Excess Pass-Through Distributions
Pass-through entity excess distributions or another way of saying it is distributions in excess of basis sometimes come as a surprise to business owners. Excess distributions arise when the owners withdraw more money from the company than they have as an investment.
An excess distribution results when an owner receives cash or property valued in excess of their basis in the entity. Basis roughly equates to the amount remaining invested which includes money initially contributed as well as the owners pro-rata accumulated un-distributed net profit of the company. The undistributed profit of the company is profit on which the owner has or will pay income tax.
Analogy to a mutual fund
A pass-through entity is similar to a mutual fund you might own. The purchase price is your initial basis. Assume for a moment that each year the fund earns dividend income that is reinvested within the fund. You pay income tax on dividends the fund earns and reinvests even though you didn't receive the dividend in cash in your bank account. The dividend amount on which you've paid tax is added to your basis in the mutual fund. When you sell the fund your gain or loss is calculated by subtracting your basis from the sales price. Any excess of sales price over basis is capital gain. You pay tax on the capital gain at capital gain rates. Currently 15% (20% if AGI exceeds about $400k).
How is that possible?
How is it possible that there is more cash in the company than the owner's basis? When debt is incurred by the business it opens up a source of cash other than owner contributions or accumulated net profits. Thereby creating a situation where the owner sees money in the bank account, takes a distribution possibly causing their basis to fall below zero.
Where is it reported?
Basis should be tracked by the pass-through entity owner. In fact, about three years ago the IRS began requiring the completion of basis worksheets that are part of the tax returns of pass-through entity owners. The excess distributions are calculated on the pass-through owner's personal income tax return based on data that is reported to them on the K-1 they receive from the pass-through entity. The gain appears on schedule D.