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The overall lesson to be learned through all this is fairly simple: disproportionate distributions should be avoided, but having them for a time will not necessarily result in termination of the S Corporation’s election, so long as they’re not .Differences in distributions for the sake of facilitating necessary payments to some shareholders and timing differences for other legitimate purposes won’t ruin the election, but every caution should be taken to make sure that, in the end, any disproportionate distributions are later corrected with equalizing distributions.Furthermore and for the sake of conservatism, it’s best if S Corporations avoid disproportionate distributions where possible.The standard procedure for the majority of S Corporations should be to make only distributions that are proportional to each shareholder’s ownership interest.In a private letter ruling (PLR) issued back in May of 1995, an S Corporation had a “misunderstanding of the regulations” regarding S Corporations and had made disproportionate distributions to some shareholders over others.The S Corporation intended “…to make a distribution to its shareholders to equalize the cumulative amount of per share distributions, including interest, to correct for the distributions made…” during 1995.
In short, yes, but only so long as corrective distributions are made afterwards, and so long as the disproportionate distributions are not made pursuant to any contract, shareholder agreement, or other binding document that would go so far as to suggest that shareholders have differing rights to any distributions from the S Corporation.So going back to our example, does this mean that if Tom and Jeff were to execute their plan, the business’ S Corporation election would be terminated? The first of these examples goes as follows: S, a corporation, has two equal shareholders, A and B.Under S’s bylaws, A and B are entitled to equal distributions.Notice, however, that the example points out that the difference wasn’t the result of a “binding agreement relating to distribution or liquidation proceeds.” If the timing difference the result of a binding agreement, this would effectively be considered a difference in the shareholder’s rights, and the business would constructively be considered to have more than one class of stock and thus lose its S Corporation election.
Several private letter rulings also give some examples where temporarily disproportionate distributions have been allowed.We go from Section 1361 to the underlying treasury regulations, and we find the following explanation regarding this “one class of stock” rule: By reading this line, we should infer the general rule that distributions from S Corporations to shareholders should be proportional to each shareholder’s ownership interest.