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.

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.

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.

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

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