That's the entire issue. It seems like "substance over form" should prevail as to allocation of the distributions. If form overrules substance, the result is a capital gains tax for distributions in excess of basis.
A worst-case scenario seems like they are indirect payments to the spouse for her benefit. She issued the checks to the husband for both (55 percent/45 percent) intending to distribute to both in proportion of their ownership, and she deposited them directly to their joint personal bank account. Any experience or direction or articles, citations, code, regulations, etc., you could provide would be helpful. I had read a similar situation in one of your articles on Bankrate.com. Thanks.
You did well at identifying the issue. Your concern is genuine because we all know that if Internal Revenue Service looked at it, they may take issue. In fact, the major part of any IRS exam is for the agent to recharacterize transactions to maximize the tax potential.
There are really two issues with disproportionate S-corp distributions (i.e., dividends that are not in proportion to stockholdings). One issue, as you pointed out, is that the husband's distributions can exceed his basis in his separate shares. Basis is decreased by distributions and increased by income recognized. In this case, he's getting 100 percent of the distributions and only recording 55 percent of the income. Eventually, the decreases will exceed the increases, and he'll have distributions in excess of basis.
The second issue deals with qualification as an S-corp. In all corporations, dividends are paid in relation to the stock owned. All common stock of one class would have the same dividend rights of all the other common shares of the same class. If distributions are not made consistent with the stock holdings, then you've created a second class of stock. An S-corp is only permitted to have one class of stock, so you've voided the S-corp election. A voided S-corp election results in two levels of taxation: one at the corporate level and the second at the shareholder level.
Since you identified the issue, you need to advise the client of the problem. You also need to offer a solution which, without more facts, I can't possibly give you. But I think you know what is right and how they need to get there. Good luck.
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