Distribution in Specie: Corporate, Trust, and Partnership Rules

A distribution in specie is a transfer of the asset itself rather than cash, and the tax on it depends almost entirely on what kind of entity is handing the asset over. Corporations are generally treated as if they sold the property at fair market value and must recognize gain. Trusts and estates default to a no-gain, carryover-basis transfer unless the fiduciary elects otherwise. Partnerships usually recognize nothing at all. On the receiving side, the recipient’s basis and taxable income are driven by the same rules, with the property’s fair market value on the distribution date as the pivot number for both sides.

Corporate Distributions

C-Corporations: Gain Yes, Loss No

A C-corporation that distributes appreciated property to a shareholder outside of a complete liquidation must recognize gain as though it sold the asset at fair market value on the distribution date.¹ Stock with a $50,000 basis and a $200,000 fair market value produces $150,000 of recognized gain on the corporation’s Form 1120.

Losses do not work the same way. If the distributed property has dropped below its basis, the corporation cannot recognize the loss. It simply disappears.¹ A company sitting on depreciated property gets no tax benefit from pushing it out to shareholders in kind.

On the shareholder’s side, the distribution’s fair market value is treated first as a taxable dividend to the extent of the corporation’s current and accumulated earnings and profits. Any excess reduces the shareholder’s stock basis. Anything beyond both earnings and profits and remaining stock basis is taxed as a capital gain.²

The shareholder’s basis in the received property is its fair market value on the distribution date, no matter which tier the distribution falls into. The holding period starts the day after the distribution. The dividend portion is reported on Form 1099-DIV and may qualify for the lower qualified dividend rate if the usual holding period requirements are met.³

S-Corporations: The Gain Spreads to Everyone

S-corporations recognize gain on in-kind distributions of appreciated property the same way C-corporations do. The difference is who pays. Because the S-corporation is a pass-through, the recognized gain flows through to every shareholder according to ownership percentage, not just the one receiving the asset. Each shareholder picks up a proportionate share on their Schedule K-1.⁴

Picture an S-corporation with three equal owners distributing a $300,000 property with a $100,000 basis to one of them. All three shareholders report roughly $66,667 of gain on their individual returns, even though only one of them actually ends up with the property. The shareholder who received the property takes a fair market value basis in it. Losses on depreciated property are disallowed, just as with C-corporations.

Complete Liquidations Are Different

If the distribution is part of a complete liquidation, the loss-disallowance rule disappears. A liquidating corporation recognizes both gains and losses on distributed property as if each asset were sold at fair market value to the shareholder.⁵ The shareholder takes a fair market value basis in the property received.

For a company winding down, this changes the math on depreciated assets. Distributing them in kind during liquidation preserves the loss deduction at the entity level. Doing the same thing outside of liquidation does not.

Trust and Estate Distributions

Carryover Basis by Default

Trusts and estates do not follow the corporate rule. By default, when a trust or estate distributes property in kind, no gain or loss is recognized at the entity level. The beneficiary takes the property with the same basis the trust or estate had.⁶ Stock the trust bought for $20,000 that is now worth $80,000 goes to the beneficiary carrying its $20,000 basis and the $60,000 of built-in gain.

The amount that counts toward distributable net income under this default is the lesser of the carryover basis or the property’s fair market value. DNI governs how much the trust can deduct and how much the beneficiary must include in gross income. The beneficiary reports their share on Schedule K-1 (Form 1041).⁷

The Fiduciary’s Section 643(e) Election

The fiduciary can override the default and treat the distribution as if the trust or estate sold the property at fair market value. The election applies to every in-kind distribution the entity makes during that tax year, and once made it cannot be revoked without IRS consent.⁶ It is made by checking a box on Form 1041.⁸

When the fiduciary elects, the trust or estate pays tax on the gain and the beneficiary gets a stepped-up basis equal to fair market value. The amount counted toward DNI also moves up to fair market value instead of the lower carryover basis. In the earlier example, the trust would recognize $60,000 of gain, the beneficiary would take an $80,000 basis, and the full $80,000 would count toward DNI.

Whether to elect is a real planning decision. If the trust sits in a lower tax bracket than the beneficiary, recognizing the gain at the entity level costs less in total tax. If the beneficiary plans to hold the asset for years, starting with the higher basis means a smaller gain down the road. Form 1041 is due by the fifteenth day of the fourth month after the entity’s tax year closes.⁹

Property Inherited From a Decedent

Property passing from a decedent gets a separate rule that overrides the carryover-basis default. The basis of property acquired from a decedent is generally the fair market value at the date of death, not the decedent’s original cost.¹⁰ Stock the decedent bought for $10,000 and worth $250,000 at death gives the beneficiary a $250,000 basis. The $240,000 of lifetime appreciation is never taxed to anyone.

Inherited property also carries an automatic long-term holding period, regardless of how quickly the beneficiary sells.¹¹ Selling the week after a funeral still qualifies for long-term capital gains rates.

Partnership Distributions

Partnerships are the gentlest entity type for in-kind distributions. When a partnership distributes property other than cash to a partner, neither side generally recognizes gain or loss.¹² The partner takes a carryover basis in the property, derived from their basis in the partnership interest, and that partnership interest basis drops accordingly.

One significant exception: marketable securities are treated as cash for purposes of determining whether a partner recognizes gain. If the fair market value of distributed marketable securities exceeds the partner’s remaining basis in the partnership interest, the excess is recognized as gain.¹² The rule exists to stop partners from using liquid-security distributions as a backdoor way to pull out cash-equivalent value tax-free.

Employer Stock From a Retirement Plan: NUA

Taking employer stock out of a qualified retirement plan in kind opens a strategy that is not available for cash distributions. When you take a lump-sum distribution that includes employer securities, the net unrealized appreciation on those shares can be excluded from gross income at the time of distribution.¹³ You pay ordinary income tax only on the cost basis of the shares, meaning what was originally paid for them inside the plan.

The appreciation that built up while the stock was inside the plan is taxed as a long-term capital gain whenever you eventually sell, no matter how long you hold the shares after the distribution.¹⁴ Any further appreciation after the distribution date follows normal rules: long-term if held more than a year, short-term if held a year or less.

The savings come from the spread between ordinary income rates and long-term capital gains rates. For 2026, the top ordinary rate is 37% and the maximum long-term capital gains rate is 20%. On $500,000 of employer stock with a $50,000 cost basis, the NUA route taxes $50,000 as ordinary income now and $450,000 as long-term capital gain when sold. Rolling the same stock into an IRA and later withdrawing it would tax the entire $500,000 as ordinary income. The strategy is not always the right call, particularly when the cost basis is high relative to the stock’s value, but when the numbers favor it the savings are substantial.

Valuation and the Penalty for Getting It Wrong

Every in-specie distribution rests on a fair market value as of the exact distribution date. For publicly traded securities, that is the closing price on the date of transfer. For real estate, it means a qualified appraisal from an independent appraiser following generally accepted standards.¹⁵ Closely held business interests need a business valuation specialist using recognized methodologies.

Misstating fair market value exposes both sides to accuracy-related penalties. If the value reported on a return is off by enough to be a substantial valuation misstatement, the IRS can impose a penalty equal to 20% of the resulting tax underpayment.¹⁶ If the misstatement is severe enough to count as a gross valuation misstatement, the penalty doubles to 40%.

For property distributions, a substantial valuation misstatement generally means the reported value is 150% or more of the correct value, or 50% or less, depending on direction. A gross misstatement raises the threshold to 200% or drops it to 25%. The penalty cuts both ways. An entity overvaluing property to inflate its deduction faces the same risk as a recipient understating value to shrink an income inclusion. Independent, well-documented appraisals are the practical defense.¹⁶

1
Office of the Law Revision Counsel. 26 U.S. Code 311 – Taxability of Corporation on Distribution
2
Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property
3
Internal Revenue Service. Instructions for Form 1099-DIV
4
Internal Revenue Service. Property Distribution – S Corporation Practice Unit
5
Office of the Law Revision Counsel. 26 U.S. Code 336 – Gain or Loss Recognized on Property Distributed in Complete Liquidation
6
Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
7
Internal Revenue Service. Schedule K-1 (Form 1041) – Beneficiary’s Share of Income, Deductions, Credits, etc.
8
Internal Revenue Service. Instructions for Form 1041 and Schedules A, B, G, J, and K-1
9
Internal Revenue Service. Forms 1041 and 1041-A: When to File
10
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
11
Office of the Law Revision Counsel. 26 U.S. Code 1223 – Holding Period of Property
12
Office of the Law Revision Counsel. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution
13
Office of the Law Revision Counsel. 26 USC 402 – Taxability of Beneficiary of Employees Trust
14
Internal Revenue Service. Notice 98-24: Net Unrealized Appreciation in Employer Securities
15
eCFR. 26 CFR 1.170A-17 – Qualified Appraisal and Qualified Appraiser
16
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments