Unlike a permanent termination of business activity, a temporary termination does not give rise to any taxation.
Example: a business operator who is forced to temporarily stop his business activity during a period of medical convalescence.
To the extent that a distribution is made from the corporation’s earnings and profits, it is taxed to the shareholder as a dividend. The portion of the distribution that is not considered a dividend is applied first to reduce the shareholder’s basis in the corporation’s stock. Any remaining portion is treated as gain from the sale or exchange of property (capital gain). Important Note: If a shareholder assumes a liability or takes property subject to a liability, the amount of the distribution is reduced by the amount of the liability. Special rules also apply at the corporate level. Special rules apply to distributions to a shareholder in exchange for the shareholder’s stock (redemptions).
Instead of being treated as dividends, redemptions are treated as a sale or exchange of the stock by the shareholder. The distinction can be important when the long-term capital gains rates (which apply to redemptions) are higher than the tax rates on dividends.
Because the income of S corporations is taxed to the owners when the income is earned, a mechanism is needed to ensure that the shareholder is not taxed again when the earnings are distributed.