How Do S-Corporation Distributions Work?
S-Corporation owners can take money out of their company in a variety of ways. For purposes of this post, we will refer to S-Corporations as corporations. However, a C-Corporation or LLC can file IRS Form 2553 to elect to be taxed as an S-Corporation. 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 a capital gain. A single distribution may result in multiple consequences.
How Do S-Corporation Distributions Affect Shareholder Basis?
A shareholder’s initial basis in the stock of the S-Corporation depends on the amount of capital that shareholder contributed to the company, i.e., either an amount of cash or the fair market value of any property contributed. An S-Corporation is a pass-through entity and a shareholder’s basis changes every year, depending on income, losses, and other items.
How Are S-Corporation Distributions Taxed?
S-corporations generally make non-dividend distributions, which are tax-free, provided the distribution does not exceed the shareholder’s stock basis. The tax-free distributions reduce the shareholder’s stock basis. If the distribution exceeds the shareholder’s stock basis, the excess amount is taxable as a capital gain.
The treatment of an S-Corporation distribution depends on the shareholder’s basis in his or her S-Corporation stock; the S-Corporation’s historic earnings and profits (E&P), if any; and the S-Corporation’s and accumulated adjustments account. An S-Corporation may have E&P only if it was previously a C-Corporation. An S-Corporation distribution from historic E&P is treated as a taxable dividend. The treatment of a distribution made by an S-Corporation without accumulated E&P depends on the shareholder’s basis in the S-Corporation stock.
S-Corporations are pass through entities, meaning that shareholders report their proportional share of income and losses on their personal income tax returns. The income is taxed only once at the shareholder level at individual income tax rates. S-Corporation distributions are not subject to payroll taxes (social security and Medicare taxes).
In addition, because an S-Corporation shareholder who works for the S-Corporation is classified as an employee, they should receive reasonable compensation for the work they perform. You can minimize employment taxes by taking a salary in the lowest reasonable amount for the type of work you perform for the business. Determining a reasonable salary may be done by comparing the average wages paid in the marketplace for similar work; however, the amount can be adjusted by the IRS if it is found to be unreasonable.
