Are S corp distributions taxable?
When you own an S corporation or an LLC taxed as an S corporation, you can receive a salary for the work you perform and distributions from your company's profits.
Distributions offer an efficient way to transfer profits to shareholders but come with essential tax considerations. Key questions include whether these distributions are tax-free, how the shareholder's stock basis impacts taxability, and the implications if the S corp was previously a C corporation.
This article answers these questions and explains the conditions for S corporation distributions' tax-free status and relevant tax rules. Understanding these factors allows S corporation shareholders to craft an effective compensation strategy.
How S corporation distributions work
An S corporation has pass-through taxation. Its profits and losses pass through to the shareholders' tax returns, and the income generated is not taxed at the corporate level.
S corporation shareholders can take non-dividend distributions tax-free since they have already been reported on their individual tax returns.
For example, the S corporation made a profit of $15,000 each year over ten years, which was taxed yearly. In the 11th year, the corporation did not generate profit, and the shareholder took a $150,000 distribution. This has no effect since it was taxed over the course of ten years.
If the distributions exceed the stock basis, long-term or short-term capital gains may be generated.
How are S corporation distributions taxed?
Stock basis and tax-free distributions
S corporation distributions are usually tax-free to the extent of the taxpayer's basis since they were already taxed on your individual return. The basis is adjusted annually for specific items, the most common of which is the business's net income.
The purpose of increasing the basis by the business net income is that when it's distributed, it's not taxed twice, thereby preserving the single level of taxation afforded to S corporations.
Capital gains and excess distributions
If you take a distribution that exceeds the stock basis, it will be subject to a capital gains tax.
Depending on how long the stock has been held, such a distribution will be subject to a short – or long-term capital gain. The capital gain is typically reported on the shareholder's personal tax return and is subject to capital gains tax rates.
Factors affecting distribution taxability
The taxability of S corp distributions depends on three main factors:
- stock basis
- Accumulated Earnings and Profits (AE&P)
- Accumulated Adjustments Account (AAA)
Generally, an S corporation has AE&P for a tax year 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 AE&P is treated as a dividend. The purpose of the AAA is only to separate out amounts received that aren't taxable as a dividend.
Pro tip. If your S corporation was never previously a C corporation and it never purchased property of a C corporation, you don't need to keep track of AE&P or AAA. You only need to keep track of your stock or debt bases.
What's the difference between salary and distributions?
Distributions are payments to shareholders from the S corporation's earnings. As has already been explained, they are usually tax-free. Salaries are compensation paid to an S corporation shareholder-employee for services rendered to the business.
The salary is subject to payroll and income taxes, while the distributions are only subject to income tax. The IRS requires owners of S corporations to pay themselves a reasonable salary to avoid misuse of the S corporation benefits.
To define a salary for an S corp owner and employee, consider using compensation analysis reports from resources like the Bureau of Labor Statistics or Glassdoor. Ensure the salary reflects your primary role in the company. Regularly adjust the wage for changes in responsibilities and maintain documentation to support your decisions for IRS compliance.
How to report S corp distributions?
S corp distributions are reported on your business's Form 1120-S. You'll receive a Schedule K-1, which you use to pay taxes when filing your individual income tax return.
Because you report distributions on your individual tax return, you might also need to pay quarterly estimated taxes on your projected S corp profits. Their accurate reporting is essential to avoid underpayment penalties and ensure compliance with tax laws.
Bottom line
As an S corporation shareholder, you can receive a salary for your work and distributions from the profits your company generates. Distributions, unlike wages, are not subject to self-employment taxes, providing a significant tax advantage.
It is crucial to understand the tax rules surrounding S corporation distributions, including stock basis considerations and the potential for capital gains if distributions exceed this basis.
Accredited tax professionals with over 20 years of experience in business taxation can help you accurately report distributions and optimize your compensation strategy to maximize tax savings.
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Learn moreFAQ
S corporation distributions are generally not taxable to the shareholders if they do not exceed the shareholder's stock basis in the corporation.
When a distribution from an S corporation exceeds a shareholder's basis in the stock, the excess amount is taxed as a short or long-term capital gain. The capital gain is typically reported on the shareholder's personal tax return and is subject to capital gains tax rates.
S corporation distributions are reported on Schedule K-1. This form is part of the S corporation's tax return (Form 1120-S) and provides detailed information on each shareholder's share of the corporation's income, deductions, and distributions.
Dividends are typically distributions of a C corporation's profits to its shareholders. They are paid from the corporation's earnings and profits and are subject to double taxation. On the other hand, distributions from an S corporation are usually not subject to double taxation. Instead, they are taxed once at the shareholder level, provided they do not exceed the shareholder's basis in the stock.
S corp distributions are generally not taxable to shareholders if they do not exceed their basis in the stock. Excess distributions are taxed as capital gains. S corporations do not pay corporate-level taxes; income is passed through to shareholders. C corp distributions are typically taxed as dividends to shareholders and are subject to double taxation. The corporation pays tax on its earnings, and then shareholders pay tax on dividends received. C corporations pay corporate income tax on their profits.
Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.
Susan Turcotte, a seasoned CPA with over 45 years of accounting experience, holds a Bachelor's in Accounting and a Master's in Taxation from Bryant College. See more
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