S-Corp Shareholder Distributions: What You Need to Know
S corp shareholder distributions are the earnings by S corporations that are paid out as dividends to shareholders and only taxed at the shareholder level. 5 min read updated on October 24, 2024
Key Takeaways:
S-Corp distributions are not subject to self-employment tax.
Distributions must not exceed a shareholder's stock basis.
Shareholder-employees must take a reasonable salary before distributions.
Disproportionate distributions can cause tax issues and disputes.
Solvency must be maintained before making shareholder distributions.
For many business owners, the S-Corporation (S-Corp) structure provides a more flexible, tax-efficient way to distribute company profits. In an S-Corp, the company does not pay any federal taxes–instead, it passes its income and tax deductions to the shareholders, who become responsible for taxes due.
This means that S-Corp distributions have specific rules and tax implications that businesses must be familiar with. In this guide, we will explore what S-Corp shareholder distributions are, how they are taxed, key rules for determining distributions, and common mistakes to avoid.
What Are Shareholder Distributions in S Corporations?
Shareholder distributions in an S-Corp are payments made to shareholders from the company’s earnings. These payments or distributions are essentially the share of profits that are due to a shareholder. Typically, the payment amount is based on the percentage of ownership each shareholder holds in the company.
It is important to note that shareholder distributions are very distinct from wages, which are subject to self-employment taxes. Since shareholder distributions are generally not subject to these taxes, they are an attractive option for employees who receive a share of the company.
How Are S-Corp Shareholder Distributions Taxed?
Another important aspect of shareholder distributions in S corporations is that the shareholders are expected to report their share of the company’s income on their personal tax returns. This is because, as we mentioned earlier, S-Corps do not pay corporate income taxes and instead pass all profits and losses through to the shareholders. For this reason, S-Corps are known as pass-through entities.
When discussing tax implications for S-Corps, it's important to differentiate between distributions and salary payments. While distributions are not subject to employment taxes, salaries paid to shareholders must comply with the IRS's “reasonable compensation” requirement. This rule ensures that shareholders who also work for the company pay employment taxes on their wages, preventing underpayment of self-employment taxes.
One big advantage of this method is that it results in higher tax savings, which leads to higher tax returns for the company. However, it is important to ensure that distributions are made in compliance with IRS rules as outlined earlier.
How to Determine S-Corp Dividend Distributions
Unlike traditional C-Corporations, S-Corps do not pay dividends in the conventional sense. Instead, they distribute profits to shareholders. To determine the amount of distribution, several factors come into play:
Ownership Percentage: Distributions are typically allocated based on the shareholder’s ownership percentage. For example, if a shareholder owns 25% of the company, they would receive 25% of the total distribution.
Stock and Debt Basis: The shareholder's stock basis (investment in the company) and any debt basis (loans the shareholder made to the S-Corp) play a role in determining the amount and tax treatment of distributions. Distributions cannot exceed the shareholder’s stock basis, and any excess may be considered capital gains, subject to higher tax rates.
Company’s Solvency: The corporation must remain solvent after paying out distributions. Distributing more than the available profits could lead to insolvency and legal consequences.
Shareholder Distributions vs. Salary in an S-Corp
For shareholder-employees of an S-Corp, there is a key distinction between distributions and salaries. The IRS requires that shareholder-employees receive a “reasonable salary” for the work they perform before taking any additional distributions. This prevents the underpayment of employment taxes by categorizing income that should be wages as distributions.
The salary should be in line with industry standards for the role performed. For example, if a shareholder is the company’s CEO, their salary should be comparable to what other CEOs in similar companies earn. Failure to pay a reasonable salary may lead to IRS scrutiny and potential penalties.
When Can S-Corp Shareholders Receive Distributions?
S-Corp shareholder distributions are typically made only when the company has sufficient earnings and profits to cover the payout. This helps ensure that the S-Corp does not jeopardize its financial stability while paying distributions.
Below are some of the guidelines that S-Corps follow when making the decision to payout shareholder distributions.
Company Must Remain Solvent: The S-Corp should not distribute more than its available retained earnings or cash reserves, as this could risk the company's ability to meet its obligations.
Equal Treatment of Shareholders: Shareholders should receive distributions proportionate to their ownership interests. Disproportionate distributions can lead to disputes and potential tax implications.
Compliance with State Laws: Different states have specific rules regarding S-Corp distributions. It's essential to ensure that the company complies with both federal and state regulations.
Shareholder Distributions and S-Corp Stock Basis
A shareholder’s stock basis in an S-Corp plays a critical role in determining the tax treatment of distributions. The stock basis represents the shareholder's investment in the company, adjusted for contributions, distributions, income, and losses.
Below are some of the key points to consider in S-Corp stock basis calculations:
Distributions Cannot Exceed Stock Basis: If distributions exceed the shareholder's stock basis, the excess amount is treated as a capital gain, subject to capital gains tax.
Adjustments to Basis: Shareholder basis increases with additional capital contributions or allocated income and decreases with distributions or allocated losses.
Debt Basis: Loans made to the S-Corp by the shareholder can create a debt basis, which allows for additional losses to be deducted.
Understanding stock and debt basis is crucial for S-Corp shareholders to avoid unintended tax consequences and ensure compliance. For expert guidance, it is recommended to speak to an S-Corp attorney.
Common Mistakes to Avoid When Taking S-Corp Distributions
While S-Corp distributions offer significant tax advantages, there are common pitfalls that shareholders should avoid:
Failing to Take a Reasonable Salary: The IRS scrutinizes S-Corps that do not pay shareholder-employees reasonable compensation. Ensure that a fair salary is paid before taking distributions.
Exceeding Stock Basis: Distributions that exceed stock basis may lead to taxable capital gains. Always track your basis accurately.
Misunderstanding Tax Treatment: Some shareholders mistakenly believe distributions are always tax-free. While they are not subject to self-employment taxes, distributions exceeding stock basis can result in capital gains tax.
Ignoring Solvency Requirements: Making distributions without considering the company’s financial health can lead to cash flow problems and legal consequences.
Inconsistent Distribution Practices: Distributions must be proportionate to ownership. Favoring certain shareholders can lead to disputes and potential tax issues.
Understanding the rules around S-Corp shareholder distributions is essential for maximizing tax benefits and avoiding costly mistakes. To maintain accurate records and ensure compliance with IRS rules, it is strongly recommended to seek legal counsel from an attorney who is experienced with S-Corp laws. You can use UpCounsel’s resources to connect with an S-Corp attorney and seek legal counsel for your business.
