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Consider the following hypothetical:

  1. I start an S-corporation as sole owner and employee but contribute no initial capital or assets. My starting basis is $0. (My initial investment is my expertise, which alas is not monetarily quantifiable.)
  2. I pay myself a completely reasonable salary of $80,000 per year.
  3. The company invoices $130,000 for the year and has no expenses of any kind. (This isn't strictly true, but I want to keep it simple.) The company's portion of payroll taxes is $8,760 per year. This leaves a company profit of $41,240, i.e., (130,000 - (80,000 + 8,760)).

My understanding is that I will pay income tax on that $41,240 as a part of my total gross income, i.e., $80,000 + $41,240 = $121,240. I'd then take the usual deductions and figure out the income tax.

Now, here's the confusing part. Since my basis for the year is $0, my understanding is that if I distribute that $41,240, I also have to pay capital gains tax on it, since it is above my basis. This means I would be double-taxed on it, paying income tax and capital gains. This just does not seem right, but every example I read online seems to imply this.

Do I have to pay income tax and capital gains on distributions when my basis is $0?

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No, you do not have to pay capital gains tax on the distributions. The basis increases from $0 to $41,240 due to the company's income, and then you decrease it back to $0 with the distribution.

Income increases basis, and losses and distributions decrease basis. As long as you never distribute more than your basis, you will not have to pay capital gains on distributions.

As as side note, I calculate your company FICA at 1.45 Med and 6.2 SS = 7.65% of $80K = $6120. I realize you were using sample numbers but I'm not sure how you arrived at $8760 for payroll taxes.

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  • I was playing fast and loose with "payroll taxes". That amount also includes SUTA, FUTA, etc. I arrived at the number by running a "test" payroll with my payroll processor to see what it would produce, then extrapolating. – Gregory Higley Oct 26 '19 at 23:24
  • For a single-owner/employee S-corp, it seems like it would be mathematically impossible to "distribute more than your basis". Or am I missing something? – Gregory Higley Oct 26 '19 at 23:29
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    @GregoryHigley Regarding SUTA/FUTA, they both max out relatively quickly so I doubt it would make much difference in your calculation. For example, SUTA in FL has a new company rate of 2.7% on the first $7K, and FUTA is effectively 0.6% on the first $7K (FUTA is 6% minus a 5.4% state credit). So combined SUTA and FUTA in FL would be at most 3.3% of $7000, or $231 per year per employee. – TTT Oct 27 '19 at 1:50
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    @GregoryHigley It's possible to distribute beyond basis if the company takes on debt. Suppose your basis is $0 and you take out a loan, and then use some of the loan for distributions; then you'd owe capital gains. But even that isn't absolute because if you're a sole owner you might be able to classify that distribution as a "company loan to officer" instead, and as long as you pay it back or cover it with future profits that you don't distribute, you could possibly avoid the capital gains. – TTT Oct 27 '19 at 2:01

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