An S corp does not pay taxes, the income, deductions and credits flow directly through to the shareholders. Under Sec. 1368, an S corporation’s distribution of cash or property may give rise to three possible tax consequences to the recipient shareholder: a tax-free reduction of the shareholder’s basis in the corporation’s stock, a taxable dividend, or gain from the sale of the stock (generally resulting in capital gain). These options are not mutually exclusive; a single distribution may result in two or even all three of those consequences.
The treatment of an S corporation distribution depends on the shareholder’s basis in his or her S corporation stock and the S corporation’s earnings and profits (E&P) and accumulated adjustments account (AAA). An S corporation will have E&P only if it was previously a C corporation or it acquired the assets of a C corporation in a Sec. 381 transaction. An S corporation distribution from E&P is treated as a dividend. The treatment of a distribution made by an S corporation without accumulated E&P depends only on the shareholder’s basis in the S corporation stock.
So you basically would not account for an excess distribution as that is not possible under the IRS laws. You would have a return of capital transaction on your hands, not a distribution. This would reduce your basis in the company, and not result in a taxable transaction.
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