Business Entities · S corporations

Non-cash distributions

A distribution of property runs through two separate provisions in sequence, and reversing them is the commonest way to get the answer wrong. First the corporation is treated as having sold the property. Only then is the distribution itself measured and characterised.

The rule

Subchapter C reaches an S corporation. except as otherwise provided in title 26 and except to the extent inconsistent with subchapter S, subchapter C applies to an S corporation and its shareholders — so the corporate distribution, redemption, liquidation and reorganisation rules reach an S corporation unless subchapter S displaces them (IRC § 1371(a))^TY2026 (IRC § 1371(a)). Nothing in subchapter S displaces IRC § 311, so it applies in full.

Appreciated property is a deemed sale. where a corporation distributes property other than its own obligation with respect to its stock and the fair market value exceeds the adjusted basis in the hands of the distributing corporation, gain is recognised to the corporation as if the property were sold to the distributee at fair market value^TY2026 (IRC § 311(b)(1)). The gain is an item of the corporation, so it passes through under IRC § 1366(a) and increases stock basis under IRC § 1367(a)(1) like any other gain — and it is characterised at the corporate level under IRC § 1366(b) by the nature of the property in the corporation’s hands.

Depreciated property is not. except for the appreciated property rule, no gain or loss is recognised to a corporation on a distribution with respect to its stock, other than in complete liquidation — so a loss on depreciated property is never recognised^TY2026 (IRC § 311(a)). The loss is not deferred, not suspended and not carried over. It is gone.

The amount of the distribution. the amount of the distribution is the money received plus the fair market value of the other property received, determined as of the date of the distribution^TY2026 (IRC § 301(b)(1), (b)(3)), and the amount is reduced, but not below zero, by any liability of the corporation assumed by the shareholder in connection with the distribution and by any liability to which the property is subject immediately before and immediately after it^TY2026 (IRC § 301(b)(2)). Where a liability is involved there is a floor: where distributed property is subject to a liability or the shareholder assumes one, the fair market value of the property is treated as not less than the amount of that liability^TY2026 (IRC § 336(b), applied by IRC § 311(b)(2)).

Then characterise it. The net amount is a distribution to which IRC § 1368 applies: the distribution is not included in gross income to the extent it does not exceed the adjusted basis of the stock, and any excess is treated as gain from the sale or exchange of property^TY2026 (IRC § 1368(b)) or where an S corporation has accumulated earnings and profits, a distribution is applied first against the accumulated adjustments account and treated as a return of basis then gain; then as a dividend to the extent of the accumulated earnings and profits; and any remainder is again treated as a return of basis then gain (IRC § 1368(c))^TY2026 (IRC § 1368(c)).

The shareholder’s basis in what they received. the shareholder's basis in property received in a distribution is the fair market value of the property^TY2026 (IRC § 301(d)) — the full fair market value, undiminished by any liability that reduced the amount of the distribution.

Current figures

How it works in practice

Take the two steps in order. The deemed sale under IRC § 311(b)(1) comes first, and its consequences are complete before the distribution is characterised. That sequence is what makes the arithmetic work: the gain increases stock basis under IRC § 1367(a)(1) and increases the accumulated adjustments account under Reg. § 1.1368-2(a)(2), and only then is the distribution measured against those larger figures under Reg. § 1.1368-2(a)(5). A candidate who characterises the distribution first will understate basis and the account by the amount of the gain and reach a different answer.

The gain is real but usually costless. In a corporation with no accumulated earnings and profits, the deemed sale produces gain that the shareholders report, basis that rises by the same amount, and a distribution that is then a tax-free recovery of that enlarged basis. The net effect is a single layer of tax on the appreciation — which is the point of subchapter S. The tax is not avoided; it is accelerated to the year of the distribution rather than the year of an eventual sale.

The loss disallowance has no such symmetry. except for the appreciated property rule, no gain or loss is recognised to a corporation on a distribution with respect to its stock, other than in complete liquidation — so a loss on depreciated property is never recognised^TY2026 (IRC § 311(a)). Distributing property worth less than its basis gives the corporation no deduction, gives the shareholders no pass-through loss, and resets the shareholder’s basis in the property to the lower fair market value under IRC § 301(d). The built-in loss is destroyed at both levels. Where the corporation wants the loss, the answer is to sell the property to a third party and distribute the proceeds.

Liabilities cut the amount, not the basis. the amount is reduced, but not below zero, by any liability of the corporation assumed by the shareholder in connection with the distribution and by any liability to which the property is subject immediately before and immediately after it^TY2026 (IRC § 301(b)(2)) reduces what the shareholder is treated as having received, while the shareholder's basis in property received in a distribution is the fair market value of the property^TY2026 (IRC § 301(d)) gives them basis equal to the whole fair market value. The two are not inconsistent: the shareholder has taken on the debt, so they have paid for the difference.

And the liability sets a floor on value. where distributed property is subject to a liability or the shareholder assumes one, the fair market value of the property is treated as not less than the amount of that liability^TY2026 (IRC § 336(b), applied by IRC § 311(b)(2)). Where the debt exceeds the property’s worth, the corporation may not use the real value to compute the IRC § 311(b) gain — the liability amount is substituted. This prevents a corporation from stripping an over-encumbered asset out at no tax cost.

Watch the built-in gains tax. where an S corporation has a net recognised built-in gain for a taxable year beginning in the recognition period, a tax is imposed on its income for that year, computed by applying the highest rate specified in IRC § 11(b) to the net recognised built-in gain (IRC § 1374(a), (b)(1))^TY2026 (IRC § 1374). A corporation still inside its recognition period converts a IRC § 311(b) deemed sale into a recognised built-in gain, and the entity-level tax follows. a § 1374 built-in gains tax imposed on the corporation is treated as a loss sustained by the corporation in that year, allocated proportionately among the recognised built-in gains giving rise to it; a § 1375 tax instead reduces each item of passive investment income in proportion to that item^TY2026 (IRC § 1366(f)(2)) then feeds that tax back through the allocation.

How this has changed

The structure here is old and stable. Pub. L. 99-514 amended IRC § 311 generally in 1986, substituting the present provisions on distributions of appreciated property for provisions that had dealt only with LIFO inventory, liabilities in excess of basis, and appreciated property used to redeem stock. The deemed sale rule in its current form dates from that amendment, and the only changes since were the technical corrections made by Pub. L. 100-647 in 1988. What has changed is the population of corporations to which it matters most: as subchapter S has absorbed more closely held businesses, the provision is most often met not as the corporate-level tax it was designed to impose but as a pass-through gain that lands on the shareholders’ own returns and is immediately offset by the basis increase it produces.

Two current interactions are worth stating because a reader will otherwise assume the deemed sale is neutral. The first is the built-in gains tax of IRC § 1374, which is a genuine entity-level tax and does bite on a IRC § 311(b) gain within the recognition period. The second is the effect on the accumulated adjustments account: the deemed sale gain increases the account under Reg. § 1.1368-2(a)(2) before the distribution reduces it under Reg. § 1.1368-2(a)(5)(iii), so a corporation with accumulated earnings and profits can distribute appreciated property without reaching the dividend tier where a cash distribution of the same value would have reached it. That is a live planning point, and it follows entirely from the ordering.

Nothing in Pub. L. 119-21 amended IRC § 311, IRC § 301 or IRC § 1368, so the 2026 rules are the 2025 rules.

Exam focus

Learn the sequence and say it out loud: deemed sale, pass-through, basis and account adjustment, then characterise the distribution. Most questions in this area supply a fair market value, an adjusted basis and a stock basis, and the whole answer is in the order of operations.

Learn the asymmetry between gain and loss. IRC § 311(b) recognises gain; IRC § 311(a) recognises no loss. The commonest wrong answer on a depreciated-property question is a pass-through loss.

Learn what a liability does and does not do: it reduces the amount of the distribution under IRC § 301(b)(2), it does not reduce the shareholder’s basis under IRC § 301(d), and it can raise the deemed sale price under IRC § 336(b) where it exceeds value.

Finally, remember that IRC § 1371(a) is the doorway. Questions sometimes ask why a subchapter C provision applies to an S corporation at all; the answer is always that subchapter C applies except as displaced, and subchapter S does not displace IRC § 311.

Check yourself

1. An S corporation with no accumulated earnings and profits distributes land worth $200,000 with a basis of $75,000. The sole shareholder’s stock basis is $50,000. What does she report?

Answer: $125,000 of gain from the deemed sale under IRC § 311(b)(1), passed through under IRC § 1366(a), which raises her stock basis to $175,000. The $200,000 distribution then exceeds that basis by $25,000, which is gain under IRC § 1368(b)(2). She reports $125,000 plus $25,000, and her basis in the land is $200,000 under IRC § 301(d).

2. The same corporation distributes equipment worth $40,000 with a basis of $110,000. What loss is recognised?

Answer: None. except for the appreciated property rule, no gain or loss is recognised to a corporation on a distribution with respect to its stock, other than in complete liquidation — so a loss on depreciated property is never recognised^TY2026 (IRC § 311(a)). The corporation recognises nothing, no loss passes through, and the shareholder’s basis in the equipment is $40,000 under IRC § 301(d), so the $70,000 of built-in loss is permanently lost.

3. Property worth $150,000 with a basis of $60,000 is distributed subject to a $190,000 mortgage. What gain does the corporation recognise?

Answer: $130,000. where distributed property is subject to a liability or the shareholder assumes one, the fair market value of the property is treated as not less than the amount of that liability^TY2026 (IRC § 336(b), applied by IRC § 311(b)(2)) treats the fair market value as not less than the $190,000 liability, so the deemed sale price is $190,000 and the gain is $190,000 less the $60,000 basis.

4. A corporation with accumulated earnings and profits distributes appreciated property. Why might that produce less dividend income than distributing the same value in cash?

Answer: Because the IRC § 311(b)(1) gain is an item of income that increases the accumulated adjustments account under Reg. § 1.1368-2(a)(2) before the distribution reduces it under Reg. § 1.1368-2(a)(5)(iii). The larger account absorbs more of the distribution in the first tier of IRC § 1368(c), leaving less to be a dividend in the second.

5. An S corporation distributes its own promissory note to a shareholder. Does IRC § 311(b) apply?

Answer: No. IRC § 311(b)(1)(A) applies to a distribution of “property (other than an obligation of such corporation),” so a corporation’s own obligation is outside the deemed sale rule and no gain is recognised on it.