Avoiding gain when appreciated property is distributed to a shareholder.

Facts

Art and Bob each own 50% of the stock of A&B, Inc., an S corporation since 1985. Each shareholder wants to receive a $20,000 distribution, but the corporation does not have that much available cash. Art suggests that the corporation distribute $20,000 cash to him and a fully depreciated piece of equipment worth $20,000 to Bob. (The equipment originally cost $50,000.) Art and Bob ask their tax adviser for advice.

Issue

Can an S corporation distribute appreciated property in lieu of cash with the same tax effects as a cash distribution?

Analysis

When appreciated property (i.e., property with a fair market value (FMV) in excess of its adjusted basis) is distributed, gain is recognized in the same manner as if the S corporation had sold the property to the shareholder at its FMV. The gain will be passed through to the shareholders and will increase their bases in their stock. In this case, if the equipment is distributed to Bob, the gain will be $20,000, and all of it will be subject to tax as ordinary income (due to depreciation recapture). Art and Bob each will report $10,000 of income from the deemed sale. Bob will be considered to have received a $20,000 distribution, and the tax attributes of the distribution are determined as if the distribution had been made in cash. Bob's basis in the equipment will be its FMV; if he sold it for $20,000. he would experience no gain or loss from the sale.

If the shareholders do not want to report gain from the distribution, they could consider distributing to Bob equipment with a higher basis in relation to its FMV so that gain at the corporate level could be reduced or eliminated. As a general rule, however, assets with basis in excess of FMV should not be distributed to a shareholder because the potential loss cannot be used by either the corporation or the distribute shareholder. The shareholders may also want to consider having the corporation borrow the money and distribute the borrowed funds to Bob and avoid the corporate level gain.

Conclusion

Distribution of the equipment to Bob would cause the corporation to recognize $20,000 of ordinary income. Distribution of an appreciated asset to a shareholder is treated at the corporate level as if the asset had been sold to the shareholder at its FMV. This can cause shareholders other than the distributee shareholder to report gain from the transaction.

Variation 1

Assume the same facts, except that the equipment is distributed to Bob and it has a basis of $25,000. Since the property's FMV is less than its basis, no gain or loss is recognized at the corporate level. The transaction is considered to be a distribution in the amount of the equipment's FMV ($20,000). Distributing property that has not appreciated solves the problem of corporate level gain on distribution, but it creates another problem - deferral of the $5,000 loss that the corporation would recognize if it sold the equipment outright. If Bob later sells the equipment at a gain, he can reduce such gain by the disallowed loss (but not below zero). For purposes of determining depreciation and loss on disposition, Bob's basis in the equipment is $20,000, its FMV.

Variation 2

Assume that A&B has been an S corporation since it was incorporated, and Bob is the sole shareholder. In the current year (1993), the corporation can either distribute $40,000 cash to Bob, or distribute an appreciated asset worth $40,000 but will result in $20,000 of an ordinary income depreciation recapture at the corporate level. Does it matter to Bob whether cash or appreciated assets are distributed?

Since the corporation has always been an S corporation (and has not previously merged with another another corporation), the asset distribution will not create liability for the corporate level built-in gains tax. And, since Bob is the sole shareholder, there is no longer the problem of gain being allocated to other shareholders.

However, the asset distribution results in a passthrough of $20,000 of ordinary income (depreciation recapture), which increases A&B's accumulated assets account (AAA) and stock basis. Since AAA and basis are increased prior to being adjusted for the distribution, the distribution of appreciated property may not cause Bob to recognize additional income. On the other hand, if the AAA and stock basis balances are already sufficient to make the distribution nontaxable, the distribution of the property will result in Bob recognizing income that would not have been recognized if cash had been distributed.