Tax Distributions: What Pass-Through Entities Need to Know

At a glance:  

• The main takeaway: Non-liquidating distributions from pass-through entities can carry significant tax and financial implications for business owners, especially without a clear understanding of how the distributions are taxed.
• Impact on your business: While not always immediately taxable, non-liquidating pass-through distributions can have lasting effects on an owner’s basis and exposure to potential capital gains.
• Next Steps: It’s important to understand the tax implications and strategic benefits of non-liquidating distributions. Aprio’s Tax Advisors can help you gain clarity and help you avoid costly mistakes.

Schedule a consultation  

Non-liquidating distributions from pass-through entities (PTE), such as partnerships, S-corporations, and LLCs can carry significant tax and financial implications for business owners. Without a clear understanding of how these distributions are taxed or how they affect ownership interests, owners may face unexpected tax liabilities, mismanagement of funds, and costly compliance errors.

This article examines the purpose, tax implications, and common misconceptions associated with non-liquidating distributions.

How does a non-liquidating distribution work?

Commonly referred to as current distributions, a non-liquidating distribution occurs when a business transfers money, property, or both to its owners without closing or dissolving the legal entity. Because distributions do not affect the business’s profitability, they are recorded in the equity section of the balance sheet.

Money is the most straightforward and common form of non-liquidating distributions, typically involving a direct transfer of cash from the business’s bank account to the business owner or to a third party on the owner’s behalf. However, the definition of money as defined by the Internal Revenue Service (IRS) is much more expansive than just the actual distribution of currency. Non-liquidating distributions of money can include the distribution of marketable securities up to its fair market value or a decrease in the partner’s allocated share of liabilities.

Property distribution involves transferring a company’s non-cash assets or property to its owners or shareholders. When determining the value of a non-liquidating distribution of property, one must first consider how the entity is classified for Federal income tax purposes. For partnerships, distributed property is generally valued based on the partnership’s adjusted basis in the property at the time of distribution, whereas the value of property distributed from a S-corporation is the fair market value of the distributed property.

Reasons for Receiving Non-Liquidating Distributions

Tax Distributions

A PTE does not pay income taxes at the entity level. Instead, the business’s income or losses are passed directly to the owners, who report it on their individual income tax returns. To ensure owners have sufficient funds to cover the tax, the business will often make tax distributions to its shareholders, owners or partners. These distributions are important because owners may owe taxes on their share of the profits, even if they haven’t actually received any cash. By providing these funds, tax distributions help prevent owners, partners, or shareholders from facing financial hardship due to tax obligations on undistributed income. 

Complying with Operating or Shareholder Agreements

Most businesses operate under formal agreements that define the timing, amount, and conditions for distributions. Although subject to state laws and IRS regulations, businesses often have the flexibility to establish their own customized rules through these governing documents.  A well-drafted operating agreement or shareholder agreement typically includes provisions for tax distributions as well as other provisions to ensure distributions are consistent and fair among all owners while protecting the economic viability of the business. 

Obtaining Favorable Tax Treatment

Pass-through business owners or partners receive compensation in two forms. First, S corporations are required to pay officers a reasonable salary for the services they provide or the time they devote to the business. Similarly, partnerships may make guaranteed payments to members as compensation for their time or services. Both salaries and guaranteed payments are subject to self-employment taxes.

Second, profits can be allocated to owners or partners as distributions. As noted earlier, distributions are taxed at individual income tax rates. Once the required compensation thresholds are met, any additional funds can be considered distributions, offering a more favorable income tax treatment.

Returning Capital to Owners

When a business is performing well, it’s common to return some of the earnings to pass-through business owners or partners. These payments may serve as a reward for their investment and may vary based on the profitability of the company. During prosperous times, distributions can be larger, while during learner periods distributions may be smaller or suspended. Distributions can help align the financial interests of the owners with the performance of the business, thereby encouraging ongoing investment and engagement.

Taxation Implications on Pass-Through Distributions

Reduction in Basis

When an owner or partner in a PTE receives a distribution, that distribution first reduces their basis (or investment) in the business. Although tracked and calculated differently among the various PTEs, a reduction in basis is not considered a taxable event. A distribution cannot reduce an owner or partner’s basis below zero. 

Taxable Dividends

If an S corporation has accumulated earnings and profits, distributions are generally treated first as a tax-free return of the shareholders’ basis, up to the amount of the corporation’s Accumulated Adjustments Account (AAA). Any distributions that exceed the AAA are then treated as taxable dividends, to the extent of the S corporation’s accumulated earnings and profits. However, with the unanimous consent of all shareholders, the S corporation may elect to treat all distributions made during the tax year as coming first from earnings and profits and then from the AAA. This election is irrevocable and applies only to the specific tax year in which it is made.

Capital Gain or Loss

If a distribution exceeds the owner’s or partner’s basis, the excess is treated as a capital gain. The IRS has established specific ordering rules to determine the taxable portion of a distribution. A clear understanding of these rules allows owners to better manage their basis over time and avoid unexpected tax liabilities. As noted earlier, special rules apply to S corporations with accumulated earnings and profits.

Common Pass-Through Distribution Misconceptions

“Distributions Are Always Taxable”

As previously discussed, most distributions are tax-free up to the owner’s basis. It’s important to note, however, that while distributions don’t generate additional tax, they also don’t reduce the tax owed on pass-through income. If you have enough basis to withdraw funds from the business, it’s still important to ensure that sufficient funds are set aside to cover the taxes.

“I Can Take Distributions Whenever I Want”

Distributions from a PTE must comply with the governing documents established at the time of formation or as subsequently amended. In addition to adhering to these internal agreements, PTEs must also follow the distribution requirements set forth by the IRS. Failure to comply with these rules and guidelines may result in shareholder disputes, tax complications, and other potential legal or financial consequences.

Recent IRS guidance clarifies that disproportionate distributions for S-corporations do not, by themselves, violate the single class of stock requirement so long as the corporation’s governing documents provide shareholders with identical rights to distribution and liquidation.

“Why Am I Taxed on Money I Didn’t Receive?”

One of the primary challenges and disadvantages of pass-through taxation is that owners can be taxed on income they haven’t actually received. This phantom income often arises from investment gains that haven’t been realized but still create a tax liability for the individual owner, shareholder or partner. Failing to monitor phantom income appropriately can cause significant cash flow issues for individuals.  Factors such as depreciation, debt restructuring, and future plans to reinvest profits back into the business should be considered when calculating tax distributions.

The bottom line

While often not immediately taxable, non-liquidating distributions can have lasting effects on an owner’s basis and exposure to potential capital gains. It’s important to fully understand the purpose, tax implications, and strategic planning benefits of non-liquidating distributions. Aprio’s Tax Advisors can help business owners maintain strong financial oversight, avoid costly mistakes, and maintain ongoing compliance.

Related Articles 

What S Corporations Actually Need to Know About Reasonable Compensation
Estimated Taxes: How They Work & Who Must Pay 
Understanding Schedule K-1: A Guide to Tax Form 1065