The primary difference between C corporations and S corporations is that C corporations are taxed twice on earned income: : once at the corporate level when the income is earned, and again at the shareholder level when the income is distributed.The rules governing distributions from C corporations differ from the rules that apply to distributions from S corporations.
Corporate shareholders may prefer that the distribution be treated as a dividend, allowing the corporation to take advantage of the special dividends-received deduction under Code § 243 (which allows the dividends to only be taxed once at the corporate level).
On the other hand, individual shareholders often prefer that the distribution be treated as a redemption, for three reasons: A distribution qualifies as a stock redemption only if it significantly reduces the interest of the shareholder in the corporation.
The Internal Revenue Code uses four tests to make this distinction: To prevent gamesmanship among related parties, Congress has added another layer of rules that must be analyzed to determine if a distribution is a redemption.
These attribution rules provide that shares owned by a shareholder’s parents, children, and grandchildren (but not siblings) are considered to be owned by the shareholder. Similarly, shares held by corporations, trusts, and partnerships are deemed to be owned by their shareholders beneficiaries, and partners, and vice versa. As a result, shares held by these family members and entities are considered to be owned by the shareholder for purposes of determining whether the distribution qualifies as a redemption.
A corporation will not recognize any gain or loss on a distribution of cash to its shareholders. But if the corporation distributes appreciated property, the corporation must recognize gain as if the property were sold to the shareholder at fair market value. Important Note: These two rules operate as a loss disallowance system.
If the corporation distributes appreciated property, the corporation is taxed on the gain under Code § 311(b).
But that section only covers gain on distributions of appreciated property.
If the corporation distributes property that has depreciated (i.e., property with a built-in loss), Code § 311(b) does not apply.
Instead, the distribution is governed by the general nonrecognition rule of Code § 311(a), which prevent the corporation from recognizing loss on a transfer of depreciated property. § 302(b)(1), this test is usually used only when the safe harbors of I.
Liquidation is a taxable event for both the shareholder and the corporation. Like the “Redemptions Not Equivalent to Dividends” test of I.
A corporation may liquidate by (a) paying off creditors and distributing the remaining assets in kind to the shareholders or (b) selling assets, paying off creditors, and distributing the remaining cash to the shareholders.