By: John S. Morlu II, CPA
S corporations operate under a unique set of rules, one of which is that distributions of profits to shareholders must be made pro rata—in direct proportion to each shareholder’s ownership stake in the corporation. While this sounds straightforward, situations can arise where distributions are unequal, or disproportionate, creating potential tax and legal complications. Let’s dive deeper into what disproportionate distributions mean, why they matter, and how S corporations can address these issues while staying compliant.
The Rule: Pro Rata Distributions
A fundamental characteristic of S corporations is that they have only one class of stock. This means that all shareholders own shares with identical rights to distributions and liquidation proceeds. To ensure fairness and compliance with this rule, distributions must be proportional to ownership percentages.
For example, if an S corporation has three shareholders—one owning 50% of the stock, another owning 30%, and the third owning 20%—the total distribution must be split according to these ownership percentages. If one shareholder receives more or less than their share, it could raise concerns about the integrity of the corporation’s tax status.
If an S corporation makes disproportionate distributions, it risks violating the one-class-of-stock rule, potentially leading to the loss of its S election. Losing the S election can result in the corporation being taxed as a C corporation, which carries different tax implications.
The Logic Behind the Rule
The rule’s logic is simple:
- If all shareholders hold the same type of shares, they should receive the same benefits in proportion to their ownership.
- Disproportionate distributions suggest unequal treatment, which might indicate the presence of multiple classes of stock—a violation of S corporation requirements.
From a practical perspective, equal treatment of shareholders helps maintain trust and prevents disputes, particularly in closely-held S corporations where personal relationships can be as important as financial ones.
What Happens If Distributions Are Disproportionate?
While disproportionate distributions may seem like a serious violation, the IRS provides flexibility in its guidance. The key question is whether the governing provisions of the corporation—its bylaws, operating agreement, or other legal documents—ensure that all shareholders retain equal rights to liquidation and distributions.
- If the governing provisions reflect equal rights, a temporary disproportionate distribution does not automatically create a second class of stock or terminate the S election.
- Correcting Distributions: If an imbalance occurs, the corporation can correct it by issuing additional distributions to underpaid shareholders or by adjusting future distributions.
IRS Guidance and Flexibility
The IRS regulations clarify that timing differences in distributions do not necessarily result in a second class of stock, provided the governing provisions remain compliant.
Example from IRS Regulations
The IRS provides an example where an S corporation made a disproportionate distribution:
- In Year 1, one shareholder received a distribution while another did not.
- To correct this, the corporation made an additional distribution to the second shareholder in Year 2.
The IRS determined that the difference in timing did not create a second class of stock because the corporate bylaws ensured equal liquidation and distribution rights for all shareholders. The correction aligned the distributions with the shareholders’ proportional ownership, preserving the S election.
Why Correcting Distributions Matters
Even though disproportionate distributions don’t always lead to immediate consequences, they can create risks:
1. Tax Implications: Disproportionate distributions could be recharacterized as wages, loans, or other forms of income, potentially resulting in additional taxes or penalties.
2. Shareholder Disputes: Unequal distributions might lead to disagreements or even legal challenges among shareholders, especially if one party feels disadvantaged.
3. S Election Risk: Persistent or uncorrected disproportionate distributions might be seen as a sign of multiple stock classes, jeopardizing the corporation’s S status.
To mitigate these risks, it’s essential to address disproportionate distributions promptly by issuing corrective distributions or adjusting future payments.
Key Takeaways
1. Pro Rata Distributions Are Non-Negotiable: S corporations must distribute profits in proportion to ownership percentages to comply with the one-class-of-stock rule.
2. Governing Provisions Provide a Safety Net: As long as the corporate bylaws ensure equal rights for all shareholders, a temporary disproportionate distribution doesn’t immediately terminate the S election.
3. Corrections Are Crucial: If a disproportionate distribution occurs, the corporation should correct it as soon as possible to prevent complications.
4. Timing Differences Are Allowable: The IRS recognizes that timing differences in distributions can occur, but they should be resolved within a reasonable timeframe.
Final Thoughts
Disproportionate distributions, while potentially problematic, are not the end of the road for an S corporation. By understanding the rules, adhering to corporate bylaws, and addressing any imbalances promptly, S corporations can preserve their tax status, maintain shareholder harmony, and avoid unnecessary tax or legal complications. Ultimately, clear communication and proactive management are the keys to navigating these situations effectively.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
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