Key Takeaways:

  • S Corp Dividends: S corporations do not pay dividends in the same manner as C corporations. Instead, they make profit distributions that are not taxed at the corporate level, avoiding double taxation.
  • Tax Implications: Distributions retain their income character and may be subject to different tax rates depending on whether they are ordinary income, qualified dividends, or capital gains.
  • Special Considerations: S corporations are subject to specific rules regarding the taxation of distributions and reporting obligations with IRS forms such as 1099-DIV and Schedule K-1.
  • Distribution Types: Payments may be categorized as wages, owner distributions, or dividend distributions if the company was previously a C corporation.
  • IRS Compliance: Accurate reporting of distributions and adherence to filing deadlines are crucial to avoid penalties.

S corp dividends are profit distributions to shareholders, which are somewhat similar to traditional C corporation dividends. The difference is the handling of the proceeds and their classification. The way the corporation pays taxes will differ based on whether its organization is as a C or S corporation.

Do S Corporations Pay Dividends?

An S corporation can pay out a distribution at any time, but it's not the same as dividends that C corporations pay. C corporation dividends are declared first by the Board of Directors and when the shareholders receive them. Shareholders in a traditional corporation pay taxes on any dividends received, but only when they receive it. S corporation shareholders have to pay taxes on all income earned by the corporation when earned, whether or not they received it as a distribution.

If the S corporation has shareholders who also work for the corporation, they are employees and not considered self-employed. The company must pay one-half of their employment taxes, which is the same for C corporations as well. The income share allocated to shareholders who don't work as employees for the S corporation is not subject to employment tax, but the loss deductions might be limited by passive activity and at-risk rules.

Tax Benefits of S Corporation Distributions

S corporations provide a significant tax advantage by avoiding double taxation. Unlike C corporations, S corporation profits are only taxed at the individual level. This structure allows income to "pass through" directly to shareholders, who report it on their personal tax returns. Shareholders must still pay taxes on their share of the company's earnings, regardless of whether they receive distributions.

About S Corporation Distributions

An S corporation's unique tax status dictates that it must allocate the profits to the shareholders each year, but there is no requirement for the company to distribute them. State law can determine whether the corporation holds on to the money as working capital or distributes the profits.

S corporations begin as traditional C corporations. If the business meets certain requirements, then it can file a special tax election for taxation under the Internal Revenue Code, subchapter S. It's taxed as a disregarded entity and the profits and losses pass through to the shareholders for taxation at individual tax rates. This means an S corporation doesn't pay income taxes at the corporate level. However, the company must file Form 1120s with the IRS, which is mostly informational in nature. The S corporation also needs to provide Schedule K-1s for each employee so they know what to put down for profits and losses on their own tax returns.

Dividend distributions are then reported on Form 1099-DIV. The S corporation must complete a 1099-DIV for each shareholder who received a dividend for that tax year, and they must mail a copy to both the shareholder and the IRS. This form has biographical information on the corporation and recipient, along with the dividend amount. The IRS imposes strict penalties if you don't file this form on time so send them to the IRS by the end of February at the latest.

Dividends paid out by C corporations are technically done with after-tax profits. A traditional corporation will calculate its net income and pay the taxes on that amount, with the remainder classified as profits and placed in the retained earnings account. Shareholders receive dividends from the retained earnings and then pay taxes on their individual federal tax returns. This is what's known as “double taxation” and why the S corporation status is important for some companies. In a sense, S corporations don't have retained earnings and don't distribute dividends because they come from after-tax profits, and an S corporation doesn't pay federal taxes. Instead, an S corporation distributes profits to the company's shareholders.

IRS Requirements for S Corporation Reporting

S corporations must adhere to strict IRS reporting requirements for distributions. Every shareholder must receive a Schedule K-1 detailing their share of the corporation's income, losses, and deductions. Additionally, any distributions paid are reported on Form 1099-DIV. The deadline for filing these forms with the IRS is typically February 28 of the following year. Failure to meet these requirements can result in financial penalties.

How Distributions Affect Shareholder Basis

The amount of a shareholder’s stock basis directly impacts the taxability of S corporation distributions. Distributions reduce the shareholder's stock basis, and amounts exceeding the basis are taxed as capital gains. Maintaining accurate records of the stock and debt basis is essential to ensure proper tax treatment. Shareholders should calculate their basis annually to determine if distributions are taxable.

Special S Corporation Dividend Rules

There are two special dividend rules that relate to S corporations:

  1. Income retains its character when it's distributed to shareholders in an S corporation. This means the type of income matters. If it is ordinary income, you pay standard income tax rates. However, if it's qualified dividends or long-term capital gains, you'll pay a lower preferential tax rate.
  2. The 3.8% net investment income tax, which is the Obamacare tax, won't apply to the ordinary income of an S corporation provided the shareholder is actively involved in the business. You might have to pay it on qualified dividends and long-term capital gains though.

Impact of Passive Income on S Corporation Status

S corporations with excessive passive income may risk losing their tax status. If passive income exceeds 25% of the company's gross receipts for three consecutive years and the corporation has retained earnings from its C corporation years, the IRS may revoke the S election. To mitigate this, companies should monitor their revenue streams closely and adjust their business strategies to maintain compliance.

Types of S Corporation Distributions

When the S corporation distributes money to its shareholders, the payment distribution takes one of several forms.

  • Wages paid to an owner-employee, which will reduce the total income amount earned by the S corporation
  • Owner distribution
  • If the business operated as a C corporation previously, it could be a dividend distribution

Guidelines for Reasonable Compensation

Owner-employees of S corporations must receive "reasonable compensation" for their services, which is subject to payroll taxes. Failure to pay adequate wages can lead to IRS audits and reclassification of distributions as wages, resulting in additional tax liabilities. Determining reasonable compensation involves assessing factors such as industry standards, the owner's role, and company profitability.

FAQ Section

  1. What are S corp dividends? S corp dividends are profit distributions to shareholders, taxed only at the individual level, avoiding corporate-level taxation.
  2. Do S corporations have to distribute all profits? No, S corporations can retain earnings for operational purposes but must allocate all profits to shareholders for tax reporting.
  3. How are S corp distributions taxed? Distributions are typically not subject to additional tax unless they exceed the shareholder's stock basis, in which case they are taxed as capital gains.
  4. What is the role of Schedule K-1 in S corporations? Schedule K-1 reports each shareholder’s share of the corporation’s income, losses, and deductions for tax filing purposes.
  5. Can S corporations lose their status due to passive income? Yes, excessive passive income for three consecutive years can jeopardize an S corporation’s tax status if it also has retained earnings from C corporation years.

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