Unequal S Corp Distributions Between Owners: Risks and Fixes

Do S corp distributions have to be pro rata, and is there a minimum?

The rights must follow the shares, but the payments in any one year do not have to match. An S corporation may have only one class of stock, so every share must carry identical rights to distribution and liquidation proceeds (26 U.S.C. 1361(b)(1)(D); 26 CFR 1.1361-1(l)). If the company's documents give every share those rights, unequal or late payments do not by themselves end the S election, but they still get tax effect (Rev. Proc. 2022-19, section 3.02). If the documents or a side agreement give owners different payout rights, the company may have two classes of stock, which ends the election.

An owner of a larger block is entitled to a proportionally larger part of each distribution. Differences in voting rights are ignored for this test (26 CFR 1.1361-1(l)(1)).

The test measures proportion, not amount. It sets no minimum distribution and does not ask how much the company paid out in a given year. Whether the company must pay anything at all comes from its own documents and state law. While the election stands, owners are taxed on their share of the income whether or not cash is paid (K-1 income without a distribution); pay for owners who work in the business is a separate question (S corporation owner salary).

A case is not simple when:

• the documents, or a side agreement, treat owners differently;
• the unequal payments repeat, or follow an agreement;
• the payments already appear on filed returns or K-1s;
• a sale, a bank, an investor or an audit will look at the numbers;
• nobody can say exactly who was paid what, and when.

What to gather: articles or certificate of incorporation, bylaws, any shareholder or operating agreement and side letters, the share ledger and any share transfers during the year, a list of every distribution by owner, date and amount, the Schedules K-1, and any loan papers between an owner and the company.

Does one unequal S corp distribution end the S election?

A single unequal distribution does not end the S election when the company's governing provisions give every share identical rights. In that case the IRS says it will not treat disproportionate distributions as breaking the one-class-of-stock rule, and the company does not need IRS relief (Rev. Proc. 2022-19, section 3.02). The IRS also says it will not issue a ruling to confirm this (section 4.01).

The revenue procedure calls a payment on one share that differs in timing or amount from the payment on another share a disproportionate distribution; actual, constructive and deemed payments all count (section 2.03(2)). What decides the election is the documents, not the payments:

What are the governing provisions, and when does a side agreement count?

The governing provisions are the corporate charter or articles, the bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (26 CFR 1.1361-1(l)(2)(i)). Together they decide whether the shares are identical.

A side agreement counts when it is a binding agreement about how distributions are paid. The regulation's Example 6 treats a binding agreement to pay extra to owners with heavier state tax burdens, so that everyone ends up with equal after-tax amounts, as a governing provision that makes the rights unequal. For an LLC with an S election, S corporation rules apply, so an operating agreement with partnership-style payout terms is the kind of document to check.

Two agreements are treated more gently:

• Commercial contracts such as a lease, employment agreement or loan agreement are not governing provisions unless a principal purpose is to get around the one-class rule.
• Buy-sell, transfer-restriction and redemption agreements are disregarded unless a principal purpose is to get around the rule and the price set at signing is significantly above or below fair market value (26 CFR 1.1361-1(l)(2)(iii)). Bona fide agreements to buy or redeem stock at death, divorce, disability or termination of employment are disregarded outright.

Principal purpose is a question of fact, and the IRS will not rule on it (Rev. Proc. 2022-19, section 4.01). The regulation also says "binding". Whether an email or spoken understanding binds the owners depends on the facts and state contract law; these sources do not settle it.

What if one shareholder was simply paid earlier than the other?

A difference in timing alone does not create a second class of stock when the documents give equal rights and no binding agreement is behind the gap. The regulation's own example has two equal owners, one paid in the current year and the other a year later, and says this does not create a second class (26 CFR 1.1361-1(l)(2)(vi), Example 2).

The same example adds that section 7872, the below-market loan rule (a loan with too little interest is treated as including a payment to the borrower), or other recharacterization principles may still apply to work out the tax result. So a long-open gap is not harmless: it may be treated as a loan or recharacterized, meaning treated as something other than how it was booked.

The example also rests on circumstances showing no binding agreement. A gap that repeats in the same owner's favor raises the question whether one exists.

If ownership changed during the year, a governing provision that pays distributions on the owners' varying interests in income for the current or prior year does not make the rights unequal. If those payments are not made within a reasonable time after year end, they may be recharacterized, but they do not create a second class of stock (26 CFR 1.1361-1(l)(2)(iv)).

How do owners fix unequal distributions, and what does appropriate tax effect mean?

The regulation says distributions that differ in timing or amount are given "appropriate tax effect" based on the facts and circumstances (26 CFR 1.1361-1(l)(2)(i)). Neither the regulation nor Rev. Proc. 2022-19 spells out what that effect is for a given case, so the fix is a preparer's judgment based on the documents, the books and what has been filed.

To size a gap when ownership did not change, divide each owner's payout by that owner's ownership percentage. Payouts are in proportion when every owner's result is the same (see the second example). If shares changed hands, first work out which period each payment covers and what the governing provisions require: one percentage for the whole period can show a gap that is not one (26 CFR 1.1361-1(l)(2)(iv)).

The regulation does not prescribe a fix. Its examples show two ideas a preparer may weigh:

The regulation does not say owners can turn an unequal payment into an advance after the fact. A loan agreement with an owner is a governing provision if a principal purpose is to get around the one-class rule (26 CFR 1.1361-1(l)(2)(i)). A loan to an owner that charges too little interest can itself be a deemed distribution under section 7872 (the regulation's Example 5), so loan terms matter.

Which approach fits depends on the cash available, what is already reported, and whether the payments followed an agreement. Once chosen, the books must show it: see recording S corporation distributions. If a filed return has to change, see correcting a filed business return. Whether a payment to an owner can count as a real loan is covered in borrowing from your own corporation.

Do state tax payments the company makes for some owners break the equal-rights rule?

State tax payments the company makes for some owners do not by themselves break the equal-rights rule. Some state laws make a corporation pay or withhold tax for certain shareholders, such as nonresidents. The regulation disregards those laws in the one-class test as long as, once the payments are counted as constructive distributions (treated as if the owner had received the cash), every share still has identical distribution rights. A timing gap between those constructive distributions and the cash paid to other owners does not create a second class (26 CFR 1.1361-1(l)(2)(ii), with its Example 7).

The limit is an agreement that adjusts payouts for state tax. The regulation's Example 6 treats a binding agreement to pay more to owners who bear heavier state tax burdens as a governing provision that creates unequal rights.

Other tax or personal bills the company pays for an owner, including state pass-through entity tax, are covered in S corporation paying personal expenses.

What if our own documents give shareholders different rights, and what relief exists?

Then the company may have more than one class of stock, and a corporation with more than one class is not a small business corporation (26 U.S.C. 1361(b)(1)(D)). An S election ends on the day the corporation stops being one (26 U.S.C. 1362(d)(2)). If the election was filed while the documents already differed, it never took effect (Rev. Proc. 2022-19, section 2.03(6)). Once an election has been terminated, a new one is barred until the fifth tax year that begins after the first year the termination is effective, unless the IRS consents (26 U.S.C. 1362(g)).

Relief has two tracks:

Section 3.06 also requires the corporate statement to represent that the election was inadvertently invalid or terminated solely because of the differing provisions, and that the company and every affected owner acted reasonably and in good faith in correcting them after discovery. Each owner must also state that they reported income consistent with S status. The company keeps the statements and the corrected documents for inspection; the signed statements are made under penalties of perjury. A side agreement that was acted on with unequal payments falls outside section 3.06 and moves to the ruling request, which the IRS decides. Eligibility turns on what has already been paid, filed and found, so have a preparer read the documents before changing anything.

Does an unequal distribution change who is taxed on the income?

An unequal distribution does not by itself change who is taxed on the income while the S election stands. Each owner reports a share of the corporation's income, loss, deductions and credits based on shares held, assigned day by day, not on cash received (26 U.S.C. 1366(a)(1); 26 U.S.C. 1377(a)(1); Form 1120-S instructions). When an owner's whole interest ends during the year, the company and every affected owner can instead elect to treat the year as two, with a statement attached to the timely filed Form 1120-S for that year (26 CFR 1.1377-1(b)).

Distributions follow a different path. The corporation reports each owner's distribution on that owner's Schedule K-1 (box 16, code D), and it reduces that owner's stock basis (Form 1120-S instructions; K-1 instructions). If the company has accumulated earnings and profits, such as from earlier C corporation years, part of a distribution can be a dividend: it goes on Form 1099-DIV, not the K-1, and does not reduce basis (Form 1120-S instructions, line 17c; 26 U.S.C. 1368(c)). So an owner who got extra cash reports the same share of income but may run out of basis sooner: see distributions in excess of basis. An owner who got less still reports a full share: see K-1 income without a distribution.

Can owners be paid different salaries without a problem?

Wages can differ without creating a second class of stock. An employment agreement is a commercial contract, not a governing provision, unless a principal purpose of the agreement is to get around the one-class rule (26 CFR 1.1361-1(l)(2)(i)). In the regulation's Example 3, even a salary found excessive does not create a second class, though the company is not allowed a deduction for the excess. Its Example 4 reaches the same result for different fringe benefit premiums.

How much each owner should be paid, and payroll tax on it, are separate questions: see S corporation owner salary.

Example

All figures are illustrative US dollars.

Same documents, different timing

Owner A and Owner B each hold half, and the documents give equal rights.

• Year 1, March: the corporation pays Owner A $50,000 and Owner B nothing. If no binding agreement is behind the gap, the regulation's own timing example treats it as not creating a second class of stock. Each owner still reports half the income; Owner A's K-1 shows the $50,000 distribution.
• Year 2, January: Owner B is paid $50,000 and the gap closes. For the time it stayed open, the preparer decides whether the below-market loan rule or another recharacterization applies.

Three owners, equal dollars

Three owners hold 40%, 40% and 20% all year, the documents give every share equal rights, and each owner takes $30,000.

• The 20% owner's $30,000 implies a $150,000 total payout, so each 40% owner should have received $60,000 and is $30,000 short.
• Catch-up: pay a further $30,000 to each 40% owner.
• Advance: measured against the 40% owners' $30,000, the 20% owner should have received $15,000, so $15,000 is the excess. Treating it as an advance to repay or offset depends on the facts and papers; the regulation's example accepts it where the governing provisions already require repayment or offset.
• The choice depends on cash, what the books and K-1s show, and whether the return is filed. The preparer decides.

A side letter on payouts

Two owners hold 50% each. Both sign a side letter with the corporation, binding under state law, that gives Owner A 60% of every payout.

• Year 1: the letter is signed. It is a binding agreement on distributions, so the shares no longer carry identical rights and the election may have ended that day.
• Year 2: the corporation paid under the letter and the problem is found. Because unequal distributions were made, the section 3.06 statements are not available. The route is a ruling request under section 1362(f), which the IRS decides.
• If found earlier: had the letter been corrected before any payment under it, with every Form 1120-S filed on time, the section 3.06 statements could apply. They also need the election to have been inadvertently ended only by the letter, everyone to have acted reasonably and in good faith, and the statements to be done before the IRS found the letter.

Different for you?

• Payments are already unequal and a return, a sale, a bank or an investor will look at them: whether a catch-up payment, a documented loan, or leaving the gap and reporting its tax effect fits depends on the documents, the books and what was filed. See corporate tax help.
• Your documents or a side letter give owners different rights: the election itself may be exposed, and the relief tests turn on what was paid and filed. See corporate tax help.
• You cannot tell who was paid what, or when: distribution records by owner and date are the starting point for any of these options. See bookkeeping help and recording S corporation distributions.
• The IRS has written to you about your S election, K-1s or distributions: the relief options narrow once the IRS has found a problem, because section 3.06 requires the correction before the IRS discovers it. See corporate tax help.
• A return is already filed: see correcting a filed business return.
• A distribution is larger than your basis, or you owe tax on income you never received: see distributions in excess of basis and K-1 income without a distribution.
• The company paid personal bills, or money moved between an owner and the company as a loan: see S corporation paying personal expenses, shareholder loans and borrowing from your own corporation.
• You are unsure the S election was filed on time or accepted: see late S corporation election relief.
• You want the basics of how an S corporation is taxed and what else ends the election: see how S corporations are taxed.