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.).
Edited by BK-CPA on 5/3/2010 at 7:11 PM EST