S Corp Distribution Tax Rate and Rules

Key Takeaways

• The S corp distribution tax rate depends on shareholder basis, earnings & profits (E&P), and whether distributions are classified as taxable dividends or return of capital.
• S corp shareholders generally avoid corporate-level tax, but must pay personal income tax on their share of business profits, regardless of whether profits are distributed.
• Distributions are typically tax-free to the extent of the shareholder’s stock basis; amounts exceeding basis may be taxed as capital gains.
• If an S corp has accumulated E&P from C corp years, part of a distribution may be taxed as a dividend.
• Proper basis tracking is essential for determining whether distributions are taxable.
• Shareholders who are employees must receive a reasonable salary before taking additional distributions.
• Certain planning strategies—such as balancing wages and distributions—can reduce self-employment taxes while staying compliant with IRS rules.

An S corp distributions tax rate depends on your business income. S corp shareholders who work for the business as employees may be classified as employees to get the same tax treatments as employees who are not shareholders. Shareholders/employees can get the following benefits:

• Paychecks
• Withheld taxes
• Employment taxes paid
• W-2

Further, shareholders who work as employees must be paid a reasonable salary for the work being conducted.

In addition, shareholders can borrow from the business, but they should use a promissory note to do so. The note should include the following:

• Interest rates
• Promise to repay
• Date of repayment

If you spend your personal money on business matters and wish to get reimbursed by the S corp, you must include documentation showing the S corp’s reimbursement to you.

C Corp Basics

When a C corp dispenses earnings from retained earnings, it is known as a dividend. C corp shareholders get Form 1099-DIV, a form that a company issues to shareholders so they can record dividends. C corp shareholders report the dividends on their personal tax returns.

How S Corp and C Corp Distribution Taxes Differ

While C corporations pay corporate income tax before distributing after-tax profits (dividends) to shareholders—creating the potential for double taxation—S corporations generally avoid this by passing income directly to shareholders. However, differences arise in how distributions are taxed:

• C Corp: Dividends are typically taxable to shareholders as ordinary or qualified dividends, depending on holding period and type of stock.
• S Corp: Distributions are generally tax-free up to the shareholder’s stock basis, with excess amounts taxed as capital gains. If the S corp has accumulated E&P from prior C corp years, part of a distribution may be taxed as a dividend.
• Rate Impact: Qualified dividends from C corps may be taxed at long-term capital gains rates (0%, 15%, or 20%), while taxable S corp distributions above basis are also taxed as capital gains, potentially at similar rates but under different rules.

Possible Consequences

According to Section 1368, the distribution of property or money by an S corp creates three possible consequences to the shareholder:

• Distribution could result in tax-free reductions of the shareholder’s basis in corporate stock
• Taxable dividends
• Gains from the selling of stock (ending in capital gains)

It’s worth noting that all consequences are not mutually exclusive, and you could face multiple penalties at once.

How to Calculate the Tax on S Corp Distributions

To determine the tax owed on an S corp distribution:

1. Start with Stock Basis: If your distribution is less than or equal to your basis, it is generally tax-free.
2. Check for Accumulated E&P: If the S corp has prior C corp earnings, distributions from E&P may be taxed as dividends.
3. Apply Capital Gains Rules: Any amount over your basis (after accounting for E&P) is taxed as a capital gain.
4. Consider State Taxes: Many states follow federal rules, but some tax S corp income differently.

Example:

• Basis: $50,000
• Distribution: $60,000
• E&P: $5,000 (taxed as dividend)
• Excess over basis: $10,000 (taxed as capital gain).

S Corp Basics

To fully understand the basic concepts of S corp distribution, you must be familiar with certain terms to determine the taxability of S corp distributions:

• Shareholder attribute
• Shareholder stock basis
• Two corporate attributes
• Profits and earnings
• Adjustment accumulated account

Salary vs. Distributions: Tax Rate Considerations

The IRS requires shareholder-employees to be paid a reasonable salary before taking additional distributions. Wages are subject to payroll taxes (Social Security and Medicare), while distributions generally are not. This creates a tax planning opportunity:

• Higher Salary: Increases payroll taxes but may boost retirement plan contributions.
• Higher Distributions: Avoid payroll taxes, but IRS scrutiny increases if salaries appear unreasonably low.

An optimal approach often involves paying a market-rate salary for services performed, then taking additional profits as distributions to reduce self-employment tax exposure.

Section Goals

The main goal of Section 1368 is to preserve differences between C and S corps, especially in regards to profits and earnings. For instance, a C corp must be taxed two times, one at the business level and another when shareholders file their personal tax returns. S corps are not taxed at the business level, and shareholders would only pay taxes upon filing their returns.

According to Section 1367, shareholders within an S corp must make annual adjustments to his or her basis in corporate stock to accurately reflect items pertaining to the following:

• Loss
• Income gains
• Deductions
• Distributions to shareholder

Such adjustments are vital in preserving single-level taxation within S corps. The shareholder should enhance the basis of his or her S corp stock regarding:

• Capital contributions
• Income items (including tax-exempt sources of income)

Further, shareholders should lower basis on distributions in the following cases:

• Other those distributions taxed as dividends under Section 1368
• Deduction and loss items (including nondeductible expenses that cannot be chargeable to capital accounts)

In addition, you must be aware of the adjustment sequence. Although distributions lower basis, in many instances, the shareholder’s stock basis will assess a distribution’s taxability.

Impact of S Corp Distributions on Personal Tax Rates

Your S corp distribution tax rate is tied to your individual income tax bracket, not a flat corporate rate. Income passed through to you—whether distributed or retained by the business—must be reported on your personal return. Key points:

• Ordinary Income: Your share of business profits (before distributions) is taxed at your marginal rate.
• Capital Gains Rates: Excess distributions above basis are taxed at capital gains rates, which may be lower than your ordinary rate.
• Dividends from E&P: If applicable, qualified dividends may receive preferential tax rates.

Proper planning can help manage your overall tax burden, especially if you expect income to push you into higher tax brackets.

Basis Breakdown

Various regulations mandate that a stock basis first be adjusted for necessary enhancements to basis. Also, stock basis is lowered via distributions before reductions in nondeductible expenses or losses. With that, a basis may not be lowered below zero in regards to the extent in which losses surpass the remaining stock basis after reductions in nondeductible expenses and distributions. This also applies to excessive losses applied to lower a basis the shareholder has in how much an S corp owes to shareholders.

If losses surpass a shareholder’s basis in debt and stock, such losses are then suspended and can be carried over on an indefinite basis.

Tracking Basis to Avoid Unexpected Taxes

Accurate basis tracking is essential because it determines whether an S corp distribution is taxable. You should update basis annually to reflect:

• Increases: Additional capital contributions, allocated income, and tax-exempt income.
• Decreases: Distributions, allocated losses, and non-deductible expenses.

If your basis reaches zero, further distributions are taxed as capital gains. Basis also affects your ability to deduct losses—loss deductions are limited to your stock and debt basis in the S corp.

Earnings and Profits

When it comes to earnings and profits, you may run into two scenarios:

• The business had amassed E&P when the S corp was a C corp in previous years
• The S corp obtained virtually all the assets of a C corp in a transaction that qualifies under Section 381, mandating that the S corp succeed to the E&P of the targets.

Special Rules for S Corps with Prior C Corp E&P

If an S corp has accumulated earnings and profits from its C corp years—or from acquiring a C corp—it must follow ordering rules for distributions:

1. AAA (Accumulated Adjustments Account): Distributions from this account are generally tax-free up to basis.
2. E&P: After AAA is exhausted, distributions are taxable as dividends to the extent of E&P.
3. Excess Over Basis: Any remaining amount is taxed as capital gain.

These rules can significantly affect your S corp distribution tax rate if prior C corp profits exist.

Frequently Asked Questions

1. Are S corp distributions always tax-free?
   No. Distributions are tax-free only up to the shareholder’s stock basis. Amounts above basis may be taxed as capital gains, and if the S corp has E&P from C corp years, part may be taxed as dividends.
2. How does my personal tax bracket affect my S corp distribution tax rate?
   Pass-through income is taxed at your individual tax rate. Excess distributions above basis are taxed at capital gains rates, which may be lower than your ordinary income rate.
3. Can I avoid payroll taxes by taking only distributions?
   No. The IRS requires shareholder-employees to take a reasonable salary before taking distributions. Salary is subject to payroll taxes; distributions generally are not.
4. What happens if my basis is zero?
   If your basis is zero, additional distributions are taxed as capital gains, and you cannot deduct further losses until basis is restored.
5. How do I track my basis in an S corp?
   Update basis annually by adding capital contributions and allocated income, and subtracting distributions, losses, and nondeductible expenses. This ensures accurate tax treatment of distributions.

To learn more about an S corp distributions tax rate, submit your legal inquiry to our UpCounsel marketplace. UpCounsel’s attorneys assist with tax law and the best way to maximize your deductions so you can get the right amount that your S corp owes you. Further, they will be at your side if you have questions regarding tax deductions, or if you have general questions on how to manage your S corp.