Tax Liabilities for 'Pass-Through' Company Shareholders

I am a minority shareholder in an S-corp that had a good fiscal year. I will have pass-through income for 2010 that will create a healthy amount of federal and state taxes, more than I could come up with. How do most S-corps handle the tax liabilities created for shareholders? Is there an obligation for the S-corp to make a distribution to cover taxes? —WEA, Portersville, Pa.

There is no IRS rule stating when the owners of a company must make cash distributions to owners or shareholders. Corporate shareholders, however, typically negotiate legal agreements before they get into business together that cover such items as distribution guidelines.

Sometimes individuals who acquire stock after the corporation has been formed do not get input on those agreements, which may be your situation. At any rate, your question points out one of the drawbacks of being a minority shareholder in a pass-through entity, a category that includes limited liability companies (LLCs) and partnerships as well as S-corps.

"In common practice, most such entities do provide a cash distribution for the owners in recognition of the potential tax liability related to earnings," says Keith Hall, national tax adviser for the National Association for the Self-Employed. "Many have this policy included in management or partnership agreements or procedures, but it certainly isn't required by any outside party."

Typically, when a business is profitable, shareholder distributions are made after the end of the year to reward investors. Those distributions, often made in April, can help cover tax liability relating to profits, says Ted Hilliard, managing consultant at Hilliard Management Group in San Francisco. "Distributing 20 percent to 40 percent of profits is usually enough to cover shareholders' federal and state income tax requirements," he says.

Open Communication

If the S-corp has had past losses funded by loans, much of the excess cash flow the company is now generating is probably going to debt repayment. "This creates an interesting problem for the business that is still cash-strapped, even though it is now making a profit," Hilliard points out. Keeping up-to-date budget and cash-flow forecasts can help determine how much profit to distribute to shareholders, while still retaining sufficient working capital.

Talk to company management and the controlling shareholders about what the company has done in past profitable years, whether a shareholder's agreement is in place, and whether you are a party to it.

Make it clear that you will not be able to fund the 2010 tax liability on your own. Open communication from you and other shareholders will "give them a clear understanding of the goals and cash needs of all shareholders," Hall says. "The good news is that majority shareholders will also have pass-through income that should generate tax liability, so that they most likely would not oppose cash distributions."

They should be aware that as corporate officers, they have a fiduciary duty to shareholders under state law, says Steve Kunkel, a CPA and tax managing director at CBIZ (CBZ) Los Angeles. If that duty does not make them sufficiently cooperative, you do have a last-ditch alternative, he says: "If there is no existing shareholders agreement, there would generally be no restriction preventing a minority shareholder from selling or transferring the S-corporation stock to an ineligible shareholder, which could terminate the S election." Before you resort to something like that, however, approach them cordially, and you're likely to get reasonable accommodation by next April.