Section 1361 of the Internal Revenue Code requires that a S-Corporation obey the following restrictions in order to be qualified and treated as an S-Corporation. The requirements for federal tax purposes are (1) the business must be a domestic corporation (organized in the U.S.), (2) the business cannot have more than 100 shareholders, (3) all owners of the business must be an individual, a trust, an estate, or a 401(a), 501(a), or 501(c)(3) tax-exempt organization, (4) none of the business owners can be nonresident aliens, and (5) the business must have only one class of stock.
What if Shareholders of a S-Corporation Receive Unequal Distribution?
With respect to a S-Corporation maintaining only one class of stock, the general rule is that distributions from S-Corporations to shareholders should be proportional to each shareholder’s ownership interest. Thus, a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. As to the question of whether a S-Corporation can make distributions to select shareholders that are disproportionate to the shareholders ownership interest, the simple answer is that it is not allowed. However, there is an exception known as the “timing difference.”
This exception, however, will only apply to instances in the following examples: (1) A S-Corporation has two equal shareholders, X and Y, and are each entitled to equal distributions. The corporation distributes $100,000 to X in the current year, but does not distribute $100,000 to Y until one full year later. Unless the time difference of distribution was done pursuant to a binding agreement relating to the distribution or liquidation proceeds, it is not effectively considered to be a difference in shareholders rights. The mere difference in timing does not cause the corporation to be treated as having more than one class of stock. (2) Another example is unequal distributions done by mistake. If a corporation makes distributions to some shareholders and not others because of a misunderstanding of the regulations, the exception applies as long as there is a determination that there was only one class of stock to begin with. (3) Lastly, where a corporation makes disproportionate distributions from year 2011 through 2014 to shareholders in order to help the shareholders satisfy their tax liability incurred from the income generated by the S-Corporation itself, but begins making proportional distributions in 2015, this can fall under the exception. The corporation, in the following years, would have to equalize its distributions to compensate for the distributions made during years 2011 through 2014.
The premise of it all is to correct and take action by equalizing the distributions once the error has been recognized. So long as the disproportionate distributions are not made pursuant to any contract, shareholder agreement, or other binding document that would go so far as to suggest that shareholders have differing rights to any distributions from the S Corporation.
What Are the Penalties for Unequal Distribution in an S-Corporation?
If a S-Corporation continues to unequally distribute to its shareholders, it has the potential of voiding itself as a S-Corporation and turning into a C-Corporation in the eyes of the IRS, which will be taxed at a corporate rate of 21%. Additionally, the company will no longer be a pass-through entity, and will be required to pay the corporate income tax and any distributions made to shareholders.