S corp shareholder distributions are the earnings by S corporations that are paid out or "passed through" as dividends to shareholders and only taxed at the shareholder level.

General Overview of S Corporation Distributions

Unlike a partnership, an S corporation is not subject to personal holding company tax or accumulated earnings tax. When income is earned by an S corporation, it is taxed only once, regardless of whether the income is distributed or invested.

Earnings that accumulate in a retained earnings account are not considered earnings and profits (E&P) since the income is included on each shareholder's individual tax return.

Each share of stock gives the shareholder equal rights to retained earnings. This means the rights to the distribution of retained earnings is reflected not by an agreement as it is with a partnership, but by the number of shares owned by a stockholder.

Section 1368 notes the distribution by an S corporation of property or cash may result in three distinct tax consequences to the shareholder receiving the distribution. These include:

  • A tax-free reduction of the shareholder's stock basis.
  • Taxable dividend.
  • The selling of the stock may result in capital gains.

A single distribution may include one or more of the above potential consequences.

Determining S corporation distributions is basic, but several attributes are required to complete the process. Taxability of an S corporation's distributions involves a shareholder-level attribute and two corporate-level attributes. The shareholder attribute involves a shareholder's stock basis and the corporate attributes involve its earnings and profits and its accumulated adjustments account.

Overall, the taxability of an S corporation's distributions is impacted by the combination of its earnings and profits, stock basis, and the accumulated adjustments account (AAA).

Having a thorough understanding of the role of each attribute and the taxability of a distribution eliminates confusion, which can lead to incorrect information.

Understanding the Intent of the S Corporation Distribution Rules

It is important to understand the reasons for different treatment of distributions between S corporations and C corporations.

  • A subchapter C is subject to double taxation. The taxable income earned by a C corp is first taxed at the corporate level. When the income is distributed to its shareholders, it is generally taxed as a dividend. This results in the same income earned by the corporation being taxed twice (double taxation); once at the entity level and again at the shareholder level.
  • S corporations are subject to single level taxation. Income generated by the corporation is typically not taxed at the corporate level; it is distributed among the shareholders and reported on individual tax returns for payment of tax due on their share of the S corporation's earnings.
  • Since an S corporation distributes income as single-level taxation, it will not be taxed a second time.
  • The purpose of Sec. 1368 and its regulations is to support the preservation of the differences between a C corporation and an S corporation, specifically the earnings and profits (E&P) and the single taxation process of an S corporation versus the double taxation process of a C corporation.

Taking Money Out of an S Corporation

The owners of S corporations have options to take money out of the business.

Wages

Any shareholder of an S corporation who works for the entity is considered an employee. Their tax treatment is the same as other employees who are not shareholders. This means they receive a paycheck, withholding tax is accounted for, employment taxes are taken care of, and they receive a W-2 form. A shareholder who works for the S corp should expect to receive a reasonable compensation for the work he or she performs.

Distribution from S Corporation Earnings

A regular C corporation distributing its earnings out of retained earnings is considered a dividend. C corp shareholders receive Form 1099-DIV and they will, in turn, report the dividend on their individual federal tax return.

S corporations, in general, do not make dividend distributions. They do make tax-free non-dividend distributions unless the distribution exceeds the shareholder's stock basis. If this happens, the excess amount of the distribution is taxable as a long-term capital gain.

Distributions made by an S corporation are not subject to Social security or Medicare taxes.

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