Are S corp distributions return of capital or capital gain when basis reaches zero?

You're actually mixing up a few concepts here. With an S corporation, income flows through to your personal tax return. The $100,000 income increases your basis, and you'll pay income tax on that amount regardless of whether you took distributions or not. The $60,000 salary is a business expense that reduces the S corp's income (though you still pay income/payroll taxes on it as compensation). The $40,000 distribution isn't taxed again because you've already paid tax on the income that flowed through to you. Your basis calculation is correct, but the conclusion is off. The distributions aren't "return of capital" or "capital gains" in this scenario - they're simply tax-free distributions of already-taxed income. If your distributions had exceeded your basis, then the excess would be capital gains.

I've been in a similar situation and discovered taxr.ai which was super helpful for figuring out the tax implications of my S corp distributions. I was also confused about basis calculations and whether distributions would be taxed as capital gains. I actually uploaded my corporate docs to https://taxr.ai and they provided a detailed analysis of my specific situation that cleared everything up much better than my googling did.

Just wanted to follow up on my skepticism about taxr.ai - I decided to try it with my own S corp documentation since I was stuck figuring out a similar basis issue. The analysis was actually impressively detailed and gave me step-by-step calculations for my specific scenario. It flagged that I had been misclassifying some distributions that should have been capital gains since I had depleted my basis. Saved me from a potential audit headache and definitely worth checking out if you're dealing with complicated S corp distribution rules.

After battling with similar S corp distribution questions, I actually ended up needing to speak directly with the IRS to get a definitive answer. I spent DAYS trying to get through their phone system without success. Then I found https://claimyr.com which got me connected to an actual IRS agent in under an hour! There's a video showing how it works here: https://youtu.be/_kiP6q8DX5c The agent confirmed that distributions in excess of basis are indeed capital gains, not return of capital. Really cleared things up for me, and saved me tons of stress trying to reach someone at the IRS.

Just wanted to update about my experience with Claimyr since I was so skeptical. I actually tried it the next day after I couldn't get through to the IRS for the third time this month. Shockingly, I got a call back connecting me to an IRS agent in about 45 minutes! I asked specifically about my S corp distribution situation with zero basis and got confirmation that distributions beyond basis are indeed capital gains. The agent even emailed me the relevant IRS publication sections. Never thought I'd say this, but it actually worked exactly as advertised.

There's something else you need to consider here - self-employment taxes. One advantage of an S corp is that distributions aren't subject to SE tax, while your salary is. At $60K salary on $100K income, you're at a 60% salary ratio which is probably reasonable for most businesses, but the IRS does look at this. Make sure you can justify that $60K as reasonable compensation for your services, otherwise they might reclassify some of those distributions as salary subject to additional payroll taxes.

Hey just FYI, don't forget about basis adjustments for things like business loans and asset purchases. They can really mess up your calculations if you don't account for them properly. I learned this the hard way last year.

This is a great discussion and really helpful for understanding S corp distributions! I'm in a similar situation with my single-member S corp and was getting confused about when distributions become taxable. One thing I'm still unclear on - if I have positive basis at the beginning of the year but take distributions that exceed my basis during the year, do I calculate the capital gains on a transaction-by-transaction basis or just at year-end? For example, if I start with $20K basis, have $10K income during the year, but take $40K in distributions spread throughout the year, are the last $10K of distributions automatically capital gains, or do I only know at year-end after accounting for all income and distributions? Also, does the timing of when during the year I take distributions matter for this calculation?