Excess Distribution

What is an excess distribution?

An excess distribution is money taken out of a pass-through entity beyond the owner's tax basis in it. Distributions up to basis are tax free because the income was already taxed. Anything above basis becomes taxable, usually as capital gain. Owners who pull cash out faster than the business generates taxable income can trigger a tax bill with no obvious cause.

How basis runs out quietly

Basis starts with what you contributed, increases with your share of income, and decreases with losses and distributions. A firm with strong cash flow but modest taxable income, perhaps because of depreciation or a loss year, can fund large distributions that outpace basis. The K-1 reveals it after the fact. By the time the return is prepared, the distributions have already happened and the gain cannot be undone.

Preventing the surprise

Track basis during the year rather than reconstructing it at filing. Compare cumulative distributions to projected income before taking a large draw. If basis is tight, options include contributing capital, delaying the distribution into the next year, or converting part of the payment to a loan with proper documentation and terms. For S corporations, loans from the shareholder create debt basis; loans from the company do not.