S Corp Distribution Tax Rate Explained for Shareholders

Key Takeaways

• The tax rate for distributions from an S corp depends on the shareholder’s stock basis, accumulated adjustments account (AAA), and whether the distribution exceeds basis.
• S corp distributions are generally tax-free to the extent of the shareholder’s basis. Any excess is taxed as a capital gain.
• Unlike C corps, S corp distributions are not dividends, since profits flow through directly to shareholders.
• The 3.8% Net Investment Income Tax (NIIT) may apply to passive shareholders who do not materially participate in the business.
• Disproportionate distributions can risk the corporation’s S status, as all shareholders must receive distributions according to their ownership percentage.
• Shareholders must maintain accurate records of their stock basis and AAA to ensure correct tax treatment and avoid double taxation.

An S corp dividend tax rate depends on variety of factors, most notably your business income. An S corp begins as a standard C corp, but you can turn it into an S corp if you make a special request to the IRS. If you meet certain parameters, you may get a special S classification from the IRS.

This means that you’ll be taxed on an individual level, and your business would not be taxed, thus avoiding double taxation. In essence, all losses and profits flow from the business to shareholders so they can file such information on their personal tax returns.

S corps are the fastest-growing entity types because they are popular choices among small business owners. However, you must adhere to certain guidelines:

• S corps may not have over 100 shareholders
• Non-U.S. citizens and residents cannot own shares in an S corp
• Other entities cannot an S corp

Overall, all shareholders within a corporation must get a share of corporate profits. The manner in which profits get distributed depends on how a corporation pays its taxes. An S corp’s tax status mandates profit corporations-are-taxed-as-a-pass-through-entity" target="_blank">allocation to shareholders annually, but corporations are not required to distribute profits. The distribution of profits, or the retention of them, depends on state law.

C Corp Essentials

In essence, C corps pay dividends from post-tax profits. Once the C corp determines net business income and pays taxes, the remaining amount is then placed in a retained earnings account. From there, the business distributes the remaining profits to shareholders from retained earnings, and the shareholders are taxed once they file their individual tax returns. An S corp does not have retained earnings in a standard sense and does not issue dividends because the dividends are paid post-tax profits, and S corps are not subject to taxation.

Understanding S Corp Distributions vs. Dividends

Unlike C corporations, which pay dividends from post-tax earnings, S corporations make distributions that pass income directly to shareholders. These distributions are not considered traditional dividends under federal tax law because an S corporation’s income is not subject to corporate-level taxation.

An S corp distribution is generally a payment of previously taxed income to shareholders, drawn from the company’s Accumulated Adjustments Account (AAA). If the S corp has no accumulated C corp earnings and profits, distributions reduce the shareholder’s stock basis tax-free. However, once distributions exceed the shareholder’s basis, the excess amount becomes taxable as a capital gain under IRC §1368.

If an S corp retains prior C corp earnings and profits (E&P), the IRS requires a specific ordering rule:

1. Distributions are first applied to the AAA and are tax-free to the extent of stock basis.
2. Distributions from C corp E&P are treated as dividends and taxed at qualified dividend rates (0%, 15%, or 20%).
3. Any remaining distributions reduce the stock basis and, if exceeded, result in capital gains.

This distinction helps ensure that S corporations maintain their pass-through status and avoid the double taxation typical of C corporations.

Income Breakdown

If an S corp allocates $125,000 profit to you (the shareholder), the character of such income is important. If income is standard income, you would pay the standard income tax rates. If the income is considered capital gains, or dividends, you would pay a lower tax rate (ranging from 0 percent to 20 percent).

How the Tax Rate for Distributions from S Corp Applies

The tax rate for distributions from S corp income depends on how the IRS characterizes the payment and the shareholder’s involvement in the business:

• Active shareholders: If the shareholder materially participates in the business, distributions are not subject to self-employment tax. These shareholders pay ordinary income tax on their share of the S corp’s profits, whether or not distributed.
• Passive shareholders: If the shareholder does not materially participate, the 3.8% Net Investment Income Tax (NIIT) may apply to S corp distributions.
• Excess distributions: Any amount distributed beyond the shareholder’s stock basis is taxed at the long-term capital gains rate, typically 15% or 20%, depending on total income.

For example, if an S corp shareholder with a $100,000 basis receives a $120,000 distribution, only $20,000 would be taxable as a capital gain. Maintaining an accurate basis calculation is essential to avoid misreporting income and triggering IRS penalties.

Tax Possibilities

Another tax you should be aware of is the 3.8 percent net investment income tax, otherwise known as the Obamacare tax. Such a tax does not affect standard income that comes out of an S corp if a shareholder is involved in the business.

Under Section 1368, a cash distribution or property via an S corp may give way to three tax ramifications to shareholders:

• Distributions could result in reductions that are tax-free to the basis of a shareholder within the corporate stock
• Dividends that are taxable
• Gains from the selling of stock (ending in capital gains)

The aforementioned consequences are not mutually exclusive, and you may end up dealing with multiple consequences at once.

Recordkeeping and the Role of Basis in S Corp Distributions

Each shareholder must track their stock basis annually, as it determines whether a distribution is tax-free or taxable. The basis increases with:

• Contributions of capital,
• Income passed through from the S corp, and
• Tax-exempt income.

It decreases with:

• Distributions,
• Non-deductible expenses, and
• Losses or deductions passed through.

Once the basis reaches zero, further distributions become taxable as capital gains. Proper basis tracking prevents double taxation and ensures compliance with the ordering rules for distributions under IRC §1368.

Key Attributes

To understand the basic concepts of S corp distributions, you must know that determining a distribution’s taxability is paramount. Also, you need to be aware of the following attributes:

• Shareholder Attribute
• Stock Basis
• Corporate Attributes
• Earnings and Profits
• Adjustments Accumulated Account

Failure to understand such attributes could result in needless hurdles and wrong answers.

S corps that issue distributions to shareholders are not taxed. For instance, a shareholder that receives a $100,000 distribution check from an S corp means the $100,000 received is not taxed.

• Note: One of the most important things to remember is the order in which adjustments are made. This is due to the fact that distributions decrease the basis in many instances, but it is a shareholder’s stock basis that determines distribution taxation.

According to Section 1367, the shareholder of an S corp must adjust his or her corporate stock on an annual basis to show accurate items in the form of:

• Loss
• Deduction
• Income Gain
• Distribution

Such adjustments are vital in preserving single-level taxation in S corps.

In addition, shareholders must increase S corp stock basis on the following items:

• Capital contributions
• Separated stated income items (including income that’s tax exempt) and non-separate computed income
• Excesses in deductions in the depletion over property basis that’s open to depletion

Disproportionate Distributions and IRS Compliance Risks

S corporations are required to make distributions proportionally based on each shareholder’s ownership percentage. If one shareholder receives more or less than their proportional share—known as a disproportionate distribution—the IRS may determine that the S corp has created a second class of stock, which can terminate the S election.

The IRS generally allows some flexibility in timing distributions, but repeated disproportionate payments or non-pro-rata bonuses disguised as distributions can raise red flags. To maintain S status, corporations should:

• Keep distribution records showing that each shareholder received their proper percentage.
• Document all payments as either distributions, wages, or loans.
• Correct any accidental disproportionate payments promptly to prevent the loss of S status.

Loss of S corp status could cause the entity to revert to C corporation taxation, exposing shareholders to double taxation on profits and dividends.

Frequently Asked Questions

1. Are S corp distributions considered income?
   Yes, but S corp income is taxed when earned, not when distributed. Distributions themselves are generally tax-free if they do not exceed a shareholder’s stock basis.
2. How do I know if my S corp distribution is taxable?
   If the distribution exceeds your stock basis, the excess is taxed as a capital gain. Otherwise, it’s tax-free.
3. Do S corp shareholders pay self-employment tax on distributions?
   No. Distributions are not subject to self-employment tax, though shareholders must pay themselves a “reasonable salary” that is subject to payroll taxes.
4. What happens if an S corp makes unequal distributions?
   Unequal or disproportionate distributions can risk the corporation’s S status, potentially reclassifying it as a C corp and triggering double taxation.
5. How does the Obamacare tax affect S corp shareholders?
   The 3.8% Net Investment Income Tax (NIIT) may apply to passive shareholders who do not actively participate in the business. Active shareholders typically are exempt.

To learn more about an S corp dividend tax rate, submit your legal inquiry to our UpCounsel marketplace. UpCounsel’s attorneys have graduated from some of the best law schools in the nation and will help you in areas pertaining to dividends and tax rates that are applicable to your business. In addition, they will guide you through adjustments and deductions so you can avoid making unnecessary mistakes.