Key Takeaways

  • S corporation distributions are not automatically considered "dividends" and are usually not taxable unless exceeding the shareholder’s basis or sourced from C corp-era earnings.
  • Dividends from an S corp may be considered qualified dividends if they come from accumulated earnings and profits (E&P) from a prior C corporation period and meet IRS requirements.
  • Qualified dividends are taxed at lower long-term capital gains rates, provided the shareholder meets the required holding period.
  • If a shareholder's basis is exhausted, excess distributions are treated as capital gains rather than dividends.
  • Strategic planning around distributions can impact tax outcomes for S corporation shareholders.

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.

Tax Planning Considerations for S Corp Dividends

Shareholders and tax professionals often explore strategic approaches to optimize distributions from an S corporation, especially when there are C corp-era E&P balances. Some considerations include:

  • Balancing salary vs. dividends: Paying a reasonable salary helps meet IRS requirements and avoid audits, but paying excess amounts as distributions may avoid payroll taxes.
  • Timing of distributions: Managing the timing of distributions can help shareholders stay within lower tax brackets for qualified dividend treatment.
  • Documenting E&P and AAA balances: Accurate accounting records are essential to support how distributions are classified and taxed.
  • Planning for capital gain treatment: If distributions exceed stock basis, careful tax planning can ensure this amount qualifies for long-term capital gain treatment where possible.

Proper structuring can result in significant tax savings, but missteps can lead to unexpected ordinary income or penalties.

S Corp Dividends vs. Distributions: Key Differences

It’s important to distinguish between dividends and distributions in an S corporation context:

  • Distributions are typically not taxable when they come from the corporation’s AAA (Accumulated Adjustments Account) and do not exceed the shareholder’s stock basis.
  • Dividends, by definition, only occur when the distribution is from accumulated C corporation E&P. These are reportable as income and may qualify for reduced tax rates if IRS requirements are met.
  • If the S corporation has no C corp E&P, distributions are generally not treated as dividends at all.

This distinction matters because treating a distribution as a qualified dividend — and not as ordinary income or capital gain — can significantly reduce a shareholder’s tax liability.

What Makes S Corp Dividends Qualified?

For a distribution from an S corporation to be considered a qualified dividend, it must meet specific IRS criteria. Most S corp distributions are not classified as dividends under federal tax rules. Instead, they are considered returns of capital or capital gains, depending on the shareholder’s basis in the company.

However, S corp dividends can be qualified if they are:

  • Paid from the corporation’s accumulated earnings and profits (E&P) from prior C corporation years.
  • Paid to shareholders who meet the IRS qualified dividend holding period requirement — generally, holding the stock for more than 60 days during the 121-day period surrounding the ex-dividend date.
  • Distributed from stock that is not part of a hedging or straddle transaction and is issued by a U.S. corporation or qualified foreign corporation.

Qualified dividends are taxed at favorable long-term capital gains rates of 0%, 15%, or 20%, depending on the shareholder's taxable income bracket. This is in contrast to ordinary dividends, which are taxed at the higher ordinary income tax rates.

Frequently Asked Questions

  1. Are S corp dividends considered qualified dividends for tax purposes?
    Only if they are paid from accumulated earnings and profits from when the company was a C corporation and meet IRS holding period and other requirements.
  2. What is the tax rate for qualified dividends from an S corporation?
    Qualified dividends are taxed at capital gains rates of 0%, 15%, or 20%, depending on the shareholder’s income level.
  3. Do all S corp shareholders receive qualified dividends?
    No. Most S corp distributions are not classified as dividends at all unless there is C corp-era E&P involved.
  4. How do I determine if my S corp has accumulated earnings and profits?
    You should consult your corporate records or tax professional. Only earnings retained from years when the business was a C corporation count.
  5. What happens if distributions exceed my stock basis in an S corp?
    Any excess distribution is treated as a capital gain, which is subject to either short- or long-term capital gains tax depending on your holding period.

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