This is multiple questions, so we'll do them one at a time:
1) Question: An Sub S corp is bringing in a new shareholder. Can they distribute the new shareholder's stock purchase as a capital gain if the cash is distributed among the shareholders?
1) Answer: No. The purchase of stock doesn't result in capital gain if the stock is purchased directly from an issuing entity in exchange for consideration given to the entity. If the new shareholder is purchasing the stock of existing shareholders, as opposed to new stock, then the gains are not going to run through the S-Corp return. It's the same as selling a share of Microsoft... Microsoft isn't going to report your capital gain on its tax return.
2) Question: Does the new shareholder get a piece of his investment back as they distribute the cash to all of the shareholders?
2) Answer: After realizing the answer to number one, you would no longer have asked this, as it doesn't make any sense.
3) or does the purchase get reduced by the amount of the distribution?
3) If I bought stock directly from Microsoft, and then they gave me some of my money back, yes, that would reduce my basis / the purchase price. The same goes if I bought Microsoft stock from a buddy as opposed to directly from Microsoft, and my buddy just gave me some money back.
Bonus answer: Distributions from S-Corporations may result in capital gains tax if the distribution is in excess of a shareholder's basis in the S-Corporation stock, otherwise distributions are just returns of capital and not income.
Bonus Bonus answer: S-Corporation income and expenses are taxable to the shareholders of the S-Corporation according to when the S-Corporation makes the income, not when the S-Corporation distributes it. The S-Corporation will choose a body of accounting principles for tax purposes (cash basis, accrual basis, etc.).
Sorry, we are not on the same page:
The S-Corp is selling stock to a new shareholder, the corp is receiving $200,000 for his 10% interest. The day after the cash is received, can the Corp then pay-out to the original shareholders a dividend (treated as a capital gain)??? and instead of paying the dividend to the new shareholder can the corp just reduce the cost of his 10% interest by the next day's distribution?
No, the distribution cannot be treated as capital gain by the S-Corp, because distributions are not treated as capital gains by the S-corp, and distributions are only subject to capital gains taxes in the case of S-Corp owners if the distributions exceed the owner's basis in the S-Corp stock.
Yes, although you're not going to change the accounting or tax treatment of the situation in the end by netting the contribution/distribution, make sure it is known and stated that both transactions are taking place, and that the purchase price is in fact $200,000, if that is what it is meant to be.... (as a technical observation, this is a little ridiculous though, as the purchase price isn't really $200,000 is it?)
Ok, then... So we have an S-Corporation that is currently 100% owned, correct? How then could the new shareholder not be purchasing directly from the former shareholders, an interest in the profits and loss of the S-Corp? Think about this now...
Indeed, the purchase is between the current shareholders and the soon-to-be shareholder, not the S-Corporation itself. All the S-Corp needs to do for taxes is whip out another K-1 and record the capital contributions/distributions (generally speaking).