Why an S corporation distribution can be taxable
A distribution is not tax-free because the company had cash. It is tax-free because you had basis. Those are different questions, and only one of them is on the bank statement.
The most common surprise in an S corporation return is a distribution that turns out to be taxable. The money came out of a profitable company, no loan was involved, and the K-1 still produces a capital gain.
The mechanism is basis, and it is worth understanding rather than trusting to software.
Two kinds of basis, and they are not interchangeable
Stock basis is what you paid for the stock, adjusted every year under section 1367 for your share of income, loss, and distributions. Debt basis arises only when you personally lend money to the corporation.
The distinction matters because only stock basis makes a distribution tax-free. Debt basis lets you deduct losses you otherwise could not. It does nothing for distributions. A shareholder who has loaned the company $200,000 and has zero stock basis still has a taxable distribution.
A guarantee is not a loan. Guaranteeing the company’s bank debt creates no debt basis, because you have not made an economic outlay. This is settled and it still catches people every year.
The ordering rules
Order is the whole game. For a given year, roughly:
- Increase stock basis for your share of income items, including tax-exempt income
- Decrease for distributions
- Decrease for nondeductible expenses and then for losses and deductions
Distributions come out before losses. That sequence produces the outcome people find least intuitive: in a year with both a distribution and a loss, the distribution can consume the basis, and the loss then has nowhere to land. It is suspended under section 1366(d) and carries forward until basis is restored.
So the same year can produce a taxable distribution and a non-deductible loss. Nothing has gone wrong. That is the statute working as written.
What happens past zero
Under section 1368, a distribution in excess of stock basis is treated as gain from the sale or exchange of property, which for most shareholders is a capital gain. It does not become a loan, it does not roll forward, and it is not fixed by putting the money back in December.
Form 7203
Basis used to live on a worksheet that many shareholders never saw. It is now reported on Form 7203, which is required when a shareholder claims a loss, receives a distribution, disposes of stock, or receives a loan repayment from the corporation.
The practical effect is that basis has moved from something reconstructed under audit pressure to something filed annually. That is an improvement, and it is also unforgiving of gaps. If the schedule has never been maintained, building it means going back to the beginning: the original contribution, and then every year of income, distribution, and loss since.
That reconstruction is tedious and entirely doable. It is much easier in the year you notice than in the year a notice arrives.
The practical version
Track basis every year, in the year, whether or not a form requires it. It is the number that determines whether your distributions are free, whether your losses are deductible, and what your gain is when you eventually sell. Three separate questions, one schedule.
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