A cash distribution by a C Corporation to a shareholder with respect to its stock is included in the shareholder’s gross income as a dividend to the extent the distribution is made out of the corporation’s accumulated, and current, earnings and profits.[xxv] If the distribution satisfies the requirements for a “qualified dividend,” it will be subject to federal income tax in the hands of the shareholder at a rate of 20 percent;[xxvi] it may also be subject to the 3.8 percent federal net investment income surtax.[xxvii] That portion of the distribution that exceeds the corporation’s earnings and profits will be applied against, and reduce, the shareholder’s adjusted basis for their stock in the corporation; basically, a tax-free return of capital.[xxviii] To the extent the distribution exceeds the shareholder’s adjusted basis for their stock, the excess portion will be treated as gain from the sale of the stock; in other words, a deemed sale that will likely be treated as capital gain,[xxix] and taxed accordingly at a maximum federal income tax rate of 20 percent (in the case of long-term capital gain); the 3.8 percent surtax may also apply. It should be noted that a partner’s outside basis is adjusted for the partner’s share of partnership income, deduction, etc., only on the last day of the partnership’s taxable year. Assuming the corporation has only one outstanding class of stock, the declaration and payment of a dividend by the corporation’s board of directors must necessarily be made to every one of its shareholders; a shareholder cannot turn their back on the distribution and its tax consequences. As mentioned elsewhere in this post, a partnership’s satisfaction of a partner’s individual liability is treated as a distribution of cash to the partner. Provided the shareholder held the redeemed shares for more than one year, the gain will be treated as long-term capital gain, without regard to the composition of the underlying assets of the corporation, and will be taxable at a federal rate of 20 percent. The distribution reduces the partner’s adjusted basis.
In addition, the gain may also be subject to the 3.8 percent surtax on net investment income, if the partnership’s trade or business is a passive activity with respect to the partner.[xxxviii] However, if any of the cash deemed to have been received by the partner – in the deemed sale of their partnership interest – is attributable to any unrealized receivables[xxxix] of the partnership, or to inventory items of the partnership, then the amount of cash attributable to such assets will be treated as having been received from the sale of such assets, not from a capital asset, and will be treated as ordinary income.[xl] If the current distribution described above did not occur, or if the amount thereof was insufficient for the needs of a particular owner, and assuming the business entity has agreed to redeem a portion of this owner’s equity in the business in order to get them additional cash, what are the tax consequences to the owner?
The tax consequences to a shareholder, some of whose shares of stock in the C corporation are acquired by the corporation from the shareholder in exchange for cash – a redemption[xli] – will depend upon the degree by which the shareholder’s ownership in the corporation is reduced relative to the ownership of the other shareholders.[xlii] Thus, if every shareholder sold 10 percent of their shares to the issuing corporation (a pro rata redemption), none of the shareholders will have experienced a reduction in their relative ownership.
In some cases, the manager of the business will be authorized to determine, in their discretion, if or when to make a distribution, and how much to distribute.[xiii] In other cases, the owners may have agreed that all “available cash” must be distributed at least annually.[xiv] Then there are those situations – in the case of a pass-through entity – where the only distribution required to be made for a taxable year is of an amount of cash sufficient to enable the owners to pay their income taxes attributable to their share of the entity’s profits.[xv] In each of these situations, however, every owner will generally receive a distribution based upon their relative equity in the business. We encourage you to read the legal notices posted on those sites, including their privacy policies.
What if only one owner, out of several, needs a cash distribution? We are not responsible for the data collection and use practices of such other sites.
A cash distribution in partial redemption or liquidation of an owner’s equity in the business provides liquidity for the owner who wants to remove value from the business, may protect the liquidity needs of the business, and may avoid the tension that otherwise could arise among the owners in the absence of a buy-back program.