Key Takeaways

  • S corporation profit distributions are pass-through, taxed at the shareholder level, and must be proportionate to ownership.
  • Shareholders must receive reasonable compensation before taking distributions.
  • Distributions reduce a shareholder's stock basis and must not exceed it to avoid taxation.
  • Retained earnings, shareholder loans, and dividend classifications can impact profit distribution strategy.
  • Accurate bookkeeping and legal compliance help preserve S corp status and avoid IRS penalties.

Understanding the profit distribution S Corp laws can help prevent business owners from making costly errors in this aspect of business management and taxation. All distributions of the net profits of an S corporation before the end of the year will not impact the shareholders' tax liability. All losses and/or profits of an S corporation will be passed through the business to the shareholders, which they must report on their tax returns. This rule applies whether the profits or losses were distributed or kept in the business.

However, S corporation owners may not use distributions in place of wages. All shareholders who are actively participating in the operations of the company are required to receive reasonable wages, according to rules set forth by the IRS. It's not easy to know what constitutes a reasonable wage, but a CPA can aid in determining what salary would be considered reasonable for shareholder-employees. Relying on a CPA to make that determination will satisfy the IRS requirement to collect and pay adequate employment taxes for all employees of S corporations.

IRS and Salary Distributions

The IRS may reclassify distributions as salaries paid to employees. These distributions may include disguised distributions. Examples of disguised distributions include in-kind property transfers and loans to shareholder-employees given by the corporation. Since the IRS doesn't provide specific guidance or a safe harbor regarding the amount of a reasonable salary, S corporations often use several common rules when determining a reasonable amount. These rules might include gross receipts, net business income, and the ratio of a shareholder employee's salary to distributions.

When a CPA is determining a reasonable salary amount, it's important to use caution when using any type of inflexible, set formula. Instead of using this type of calculation, a CPA should look at other factors, such as:

  • Geographic region of the corporation
  • Comparable wages within the same sector
  • Time spent working on business-related activities
  • Experience and skill of the shareholder-employee

When choosing a method, a CPA should keep careful records to document the decision, including any factors that may have been considered and applied to the process. The way you qualify the corporation under the federal tax code subchapter S will impact how profits can be distributed to shareholders.

According to rules set forth by the IRS, all S corporations must allocate losses and profits to each shareholder within the company on an annual basis for tax reporting. Failure to manage all distributions and allocations of the S corporation each year could result in a loss of the subchapter S tax status, which is a favorable business setup.

Understanding Shareholder Basis and Tax Impact

Profit distributions in an S corporation are tax-free to the extent of a shareholder’s stock basis. Once that basis is reduced to zero, any additional distribution becomes taxable as a capital gain. Shareholder basis typically includes initial investment, additional capital contributions, and allocable share of income, minus any prior distributions and losses. Accurate tracking of basis is critical for both tax planning and compliance. A failure to do so may result in unexpected tax liabilities for shareholders.

Disguised Distributions and IRS Scrutiny

The IRS pays close attention to cases where S corporations attempt to minimize employment taxes by classifying wages as distributions. These so-called "disguised distributions" may include personal expenses paid by the corporation, rent paid above market value to shareholder-owned property, or zero-interest loans. If the IRS reclassifies these as wages, the S corp could be liable for back payroll taxes and penalties. To avoid this, maintain clear records, issue reasonable salaries, and consult a tax advisor for any non-standard transactions between the business and its shareholders.

How to Distribute Net Profits for an S Corp

The first step in distributing net profits is setting reasonable salaries for all shareholders involved in providing any type of service for the business. Although the IRS doesn't outline any specific rules on what makes a reasonable salary, you can base the amount on comparable wages for other positions in the same industry. This approach is generally acceptable to the IRS.

All wages paid to shareholders are subject to employment and federal taxes, including Medicare and social security contributions, along with any required federal employment taxes. Employment taxes and wages are deductible from the company's income when looking at the net profit since these amounts are business expenses. 

The second step to distributing net profits is keeping records of all profit distributions made before the end of the year. These distributions could be reductions of investments in the business or the shareholder's basis, but they should not be recorded as business expenses. When an S corporation distributes profits, these amounts aren't subject to employment taxes or federal withholding. 

Step three is using IRS form 1120S, schedule K at the end of each tax year. This form will help you determine the portion of the business profits that is due to each shareholder. An S corporation is not required to pay corporate tax on its business profits. This business entity type is set up similarly to a partnership in that all profits of the S corporation pass through the company to its shareholders. All shareholders of an S corporation are responsible to report profits on their personal tax returns, whether or not those profits were distributed.

Profit Distribution Best Practices

To ensure proper profit distribution in an S corporation:

  • Document Distributions: Maintain detailed records of each distribution, including date, amount, and recipient.
  • Distribute Proportionally: All distributions must align with each shareholder’s ownership percentage.
  • Pay Reasonable Wages First: Salaries should reflect industry standards before issuing any distributions.
  • Track Shareholder Basis: Monitor individual basis to avoid taxable distributions.
  • Avoid Unequal Distributions: Non-pro rata distributions can jeopardize S corp status.
  • Use Consistent Schedules: Regular, predictable distributions reduce audit risks and maintain shareholder trust.

Retained Earnings vs. Distributions

Not all profits must be distributed. S corporations may retain earnings to reinvest in the business. However, those retained profits still flow through to shareholders' tax returns, and taxes are due on them regardless of whether a distribution was made. Retaining profits can be beneficial for business growth, but shareholders must be prepared to pay taxes on income they haven't received. A balanced strategy that considers both distribution needs and reinvestment goals can help ensure smooth operations and shareholder satisfaction.

Frequently Asked Questions

1. Can an S Corp distribute profits unequally among shareholders? No. Profit distributions must be made strictly in proportion to each shareholder’s ownership percentage to preserve the S corporation’s tax status.

2. Are S Corp profit distributions subject to self-employment tax? No. Distributions are not subject to self-employment tax, unlike salaries, which are subject to payroll taxes.

3. What happens if a shareholder’s basis is zero? If a shareholder’s stock basis reaches zero, any further distributions are treated as capital gains and are subject to tax.

4. Can S corporations retain profits? Yes. S corporations may retain profits, but those earnings are still passed through to shareholders for tax purposes, even if not distributed.

5. How do I determine a reasonable salary for a shareholder-employee? Consider the market rate for similar positions, location, responsibilities, and time devoted to the business. A CPA can help ensure the salary is IRS-compliant.

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