I have an S Corporation that is a holding company for a C Corporation. There are 4 members owning 25% interest in the S Corporation. Last year, one of the members of the S corporation sold 5% of his interest. Since the S Corporation is fully investing the C Corporation, we sold some shares in the C Corporation. Now, how to we allocated the proceeds directly to the S Corp owner? I know S Corp income/gains needs to be allocated on a pro-rate basis. So, do we make a disproportionate distribution?

Changes in the ownership of S Corps are governed by shareholder agreements. While all corporations with multiple shareholders should have shareholder agreements in place, often many corporations do not have one. shareholder agreements spell out the terms and conditions under which shareholders may buy, sell, or transfer their shares in the corporation. Transferring the ownership in an S corp is accomplished by one party selling shares to another. Generally speaking, without a shareholders agreement in place, shares can be freely purchased or sold without restriction. S corp shareholders are required to take into account their pro rata share of the corporation's income, loss, deduction, and credit. For this purpose, each shareholder's share of an item for a tax year is normally determined by assigning an equal portion of the item to each day in the tax year, and then dividing that portion pro rata among the shares outstanding on that day. The regulations also provide that when a shareholder disposes of stock, the transaction is treated as occurring at the end of the day of disposition. It is important for S corps with multiple shareholders to get schK-1 forms out early, because they're necessary for individual shareholders to do their 1040 income tax return.

Thanks, but this doesn't really answer my question. How, do we allocate the proceeds directly to the S Corp owner? I know S Corp income/gains needs to be allocated on a pro-rate basis. So, do we make a disproportionate distribution?

there’s nothing in the statute or regulations that says you can’t make a disproportionate distribution; it simply says that the underlying stock can’t confer upon the shareholders different rights to distributions. An S Corp 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 Corp 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 Corp has three shareholders owning 20%, 55% and 25% 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 FMVcan 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 Corp is that it only have one class of stock, a disproportionate distribution can invalidate the S Corp election.

If a disproportionate distribution has occurred, the corporation must take immediate action to correct the error by equalizing the distributions. The first step in this regard is to determine the actual distribution per share to each shareholder.and thenyou need to identify the shareholder who received the highest distribution per share. Then, determine the amount that each shareholder should have received at that per share level. Next, subtract the amount each shareholder received to determine the amount of equalizing distributions that must be paid to each shareholder. This must be done separately for each distribution that the corporation makes – each distribution stands on its own.It should then be determined if the distributions to each shareholder can be paid tax-free out of profits and do not violate corporate distribution limitations. If this requirement cannot be met, other actions must be taken.