Income Tax Effects of Inventory Distributions from an S Corporation
In this article, I will walk through the tax implications that result when a shareholder of an S Corporation withdraws inventory from the business for personal use. Because a withdrawal of inventory from the business by the shareholder represents a transfer of value from the business to the owner, we view this transaction as a shareholder distribution. The below analysis therefore frames our discussion around how we treat an inventory distribution from an S Corporation.
We’ll start with an example that will give us a concrete fact scenario to use for analyzing the relevant tax law:
Based on the above fact pattern, several questions regarding the tax implications of this move arise:
- Does a shareholder who withdraws inventory from an S Corporation have to recognize any income for doing so?
- What do we consider the amount or value of a distribution of inventory to be?
- Does an S Corporation that allows a shareholder to withdraw inventory have to recognize any income at the time the shareholder withdraws the inventory?
- How does the S Corporation account for the inventory distribution in their accounting and on the shareholder’s Schedule K-1?
- Do the other shareholders of the S Corporation also have to withdraw inventory in order to keep distributions equal?
With the below analysis, we’ll address these issues and draw some conclusions based on guidance found in the tax law.
S Corporations are controlled by Subchapter S of the Internal Revenue Code, which incorporates Subchapter C except where “inconsistent” with provisions of Subchapter S (see I.R.C. § 1371). Because Subchapter S does not have any provisions related to how distributions are handled, we look to Subchapter C for guidance. In Subchapter C, we find Section 301(a) that covers distributions of “property”.
Shareholder Recognition of Inventory Distribution
Property in this particular case doesn’t mean what we might otherwise understand it to mean. Rather, it is much broader. The definition of the term as used here is found in Section 317(a), which says: “money, securities, and any other property… except stock in the corporation making the distribution (or rights to acquire such stock).” The inventory in question here certainly fits that definition. Section 301(a) says to treat such distributions in accordance with Section 301(c).
So we turn now to Section 301(c)(1), which says the following:
Continuing on to Section 301(c)(2), we then read that any amount that is not a dividend simply reduces the shareholder’s basis in the stock. Therefore, if the inventory distribution is considered a dividend, then we include the amount of the distribution in the shareholder’s gross income. If it’s NOT a dividend, then it simply reduces the shareholder’s basis in the S Corporation.
To determine whether it’s a dividend or not, we look to Section 316. In Section 316(a), it basically defines a dividend as any distribution of property made by a corporation to its shareholders out of its “earnings and profits”. The term earnings and profits, or “E&P”, again is not a loosely used term. It’s a very key term. In our case, it’s very key because S Corporations cannot generate E&P — they can only have existing E&P if they were previously taxed as a C Corporation.
Most S Corporations were never previously taxed as a C Corporation, so for our purposes, we can reasonably conclude that the inventory distribution definitely is not a dividend. Therefore, the distribution is not included in the shareholder’s gross income, but instead only reduces the shareholder’s basis in the S Corporation. With that, we have answered question number one in the list above.
Amount of Inventory Distribution
Moving to question two, i.e. what is the actual amount of the inventory distribution: Section 301(b)(1) says the amount of the distribution is “the amount of money received, plus the fair market value of the other property received.” Inventory is of course not the same thing as money, and so here is considered “other property” and so should be measured based on the “fair market value” of the inventory. Section 301(b)(3) says the fair market value is determined as of the date of the distribution.
So the real question is: what should we consider to be the “fair market value” of the inventory on the date that the shareholder takes it from the business for personal use? Should it be what the business paid for it (i.e. its basis in the inventory)? Or should it be what the business could reasonably sell it for? Using the fact pattern above, if we go with what the business paid for it, then the amount of the distribution is $10,000. If we go with what the business could reasonably sell it for, the amount of the distribution is $15,000.
This is the point where the tax law gets pretty silent. Therefore, we are left, for the most part, to make this determination for ourselves. My opinion is that it is logical to say the fair market value of the inventory is what the business paid for it rather than what the business might be able to mark it up and sell it for. My reasoning for this is that the transaction in question here (a distribution from an S Corporation to a shareholder) is between a business and its owner, not between a business and a customer. Therefore, the business does not have to incur any of the normal costs of doing business to market, sell and distribute the inventory that would justify its markup of $10,000 of inventory to its actual sale price of $15,000. As such, I think it’s only fair to the shareholder in turn that the distribution amount be set at $10,000, rather than $15,000. I therefore take this as our answer to question two: the amount of an inventory distribution is the amount that the S Corporation paid for the inventory distributed.
S Corporation Recognition of Inventory Distribution
With question two answered, we now move to question three, i.e. does the S Corporation need to recognize any gain or income from the inventory distribution? Assuming we take the previous answer to question two and say that the amount of the inventory distribution is the same as the amount the S Corporation paid to acquire the inventory, then the answer is clearly no. The S Corporation simply posts an entry to their accounting with a credit to either their inventory account (if they’re accrual basis) or Cost of Goods Sold (if they’re cash basis) and with a debit to their Shareholder Distributions or Shareholder Equity account (depending on how the S Corporation handles equity transactions).
Because the inventory distribution only reduces the shareholder’s basis in the S Corporation (and is not included in gross income), the amount of the distribution therefore would be reflected on the shareholder’s Form 1120S, Schedule K-1, Part III, Line 16, using Code D, and included with the amount of any cash or other property distributions the shareholder received for the year. With this, we now have answers to questions three and four.
Considerations for Other Shareholders
So finally, we turn to consideration of how an inventory distribution to one shareholder affects the other shareholders. Are the other shareholders required to also withdraw the same amount of inventory from the S Corporation in order for the S Corporation to stay compliant with the “one class of stock” rule and keep distributions even between shareholders? Again, specific guidance from the tax law is hard to find here, but my opinion is that while the other shareholders need to receive distributions equaling the value of the inventory distribution that the first shareholder received, I believe it’s perfectly fine for the distribution to be in the form of cash, rather than inventory.
- For more information about S Corporations and Earnings & Profits, see: https://www.thetaxadviser.com/issues/2010/dec/banner-traum-dec10.html; See also: I.R.C. § 1371(c).↵