S corp qualified dividends usually refer to the dividends paid out of earnings accumulated during the tax years when an S corporation operated as a C corporation. They are often taxed at a special rate in the hands of the shareholders.

S Corp Income Taxation

S corporations are growing at the fastest speed among all business types. There are currently about 4 million S corporations in the United States.

An S corporation is a small company that fulfills special conditions set out by the IRS: it can't have more than 100 shareholders. S corporations usually distribute their earnings among their owners, also known as shareholders.

C corporations are traditional companies that pay dividends to their shareholders. C corporation dividends are taxable. However, distributions of earnings by an S corporation are not treated as dividends. They are considered as drawings from the company's Accumulated Adjustments Account, which is similar to a capital account.

An S corporation does not have to pay income tax on its earnings. The shareholders include their share of earnings in their income while calculating their individual tax liability. Thus, there is no double taxation on an S corporation's income.

Tax treatment of income distribution depends upon shareholders' basis, balance in the earnings and profits account (E&P), and the accumulated adjustments account (AAA) of the company. The E&P account contains earnings from the years when the S corporation operated as a C corporation. The distribution of earnings from an E&P account is considered as dividend payment.

At the shareholder level, S corporation distribution usually results in one or more of the following tax treatments:

  • Reduction in shareholders' basis, which is tax-free
  • Taxable dividend
  • Profit from sale of stock, which is usually capital gain

S Corp Taxation: The Usual Rule - Distributions Don't Get Taxed

When an S corp shareholder receives a distribution check, it is not taxable as such. However, this doesn't mean that S corp shareholders don't have to pay taxes on the company's profits. Shareholders are liable to pay taxes on their proportionate share in a company's profits.

Whether the company keeps the profits or distributes them among the shareholders is irrelevant. Shareholders need to pay taxes even if the company retains the profits.

Tax treatment differs for distributions coming from an S corporation having accumulated earnings and profits and those coming from an S corporation without accumulated earnings and profits. Determining taxability is more complicated in the former case.

Shareholders must report their shares in an S corporation's income and deductions via Form 1040. They pay income tax at marginal rates on the ordinary business income of the company. Capital gains and income from interest and dividends should be reported separately in schedules B and D.

Interest is a part of ordinary income. Treatment of dividends depends up their source. They either fall under ordinary income or become eligible for qualified dividends, which are taxable at a lower capital gain rate. Capital gain dividends can either be long or short term. Standard tax rates for capital gain apply to the long-term capital gain, whereas short-term capital gain becomes part of ordinary income.

Shareholders must report charitable contributions separately, along with investment expenses, in an appropriate schedule to Form 1040.

In case of an S corp with E&P, distribution of income in excess of an accumulated adjustments account is considered to be from an E&P account and is taxable as dividends. You can, however, choose to make distributions from the Earnings and Profits account first, instead of from the accumulated adjustments account.

When an S corp distribution is more than a shareholder's basis in the corporation, it is considered as capital gain. Just like qualified dividends, capital gain dividend sand long-term capital gains too are subject to special capital gain rates in the hands of an S corp shareholder.

S Corp Taxation: Exceptions to the General Rule

  • When an S corporation pays out to its shareholders from the old profits retained during the period when it operated as a regular company, such payment is considered as a dividend, which is taxable to the shareholders.
  • When the distribution amount paid to a shareholder is more than his basis in the corporation, the excess distribution is considered as long-term capital gain, which may be taxable.

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