions would be disallowed.
The restriction relates to how businesses can be qualified to be treated as an S Corporation in the first place. These rules are found in Internal Revenue Code Section 1361. Section 1361 requires that each business meet the following qualifications in order to be an S Corporation for federal tax purposes:1
- the business must be a domestic corporation (organized in the U.S.)
- the business cannot have more than 100 shareholders
- all owners of the business must be an individual, a trust, an estate, or a 401(a), 501(a), or 501(c)(3) tax-exempt organization
- none of the business owners can be nonresident aliens
- the business must have only one class of stock
Now, note that the business, in addition to being required to meet these requirements in order to become an S Corporation, must also continue to meet these requirements in order to continue as an S Corporation. If at any point the business stops meeting these requirements, the S Corporation status is terminated and the business will be treated as either a partnership or a C Corporation.2 It is from the last of these requirements (i.e. that the business must have only one class of stock) that we derive some guidance in regards to S Corporation distribution rules. We go from Section 1361 to the underlying treasury regulations, and we find the following explanation regarding this “one class of stock” rule:3
…A corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. (emphasis added)
By reading this line, we should infer the general rule that distributions from S Corporations to shareholders should be proportional to each shareholder’s ownership interest. After all, if there is only one type of stock with “identical rights to distribution” proceeds, you cannot meet this rule by allowing a shareholder to have the rights to a higher ratio of the distributions than that shareholder’s ownership right would entitle him/her to.
So going back to our example, does this mean that if Tom and Jeff were to execute their plan, the business’ S Corporation election would be terminated? Not necessarily. Read on.
Exception for Timing Differences
The regulations contain a few examples of when a disproportionate distribution would not harm the status of the business as an S Corporation. The first of these examples goes as follows:
S, a corporation, has two equal shareholders, A and B. Under S’s bylaws, A and B are entitled to equal distributions. S distributes $50,000 to A in the current year, but does not distribute $50,000 to B until one year later. The circumstances indicate that the difference in timing did not occur by reason of a binding agreement relating to distribution or liquidation proceeds… the difference in timing of the distributions to A and B does not cause S to be treated as having more than one class of stock.
Based on this example, we learn that timing differences between distributions will not alone cause an S Corporation to be treated as having more than one class of stock and, therefore, the validity of the S election won’t be lost. Notice, however, that the example points out that the difference wasn’t the result of a “binding agreement relating to distribution or liquidation proceeds.” If the timing difference were the result of a binding agreement, this would effectively be considered a difference in the shareholder’s rights, and the business would constructively be considered to have more than one class of stock and thus lose its S Corporation election.
Several private letter rulings also give some examples where temporarily disproportionate distributions have been allowed. In a private letter ruling (PLR) issued back in May of 1995, an S Corporation had a “misunderstanding of the regulations” regarding S Corporations and had made disproportionate distributions to some shareholders over others. The S Corporation intended “…to make a distribution to its shareholders to equalize the cumulative amount of per share distributions, including interest, to correct for the distributions made…” during 1995. After determining under the facts that there was only one class of stock in this particular S Corporation, the ruling was that the business under the circumstances should not lose its S Corporation election.4
In another PLR issued on the same day, another S Corporation had made disproportionate distributions to shareholders in order to help the shareholders satisfy their tax liability incurred from the income generated by the S Corporation itself. The disproportionate distributions were made during tax years 1987 through 1991. The S Corporation then made proportional distributions beginning in 1992. In 1994, the S Corporation made equalizing distributions to compensate for the distributions made during the years 1987 through 1991. Again, the IRS ruled here that because the corporation had only one class of stock with equal rights to distributions, in the end the distributions made had not adversely impacted the S status of the corporation.5
So going back to our initial example, may we conclude that TJ Engineering may make the disproportionate distributions to satisfy the desires of both shareholders? In short, yes, but only so long as corrective distributions are made afterwards, and so long as the disproportionate distributions are not made pursuant to any contract, shareholder agreement, or other binding document that would go so far as to suggest that shareholders have differing rights to any distributions from the S Corporation.
The overall lesson to be learned through all this is fairly simple: disproportionate distributions should be avoided, but having them for a time will not necessarily result in termination of the S Corporation’s election, so long as they’re not permanent. Differences in distributions for the sake of facilitating necessary payments to some shareholders and timing differences for other legitimate purposes won’t ruin the election, but every caution should be taken to make sure that, in the end, any disproportionate distributions are later corrected with equalizing distributions. Furthermore and for the sake of conservatism, it’s best if S Corporations avoid disproportionate distributions where possible. The standard procedure for the majority of S Corporations should be to make only distributions that are proportional to each shareholder’s ownership interest.