“Participating” preferred also typically receives an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event.

However, participating preferred then participates on an “as converted to common stock” basis with the common stock in the distribution of the remaining assets.

If the corporation distributes the assets in kind to a shareholder pursuant to a plan of liquidation, it is treated as having sold the assets to the shareholder for fair market value.

Like C corporations, S corporations do not recognize any gain or loss on a distribution of cash to its shareholders.

If the S corporation distributes appreciated property to a shareholder, the corporation must recognize gain as if the property were sold to the shareholder at fair market value.

The amount that a shareholder receives in a liquidating distribution is treated as full payment in exchange for the shareholder’s S corporation stock.

In other words, if the S corporation is making a liquidating distribution, the shareholder is treated as having sold her stock for the amount of the distribution.

Holders of common stock then receive the remaining assets.

If holders of common stock would receive more per share than holders of preferred stock upon a sale or liquidation (typically where the company is being sold at a high valuation), then holders of preferred stock should convert their shares into common stock and give up their preference in exchange for the right to share pro rata in the total liquidation proceeds.

A shareholder’s basis in his S corporation stock is increased by the share of the S corporation income that is passed through to the shareholder.

This effectively gives the shareholder a credit to apply against the earned income when it is ultimately distributed to the shareholder, ensuring that the income is only taxed once.

While there are some differences, the S corporation basis system is similar to the rules that apply to partnerships.

The tax consequences of distributions by an S corporation to a shareholder depend on the shareholder’s basis in the S corporation stock.

The shareholder’s basis is decreased (but not below zero) by the shareholder’s share of the S corporation’s items of loss and deduction, nondeductible expenses (except expenses that are not chargeable to the capital account), depletion deduction for oil and gas property, and distributions to the shareholder that are not made from accumulated earnings and profits.