A business can borrow money and distribute the cash to its owners, with very different tax consequences depending on whether it is a partnership or an S…

A business can borrow money and distribute the cash to its owners, with very different tax consequences depending on whether it is a partnership or an S corporation.

S corporation and partnership basis are calculated differently. A partner’s allocated share of partnership liabilities increases basis in the partnership interest. An S corporation’s borrowings do not increase its shareholders’ stock basis. The same bank loan can therefore support a tax-free distribution in one structure and a taxable distribution in the other.

Assume an owner has $50,000 of basis before the business borrows from a bank. The owner receives a $200,000 cash distribution. If the business is a partnership and $200,000 of the new debt is properly allocated to that partner, basis increases to $250,000. The distribution reduces basis to $50,000 without creating gain.

If the business is an S corporation, the bank loan adds nothing to the shareholder’s stock basis. The same $200,000 distribution exceeds the $50,000 stock basis by $150,000, producing taxable gain. This assumes no other basis adjustments or accumulated earnings and profits from C corporation years.

This is one reason real estate is a horrible asset to own in an S corporation. Borrowing against the property and distributing the proceeds is a normal part of real estate ownership. Depreciation may have reduced the owner’s basis over time. The property can increase in value, the bank can lend against that value, and the shareholder can still owe tax when the borrowed cash comes out. The borrowing did not replenish stock basis.

But an S corporation can be useful for an operating business. An owner who works in the business must receive reasonable compensation subject to payroll taxes. The remaining nonwage distributions generally are not subject to employment taxes. That can produce a real saving compared with partnership business earnings subject to self-employment tax.

Ordinary rental income, however, generally is already excluded from self-employment tax. Putting rental real estate in an S corporation may give up borrowing and distribution flexibility without producing that payroll-tax benefit.

So it is always a balance between the two, based in part on the business. A structure that saves payroll taxes for an operating business may be a poor choice for the real estate it uses. Look at how the business earns its money, how it will borrow and how the owners expect to take money out before choosing the entity.