S Corporation Dividends

Can an S corp pay dividends? While an S corporation does distribute profits to its shareholders, they are not considered dividends because that term specifically refers to profits paid out after taxes. An S corporation is not subject to corporate tax.

Dividends are paid by C corporations after net income is calculated and taxed. The leftover funds are distributed as dividends, which are taxed again on the individual shareholder's personal income tax return. Because an S corporation is not taxed on these profits as corporate income, it avoids this double taxation.

An S corporation is considered a disregarded entity and thus subject to pass-through taxation. This means that profits are allocated and taxed on the individual level. However, while this prevents double taxation, a shareholder can end up being taxed on profits they did not receive.

However, if an S corporation was previously taxed as a C corporation and has a leftover retained earnings account, those profits would be paid out as traditional dividends.

When a S corporation distributes assets to a shareholder, one of three tax consequences may occur:

  • The taxable portion of the shareholder's stock holdings is reduced.
  • He or she receives a taxable dividend.
  • The stock is sold for capital gain.

These regulations, which fall under Section 1368, provide the key difference between the earnings, profits, and taxation of C and S corporations. The non-dividend distributions made  by S corporations are tax-free as long as they do not exceed the stock basis of each stockholder. If this occurs, the excess amount is subject to long-term capital gains.

Distributions made to S corp shareholders are not subject to Medicare and Social Security taxes (FICA). For this reason, shareholders typically prefer dividends rather than compensation payments, which are taxable. However, shareholders who perform services for the company must receive a reasonable salary as compensation to prevent these corporations from avoiding payroll taxes.

Characteristics of an S Corporation

An S corporation is a C corporation that has opted to be taxed under subchapter S of the Internal Revenue Code to avoid double taxation. A S corp is considered a disregarded entity and is thus subject to pass-through taxation, in which shareholders report profits and losses on their individual tax returns.

S Corp Profit Distribution

The board of directors of a S corporation decides if and how profits are distributed to shareholders. This board is also responsible for the corporation's day to day management. The shareholders vote to elect the board members but that is the extent of their influence. Some shareholders may have enough shares to elect themselves as board members and are thus considered shareholder-directors.

Taxation of S Corporation Dividends

Each year, every shareholder must adjust his or her stock basis to reflect income gains, losses, distributions, and deduction. This is required to preserve S corporation status and avoid double taxation. Stock basis must be increased for all income, capital contributions, and excess deductions and decreased for distributions, loss and deduction items, and the amount of the shareholder deduction provided it is not greater than the shareholder's portion of the corporation's oil and gas profits, if applicable.

These adjustments must be made in a specific order because usually the stock basis determines whether a specific distribution is taxable.

  • First, required increases must be accounted for.
  • Next, basis is reduced by distributions.
  • Next, basis is reduced based on expenses that are not deductible.
  • Finally, basis is reduced for deduction and loss items if applicable.

Basis cannot be lower than zero; if losses exceed assets, they are carried forward indefinitely.

S corporations are not permitted to generate current earnings and profits. They can have accumulated earnings and profits if:

  • These earnings and profits date from before the corporation opted for S election.
  • The S corp acquired all of a C corporation's assets in a Section 381-qualifying transaction.

If an S corporation has earnings and profits and makes a distribution in that same year, taxation becomes more complex to preserve double taxation of distributed S corporation income. The amount of earnings and profits a corporation has for a specific year determines a cap on the level of distributions that are doubly taxed.

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