Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.
Instead of paying a dividend (in the case of a C corporation) or a distribution (for an S corporation) in cash, you may be tempted to distribute property (car, computer, etc.) out of the corporation. Resist the temptation. It could prove costly. As a shareholder/owner you may think it's your property, but it's not. It really belongs to the corporation. In addition, a distribution can affect your basis in the corporation.
Appreciated Property, S Corporation
If an S corporation distributes appreciated property to its shareholders, the difference between the fair market value and the property's basis will result in a gain that will be passed through to the shareholders.
Example--Madison Inc. (an S corporation) owns a truck that was purchased for $20,000. The truck has been depreciated so that is adjusted basis for tax purposes is now $2,500. the truck has a fair market value of $12,500. Madison distributes the truck to its sole shareholder. Madison must recognize a $10,000 gain (all ordinary income). The gain is passed through to the shareholder and has to be reported on his tax return.This can get messier if there's more than one shareholder. In that case the gain is income to the other shareholders as well, based on share ownership. Of course, if the corporation should the asset and distributed the cash to the shareholder, the result would be the same.
Appreciated Property, C Corporation
The result would be similar if Madison is a regular corporation, except that the tax would have to be paid at the corporate level. However, in this case there would be a second tax at the shareholder level. Thus, the shareholder would report the $12,500 dividend (the fair market value) on his personal return and pay tax a second time.
Not only may there be a double tax, the combined tax may be so much that you may create cash flow problems paying the tax.
There's another problem, common to both regular and S corporations. That's one of valuation. Even with an appraisal, the IRS could argue the property's fair market value was higher. Winning such an argument can be difficult and costly. The problem is considerably diminished if the asset is easily valued. For example, an auto or truck (you can use a blue book), marketable securities, etc.
Distributing depreciated property may be worst than distributing appreciated property. the value of the distribution or dividend will be the fair market value of the property, but the company will get no benefit for the loss. The shareholder's basis in the property is the property distributed is the fair market value. That's an problem if the shareholder wants to use the property in another business.
Example--Madison Inc. distributes a car to its shareholder, Fred Flood. Madison bought the car for $30,000. The tax basis (cost less depreciation) is $26,840, but the fair market value is $20,000. The value of the dividend is $20,000. Madison gets no benefit for the loss. Fred uses the care in another business. His basis for depreciation is only $20,000.Could things get worse? Sure. Assume Madison distributes two assets at the same time--a truck that had a fair market value of $10,000 more than its tax basis (cost less depreciation), and a car with a fair market value of $10,000 less than its tax basis. You can't net the two. Thus, Madison would have a $10,000 taxable gain on the truck and a $10,000 nondeductible loss on the car.
If you want to get rid of loss property, the best approach is to have the corporation sell the property, then distribute the cash. That way the corporation (or the shareholders in an S corporation) can get the tax benefit of the loss. Moreover, the sale of business assets at a loss generally produces ordinary loss.
Selling the property and distributing the cash may also make sense in the case of appreciated property since you avoid any arguments over the fair market value of the assets and you'll have the cash to pay any taxes.
If your real intention is to transfer property from one entity to another, things can get more complicated. Selling the asset to the other company may not be the answer. Losses between related entities can be disallowed. Simply transferring the property will generally be deemed to be a dividend (or distribution) from the company to the shareholders followed by a capital contribution to the new company. That can create some additional problems. There may be some other options. Check with your tax adviser. Be sure to explain exactly what you want to do and give him or her all the facts.
We didn't discuss the problems you might have with an S corporation if there are built-in gains. (That's when the S corporation was a C corporation when the asset was purchased and it appreciated in value.) That's another complex issue. We've also simplified the discussion by ignoring property that's encumbered by a loan.
Remember that any distribution will reduce your basis in an S corporation. Making a large property distribution is so easy you could end up reducing your basis to below zero. That will generate capital gain and restrict your deduction for losses generated by the corporation.
The rules discussed above apply to nonliquidating distributions. If you're liquidating the company, you can generally recognize a loss.
We haven't discussed partnerships and LLCs taxed as partnerships because the rules can be much more involved. They can also create complexities in accounting for partnership basis and capital. Distributions can also have unintended consequences on the other partners. Consult your tax adviser before making any distributions of property from a partnership or LLC.
Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 09/29/14