S Corporation Distributions

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A distribution from an S corporation is tax-free to the extent of the shareholder’s stock basis, and that is the whole rule for a corporation that has always been an S corporation. The complications come from two directions: the shareholder who takes out more than basis, which is a capital gain that often goes unreported because nobody computed basis; and the corporation that used to be a C corporation and still has earnings and profits, where a distribution can be an ordinary dividend even though the S election is years old.

This page is the distribution procedure: the shareholder-level test, the corporate-level accounts, the order they apply in, and the two side issues that recharacterize distributions as something else entirely (loans that aren’t loans, and distributions that aren’t proportionate).

Step 1: The Shareholder Test

For every shareholder, every year, before anything at the corporate level.

• Begin with stock basis at the start of the year (Form 7203 Part I, prior year ending).
• Add current-year income items (§1367(a)(1)) first, including tax-exempt income.
• Subtract distributions. To the extent of basis, tax-free (§1368(b)(1)); the excess is gain from the sale or exchange of stock (§1368(b)(2)): capital gain, long-term if the stock has been held over a year, reported on Form 8949 / Schedule D with no 1099.
• Then nondeductible expenses, then losses, as in the ordering rules.
• Debt basis does not shelter distributions. A shareholder with zero stock basis and $50,000 of debt basis who takes a $20,000 distribution has $20,000 of capital gain. (Debt basis absorbs losses, not distributions.)
• Distributions are tested against basis for the whole year, not on the date paid; a January distribution against zero basis is sheltered by December income (Reg. §1.1368-1(e)).

This is where the unreported gain lives: a shareholder in a loss year who kept taking the same monthly draw. The corporation’s books show a distribution; the K-1 box 16 code D shows it; the 7203 shows basis gone to zero in July; and the 1040 shows nothing because the preparer never ran Part I.

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Step 2: The Corporate Accounts

Account	What it is	Where it comes from
AAA (accumulated adjustments account, §1368(e)(1))	The corporation’s cumulative taxable income less losses, deductions and distributions during S years; tax-exempt income and related expenses excluded	Schedule M-2 column (a). Corporate-level, not per shareholder; can go negative from losses but not from distributions
PTI (previously taxed income)	Undistributed S income from pre-1983 S years	Rare; per shareholder
E&P (accumulated earnings and profits, §1362(d)(3), §1368(c))	C corporation earnings never distributed, carried into the S years; also E&P inherited in a reorganization	The C-year returns and a §312 computation; Schedule M-2 doesn’t track it; the preparer must
OAA (other adjustments account)	Tax-exempt income (municipal interest, life insurance proceeds, forgiven PPP loans) less related nondeductible expenses	Schedule M-2 column (b); distributed after AAA and E&P

A corporation that has been an S corporation since formation and has never acquired a C corporation has no E&P, and for it the corporate accounts are bookkeeping: every distribution is tested against shareholder basis alone. AAA still has to be computed (Schedule M-2 is required when the corporation’s receipts or assets exceed $250,000, and worth doing always), because it matters the day the corporation acquires E&P or terminates its election.

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Step 3: The Ordering Rule

For a corporation with E&P, §1368(c) governs:

1. Distributions come first from AAA: tax-free to the extent of basis, capital gain beyond basis (same as Step 1).
2. Then from PTI, if any: tax-free.
3. Then from E&P: an ordinary dividend (qualified, if the holding-period rules are met), taxable regardless of basis, reported on Form 1099-DIV by the corporation. Basis is not reduced.
4. Then from OAA and remaining basis: tax-free to basis, gain beyond.

AAA is allocated among distributions during the year pro rata if total distributions exceed AAA (Reg. §1.1368-2(b)). If the year shows a net negative adjustment (losses exceed income), AAA is reduced for distributions before the net loss (§1368(e)(1)(C)), which preserves AAA for distributions in a loss year; this is the opposite of the shareholder basis ordering and is a frequent source of confusion.

Elections (Reg. §1.1368-1(f)), made by attaching a statement with the consent of all shareholders who received distributions:

• §1368(e)(3), distribute E&P first. Used to purge E&P deliberately: a small E&P balance that exposes the corporation to the §1375 passive investment income tax (and termination under §1362(d)(3) after three consecutive years) can be distributed as a dividend on purpose, at qualified-dividend rates, to end the problem.
• Deemed dividend election. Treat E&P as distributed and recontributed with no cash moving; same purpose when the corporation has no cash.
• Forgo PTI. Rare.

Check for E&P exposure whenever the corporation has rents, royalties, interest or dividends exceeding 25% of gross receipts (§1375 tax at the corporate rate on excess net passive income; §1362(d)(3) termination after three consecutive years with E&P and excess passive income). The cure is a §1368(e)(3) distribution before the third year closes.

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Step 4: Schedule M-2

• Column (a) AAA: beginning balance, ordinary income, other additions, losses and other reductions (nondeductible expenses other than those related to tax-exempt income go here), distributions, ending balance.
• AAA can be negative from losses. Distributions cannot take it below zero; if beginning AAA is $10,000 and distributions are $40,000, AAA goes to zero and the $30,000 excess is tested against E&P, then OAA, then basis.
• AAA is not basis. It diverges from any shareholder’s basis whenever stock has been purchased from another shareholder (buyer’s basis is cost; AAA is unchanged), when stock is inherited (basis steps up; AAA doesn’t), and when a shareholder lends money (debt basis; no AAA effect). The common error is using AAA ÷ ownership percentage as basis.
• Column (b) OAA: tax-exempt income and the expenses related to it; PPP forgiveness and the related expenses went here by Rev. Proc. 2021-48/49 for the years involved.
• Column (c) PTI: almost always blank.
• Schedule M-2 does not reconcile to retained earnings on Schedule L for most corporations; book-tax differences (depreciation, the 50% of meals, accrued but unpaid officer bonuses) make them diverge. Keep a reconciliation in the workpapers so the question has an answer.

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Step 5: Loans to Shareholders

Money that leaves the corporation labeled “loan to shareholder” is a distribution if it isn’t a loan. The factors (from Fin Hay Realty, Roth Steel Tube, and the S corporation cases that apply them): a written note, a stated interest rate at or above the applicable federal rate, a fixed maturity, actual repayments on schedule, security, the shareholder’s ability to repay, and whether the “loan” balance tracks the owner’s living expenses. A $120,000 receivable that grows every year, carries no interest, and has never been repaid is a distribution in the year of each advance, with the capital-gain consequence above when basis is gone.

If the loan is real, below-market interest triggers §7872: imputed interest is a deemed distribution (the forgone interest) and deemed interest income to the corporation, with a $10,000 de minimis exception for compensation-related and corporation-shareholder loans where tax avoidance is not a principal purpose. Charge the AFR and the issue disappears.

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Step 6: Disproportionate Distributions

An S corporation may have only one class of stock (§1361(b)(1)(D)), meaning all shares confer identical rights to distribution and liquidation proceeds (Reg. §1.1361-1(l)(1)). Distributions that are not proportionate to ownership are evidence that the governing documents or a binding agreement create a second class, which terminates the election. The regulations look to the governing provisions (articles, bylaws, shareholder agreements, state law), not to whether a particular year’s distributions happened to be uneven; a timing difference, or a distribution made to one shareholder and caught up to the other soon after, does not create a second class (Reg. §1.1361-1(l)(2)(i)). Rev. Proc. 2022-19 lets a corporation self-correct certain disproportionate distributions and non-identical governing provisions without a private letter ruling.

At the desk: distributions should be proportionate to shares during the year; if one shareholder needs more, pay it as salary or bonus (compensation can differ) or as a documented loan at AFR; if a disproportionate distribution has already happened, equalize it within the year and document that the governing documents require proportionality.

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A Worked Example

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Property Distributions

A distribution of appreciated property (a vehicle, real estate, equipment) is treated as a sale by the corporation at fair market value (§311(b), applied through §1371(a)): the gain passes through to all shareholders on the K-1, increases their basis, and the distributee takes the property at fair market value. Depreciation recapture under §1245 is ordinary income. A distribution of property that has declined in value produces no loss to the corporation (§311(a)); sell it instead and distribute the cash. The amount of the distribution for the basis and AAA tests is the property’s fair market value, reduced by any liability the shareholder assumes.

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Questions at the desk

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Written for the Tax Shop desk; figures are for the 2026 tax year as currently published. Items marked (verify) are to be confirmed against primary sources before the figures freeze in December. Last updated October 16, 2026.