S Corp Distribution Rules: Everything You Need to Know
S Corp Distribution Rules can be found in Section 1368, and involve three potential tax consequences to the shareholder of the S Corp.3 min read
2. Earnings and Profits
3. Accumulated Adjustment Account
4. Taking Money Out of an S Corp
7. Reimbursement of Expenses
S Corp Distribution Rules can be found in Section 1368, and involve three potential tax consequences to the shareholder of the S Corp, which include a tax-free reduction of the shareholder’s basis, a taxable dividend, or a capital gain for the sale of stock. Unlike S Corp distribution rules, a regular C Corp distributes its earnings out of retained earnings, also referred to as dividends. Therefore, the C Corp shareholders receive Form 1099-DIV, and you must identify such dividends on this form.
Shareholders in an S Corp must adjust their stock basis in order to reflect income gains/losses, deductions, and distributions provided to the shareholder throughout the taxable year. Therefore, the shareholder must increase his or her stock basis for any one of the following:
- Capital contributions
- Separate items of income, including tax-exempt income and non-separately computed income
- Excess of deductions for depleted property
A shareholder must decrease his or her stock basis for the following:
- Separate losses and deductions, including non-separately computed losses
- Non-deductible expenses
- Depletion deduction for oil or gas properties held by the S Corp to the extent in which the deduction doesn’t exceed the shareholder’s adjusted basis of the property
Earnings and Profits
S Corps cannot generate earnings and profits. However, there are two ways in which an S Corp can possess accumulated earnings and profit:
- If the S Corp accumulated earnings and profits from operating as a C Corp previously
- If the S Corp acquired all of the assets of a C Corp
If an S Corp makes a distribution in a year in which it does in fact have earnings and profits, then identifying tax for those distributions can be a bit more complex.
Accumulated Adjustment Account
S Corps can distribute income earned while operating as an S Corp before being treated as having made a distribution from the earnings and profits, thereby deferring the tax consequences of dividends. However, this deference is limited to the amount of net income that the S Corp has in its accumulated adjustment account (AAA).
The AAA was created to track the cumulative taxable income earned by S Corporations that are not yet distributed to shareholders. Therefore, a newly created S Corp will have an AAA with zero dollars in it, regardless of whether or not the newly created S Corp previously operated as another business entity.
This account is especially important for an S Corp that has accumulated earnings and profits because the balance in the AAA will serve as the indicator for how much will be taxed. For example, the S Corp will be taxed on the amount in the AAA. The S Corp will not be taxed a second time. However, C Corps will be taxed on the amount in the AAA as well as the amount of dividends paid to the shareholders.
Taking Money Out of an S Corp
If you need to take money out of an S Corp, then you should be mindful of the potential consequences of withdrawing funds, particularly depending on the reason as to why you are withdrawing the funds, whether it be to pay wages, provide a loan, or reimburse for expenses paid.
S Corp shareholders who also work for the S Corp as an employee are classified as employees for tax purposes, and receive the same type of tax treatment as any other employee who works for the business, regardless of whether or not that person is a shareholder. This means that you will be given a paycheck, taxes will be withheld, employment taxes will be paid, and a W-2 will be issued to you. If you fall into this category, then you must be paid a reasonable compensation for the type of work you are doing.
Shareholders in an S Corp can borrow money from the business. If you do borrow money, you will need to take out a loan and draft a promissory note. It should including all applicable lending terms, i.e. fair market value interest rate, repayment, etc.
Reimbursement of Expenses
If you use your own funds on business expenses, then you will be reimbursed by the business. Just ensure that you provide all relevant documentation, i.e. receipts, to ensure that you are reimbursed.
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