Key Takeaways

  • S corporations do not typically pay "dividends" in the traditional sense; they issue distributions, which are generally not subject to double taxation.
  • Distributions from S corps are generally tax-free up to the shareholder’s stock basis; amounts exceeding the basis are taxed as capital gains.
  • Dividends are associated with C corps and are taxed twice—once at the corporate level and again at the shareholder level.
  • An S corp may pay taxable dividends only if it has accumulated earnings and profits from when it was a C corp.
  • Reasonable compensation must be paid to shareholders who work in the business; distributions alone cannot substitute for salary.
  • Understanding the difference between S corp dividends vs distributions is essential for proper tax planning and compliance.

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 an 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.

S Corp Dividends vs Distributions Explained

While the term "dividends" is often used broadly, it’s important to distinguish between dividends and distributions when discussing S corporations. S corps typically issue distributions, not dividends in the traditional C corp sense.

A dividend is a corporate payment made from after-tax profits. Because C corporations are taxed at the entity level, and shareholders are taxed again on dividends received, these are subject to double taxation.

S corporations, on the other hand, are pass-through entities. They avoid corporate-level taxation, and earnings are reported on shareholders’ individual tax returns. The funds S corp shareholders receive are called distributions, not dividends, and they are usually not taxed again if within the shareholder’s basis. This distinction is critical in understanding the keyword topic "S corp dividends vs distributions".

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. An 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.

When S Corps Pay Taxable Dividends

Although uncommon, S corporations can pay taxable dividends in certain scenarios. This occurs only when the S corp has accumulated earnings and profits (E&P) from its prior life as a C corp or from acquiring a C corp through a Section 381 transaction.

In this case, the IRS rules under Section 1368 dictate the order of distributions:

  1. Return of basis (non-taxable distribution)
  2. Taxable dividend (if E&P exists)
  3. Capital gain (if the distribution exceeds basis)

If the S corp has no accumulated E&P, all distributions are considered a return of capital up to basis, then treated as capital gain.

S Corp Profit Distribution

The board of directors of an 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.

Distributions vs Compensation for Shareholders

Shareholders who actively work for an S corp must receive reasonable compensation in the form of wages before they can take distributions. These wages are subject to payroll taxes (Social Security and Medicare), while distributions are not.

This IRS requirement is designed to prevent S corps from misclassifying earnings as distributions to avoid employment taxes. If an S corp distributes profits to a working shareholder without paying a reasonable salary, it risks IRS audits and reclassification of distributions as wages with associated penalties.

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. The 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.

Reporting Distributions and Dividends on Tax Forms

S corp shareholders must accurately report distributions on their personal income tax returns. Here's how they're typically handled:

  • Schedule K-1 (Form 1120-S): Each shareholder receives this form showing their share of the S corp’s income, deductions, and distributions.
  • Non-dividend distributions: Not taxed if within basis; reported on Schedule E.
  • Dividends (if E&P exists): Reported as taxable dividend income on the shareholder’s Form 1040.
  • Capital gains: Triggered if distributions exceed basis.

Maintaining accurate basis calculations year-to-year is essential to ensure correct tax reporting and to avoid unnecessary tax liabilities.

Frequently Asked Questions

  1. Can an S corp pay traditional dividends like a C corp?
    Not typically. S corps generally make distributions, not dividends. However, if the S corp has accumulated earnings and profits from a prior C corp structure, it may issue taxable dividends.
  2. Are S corp distributions taxed twice?
    No. Unlike C corp dividends, S corp distributions are usually not taxed at the corporate level and are only taxed at the shareholder level if they exceed the shareholder’s basis.
  3. What happens if a distribution exceeds a shareholder's basis?
    Any amount above the shareholder’s stock basis is treated as a long-term capital gain and is taxable accordingly.
  4. Do S corp shareholders have to be paid a salary?
    Yes, if they perform work for the company, they must be paid a reasonable salary subject to payroll taxes before taking distributions.
  5. How are S corp distributions reported for tax purposes?
    Distributions are detailed on Schedule K-1, and any taxable portion (such as dividends or capital gains) must be included in the shareholder’s Form 1040.

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