What are the tax consequences if a corporation distributes property?
The corporation does not recognize gain when it distributes cash to its shareholders. Also when a shareholder in exchange for cash, redeems a corporation stock, the corporation recognizes no gain. (Sec. 311(a)). On the other hand, if a corporation distributes property in connection to stock redemption, this may result in corporate-level capital gain and/or ordinary income.
Generally a corporation will recognize capital gains when it distributes capital assets or Sec 1231 assets. So what happens if a corporation (C Corp or S Corp) distributes property or stock other than cash to a departing shareholder? The corporation will recognized gain (not loss) if the fair market value (FMV) of the property exceeds its adjusted cost basis (Sec. 311(b)(1)). The depreciation recapture of certain capital assets will trigger ordinary income and/or special unrecaptured sec. 1250 gain that is subject to 25% capital gain tax. Basically the non-cash distribution is treated as if the corporation (C Corp or S Corp) had sold that property to the exiting shareholder. This taxable transaction is reported on Form 1099-DIV and Form 5452.
Unfortunately, a corporation (C Corp or S Corp) cannot recognize any losses on a distribution of appreciated property (i.e., where the property’s FMV is less than the adjusted cost basis). Although a corporation is allowed to recognize tax losses when depreciated property is distributed to shareholders in complete liquidation of the corporation (Sec. 311(a)).
At the shareholder level the stock redemption or non-cash distribution can result in a variety of tax consequences: taxable dividends or capital gain taxes.
Lets illustrate the above in an example. Lets say XYZ Inc (S Corp) has three unrelated shareholders. Each shareholder owns 100 shares of XYZ Inc stock @ $100 per share. (Total shares issued by the corporation are 300). XYZ Inc also owns 2 separate pieces of land. One in NJ with adjusted cost basis of 5K and one in NY with adjusted cost basis of 7K. After 5 years, one of the shareholders wants to leave the corporation and requests the corporation to buy back his 100 shares for 12K. The XYZ Inc has only 7K in cash and it needs to come up with additional 5K. The XYZ Inc offers the departing shareholder NJ peace of land to cover the 5K shortfalls. The FMV of the NJ land is 8K. The shareholder accepts the offer and receives 4K in cash and NJ land. In the above scenario, by distributing the property to the shareholder, the XYZ Inc will recognized 3K in capital gain (8K FVM – 5K cost basis). The shareholder will recognize 2K long-term capital gain upon redemption of his stock (12K stock value (8K FMV of land+4K Cash) – 10K stocks cost basis)).
As you can see the corporation is taxed on the difference between fair market value and cost basis of the distributed appreciated property and the shareholder is taxes on the fair market value of the appreciated property received. This is a good example of double taxation on the corporate level and on the individual level. The better solutions for the corporation would have been to borrow 5K to cover the balance.Posted in:Business Tax ArticlesThis article was written by TaxBizPro, LLC 2023, all rights reserved ©.
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