S-Corporation distributions in excess of Shareholder Basis

Best Answer - Chosen by the Community

I totally understand the confusion here, I even have it too at times, then I have to get out the ole "journal entry" analysis to fix it in my head. Let's do that here with a simple example and see the effect on S/H Basis, AAA, Bal Sheet accts, and the 1040. I hope I can do this here w/o making somebody mad for my large post.

Let's assume the S Corp is 100% owned, has no other balances, starts business 01/01/08. Has Sales of $100, no expenses, takes a loan out for $1,000, and takes Distributions for $1,100. Journal entries are:

Sales: $100 (Debit) Cash 100 (Credit) Sales (RE) 100

Loan: $1,000 (Debit) Cash 1,000 (Credit) Note Payable 1000

Now the Balance Sheet at this point looks like this:

Cash 1,100 N/P 1,000 RE 100

S/H Basis looks like this: +100 (from Net Profit)

AAA account looks like this: +100 (from Net Profit)

------------------------------------------------------------------------------------------

Then he goes and takes a $1,100 Distribution:

(Debit) Distributions or RE 1,100 (Credit) Cash 1,100

Now the Bal Sheet looks like this: Cash 0 N/P 1,000 RE -1,000

AAA account looks like this: Beg 100 minus Distribution -100 = 0 Balance

(AAA is reduced by S/H Distributions but only to zero, net losses can reduce AAA below 0)

S/H Basis looks like this: Beg Bal 100 minus 100 = 0

(Basis cannot be reduced below 0)

What do we do with that excess 1,000 of distribution below 0? It didn't reflect in the AAA to reduce it below 0 nor did it reflect in the S/H Basis to reduce it below 0. It shows on the personal return Form 1040 Sch D as a "sale of stock" listed as "Dist in excess of basis" and a Capital gain of $1,000. It does NOT affect basis, ie: he still has a 0 basis. I think this is where alot of the confusion comes in, ie: not being able to reduce basis below zero.........yes, I guess you could say his basis is restored to 0 but you didn't take it to a negative anyway so it's irrelevant.

I'd like to add a couple of things here.

1. The "Other Adjustments Account" will NOT be used if the S Corp was never a C Corp. Only if the Corporation had been a prior C Corp with AE&P (accumulated earnings and profits)

2. The AAA account belongs to the Corporation not the Shareholders.

3. Net losses CAN take the AAA below -0- but NOT S/H Distributions.

4. Retained Earnings CAN be negative.

The example above is EXACTLY what we all face with our clients that causes us nightmares....ie: they suck the cash out of their S Corps that's not really proper to suck out.....ie: above the Shareholder in effect took money out of the Corporation that came from where????? THE LOAN!!!!! The results:............the IRS wants that money taxed as an "arms length" transaction of receiving money from an entity separate from the S/H personally and rightfully so.

S-Corporation distributions in excess of Shareholder Basis

If a shareholder of an S-corporation has distributions in excess of the calculated basis how is the cpaital transaction reported on Form 1040.