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Owners of an S Corporation needs to carefully monitor distributions to shareholders to be certain that there are no disproportionate distributions. Failure to make distributions in proportion to ownership interests can void the S Corporation election.
Distributions to shareholders must be made in proportion to the ownership interests of the shareholders or a disproportionate distribution has occurred. For example, if an S Corporation has three shareholders owning 50%, 35% and 15% of the corporate stock, all distributions to shareholders should be in this ratio. These are distributions of profits, if the shareholders are also employees, amounts paid to them in salary are not distributions for this purpose.
A disproportionate distribution can occur inadvertently. A loan to a shareholder that is not properly documented as a loan can be a distribution. The distribution of non-cash property can be a distribution. A sale of corporate property at less than fair market value can be a distribution. Under IRS regulations, disproportionate distributions are viewed as evidence of a second class of stock. Since one of the requirements of an S Corporation is that it only have one class of stock, a disproportionate distribution can invalidate the S Corporation election.
If a disproportionate distribution has occurred, the corporation must take immediate action to correct the error by equalizing the distributions. If you find yourself in this situation, please let us know so we can help you correct it as soon as possible.