S Corporation Distributions: Basis, AAA, and E&P Ordering Rules

S corporation distributions are generally tax-free to the extent they don’t exceed the shareholder’s adjusted stock basis, and any amount above that basis is taxed as a capital gain. The reason distributions escape a second tax is that S corporation income already flowed through to the shareholder’s individual return and was taxed there, whether or not any cash was paid out. The tax treatment of S corporation distributions gets more complicated when the company converted from a C corporation and still carries old earnings on its books, because the ordering rules then decide how much of a payment is a tax-free return of basis, how much is a dividend, and how much is capital gain.

Pay Reasonable Compensation Before Taking Distributions

Before the distribution rules matter, a shareholder who works in the business has to be paid a reasonable W-2 salary. The IRS requires any shareholder performing services to receive compensation subject to Social Security, Medicare, and federal income tax withholding.¹ Only after that wage is paid can remaining profits be pulled out as distributions, which carry no payroll tax.

There is no formula for what counts as reasonable. The factors include the shareholder’s training, duties, hours devoted to the business, and what similar businesses pay for comparable work.² When the IRS reclassifies distributions as disguised wages, the corporation owes back employment taxes plus penalties and interest. The point is worth stating clearly because distribution planning does not begin until the wage question is settled.

Stock Basis Decides Whether a Distribution Is Taxable

The taxability of every distribution turns on one number: the shareholder’s adjusted stock basis. Basis is the shareholder’s after-tax investment in the corporation. It starts with the price paid for the stock or the amount contributed, then rises with allocated income and falls with losses, nondeductible expenses, and distributions.³

A distribution that does not exceed stock basis is a tax-free return of investment and reduces basis dollar-for-dollar. Anything above basis is a capital gain, long-term if the shares have been held more than a year.⁴

Shareholders carry the burden of proving basis. In Maloof v. Commissioner, the Sixth Circuit held that a shareholder must show an actual economic outlay and that guaranteeing a corporate loan does not create stock or debt basis.⁵ Without verifiable records, the IRS can treat what the shareholder called a tax-free distribution as a taxable gain. Keeping a running ledger of contributions, income and loss allocations, and distributions is how you defend the position.

The Order of Annual Basis Adjustments

Within a single tax year, the sequence of basis adjustments changes the result. Treasury regulations require this order:⁶

Increase basis first for the shareholder’s share of taxable and tax-exempt income.
Reduce basis next for distributions.
Reduce basis for nondeductible expenses.
Reduce basis last for losses and deductions.

Because income is added before distributions are subtracted, a distribution taken in a profitable year is more likely to fit inside basis and stay tax-free. If losses came first, they could zero out basis and push an otherwise safe distribution into capital gain. Shareholders can elect to apply losses before nondeductible expenses by attaching a statement to a timely filed return, but that election binds future years unless the IRS lets you undo it.⁶

Debt Basis Does Not Help With Distributions

Shareholders sometimes assume a loan they made to the corporation cushions distributions. It does not. Debt basis, created when a shareholder lends money directly to the corporation, exists only to let the shareholder deduct losses that exceed stock basis, up to the outstanding loan amount.⁴ When testing whether a distribution is taxable, only stock basis counts. A shareholder with zero stock basis and $50,000 of debt basis still owes capital gains tax on any distribution.

Stock and debt basis are both reported on Form 7203 with the shareholder’s personal return.⁷

Distributions From an S Corporation With No C Corporation History

For the typical small S corporation that has never been a C corporation, the rule has two steps:

The distribution is tax-free up to the shareholder’s stock basis and reduces basis dollar-for-dollar.
Any amount above stock basis is a capital gain, taxed at long-term rates of 0%, 15%, or 20% if the shares have been held more than a year.⁴

A worked example: a shareholder with $40,000 of stock basis who receives a $55,000 distribution treats $40,000 as tax-free, reports $15,000 as a capital gain, and ends the year with zero stock basis. The shareholder’s share of corporate income is reported on Schedule K-1 (Form 1120-S) and picked up on the individual return.⁸

Distributions When the Corporation Has Accumulated E&P

A corporation that was a C corporation before electing S status may still carry accumulated earnings and profits from those C years. Those profits were taxed at the corporate level but never at the shareholder level, so the code treats them differently from S corporation income. Section 1368(c) sets the ordering.⁹

The corporation tracks the source of S corporation earnings in its Accumulated Adjustments Account (AAA), a corporate-level account adjusted much like stock basis except that tax-exempt income is excluded. Tax-exempt items flow to a separate Other Adjustments Account.⁹ AAA can go negative when losses outstrip income. It is reported on Schedule M-2 of Form 1120-S.¹⁰

Tier One: AAA Distributions

The first slice of any distribution comes out of AAA. That slice is tax-free up to the shareholder’s stock basis, with any excess taxed as capital gain. This is the same treatment as a distribution from a corporation with no E&P.⁹

Tier Two: Dividends From Accumulated E&P

Once AAA is used up, the next slice is a dividend, up to the remaining accumulated E&P balance. These dividends generally qualify for the preferential qualified dividend rates of 0%, 15%, or 20%, depending on the shareholder’s income.¹¹ The corporation reports the dividend portion on Form 1099-DIV; only this tier is reported on that form.¹²

Tier Three: Remaining Distributions

After AAA and accumulated E&P are drained, anything left follows the basic two-step rule: tax-free to the extent of remaining stock basis, capital gain above it.¹³ The Other Adjustments Account helps identify amounts sourced from tax-exempt income at this stage.

Electing to Distribute E&P First

Section 1368(e)(3) lets the corporation flip the default order and treat distributions as coming from accumulated E&P before AAA. Shareholders sometimes want this, for instance to eliminate accumulated E&P and escape the passive investment income tax under Section 1375. The election is made by a statement attached to a timely filed return (original or amended), needs the consent of every shareholder, applies only to the year of election, and is irrevocable for that year.⁹

Distributions of Property Instead of Cash

When the corporation distributes appreciated property, it is treated as having sold that property to the shareholder at fair market value. The corporation recognizes gain, that gain passes through to shareholders and increases their stock basis, and the receiving shareholder takes the property with a basis equal to fair market value.¹⁴

The rule is one-sided. The corporation recognizes gains on distributed property but cannot recognize losses.¹⁵ When several properties are distributed together, gain items still trigger gain, and loss items are simply disallowed rather than netted.¹⁴ Selling the depreciated asset and distributing the cash typically produces a better result than distributing the property.

Built-in Gains Tax for Converted Corporations

A corporation that converted from C to S status faces one more issue when it disposes of assets it held on the conversion date. If an asset had a built-in gain at conversion (fair market value above tax basis on the first day of S status) and the corporation sells or distributes it, the corporation itself owes a corporate-level tax on that gain at the top corporate rate, currently 21%.¹⁶¹⁷

The tax applies only during a five-year recognition period beginning on the first day of S corporation status.¹⁶ The gain also passes through to shareholders under the normal S corporation rules, so the built-in gains tax sits on top of that pass-through, not in place of it. For a C-to-S conversion with significant appreciated assets, timing dispositions until after the five-year window is one of the largest planning levers available.

Distributions After the S Election Ends

If the S election is revoked or lost, the corporation does not immediately switch to full C corporation dividend treatment for every dollar paid out. A post-termination transition period runs generally for one year after the last day of the final S corporation tax year, or until the extended due date for that final return, whichever is later.¹⁸

Cash distributed during that window is treated as a tax-free return of stock basis to the extent of remaining basis from the S years. It is the last chance to pull out previously taxed S corporation earnings without dividend treatment. When the transition period ends, any remaining AAA balance loses its shielding effect and later distributions are taxed under standard C corporation rules.

1
Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers
2
Internal Revenue Service. Wage Compensation for S Corporation Officers (FS-2008-25)
3
Office of the Law Revision Counsel. 26 USC 1367 – Adjustments to Basis of Stock of Shareholders, Etc.
4
Internal Revenue Service. S Corporation Stock and Debt Basis
5
FindLaw. Maloof v. Commissioner of Internal Revenue
6
eCFR. 26 CFR 1.1367-1 – Adjustments to Basis of Shareholder’s Stock in an S Corporation
7
Internal Revenue Service. Instructions for Form 7203
8
Internal Revenue Service. Shareholders Instructions for Schedule K-1 (Form 1120-S)
9
Office of the Law Revision Counsel. 26 USC 1368 – Distributions
10
Internal Revenue Service. Instructions for Form 1120-S – Section: Schedule M-2
11
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
12
Internal Revenue Service. Instructions for Form 1099-DIV
13
Internal Revenue Service. Distributions with Accumulated Earnings and Profits (Practice Unit SCO-T-008)
14
Internal Revenue Service. S Corporation Distributions of Property
15
Office of the Law Revision Counsel. 26 USC 311 – Taxability of Corporation on Distribution
16
Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-in Gains
17
Office of the Law Revision Counsel. 26 USC 11 – Tax Imposed
18
eCFR. 26 CFR 1.1377-2 – Post-Termination Transition Period