Do S Corp Distributions Count as Income?

S corporations are a popular business structure, especially for smaller businesses, largely due to their unique tax treatment. These entities are known for “pass-through taxation,” meaning the business itself generally avoids federal income tax. Instead, its profits and losses are passed directly to the owners’ personal tax returns. This structure raises a common question for S corporation owners: how are distributions from the company treated for income tax purposes? This article clarifies whether S corporation distributions count as taxable income for the owner.

Understanding S Corporation Distributions

An S corporation distribution refers to money or property that an S corporation pays out to its shareholders. These distributions are a way for owners to withdraw the profits generated by the business. Unlike wages or dividends from a C corporation, S corporation distributions are generally not considered taxable income at the time they are received. This tax treatment is a key advantage of the S corporation structure, as it helps avoid the “double taxation” that can occur with C corporations, where profits are taxed at the corporate level and again when distributed to shareholders as dividends.

The reason distributions are often not immediately taxable is because S corporations are pass-through entities. This means that the company’s income, losses, deductions, and credits are passed directly to the shareholders’ personal tax returns, where they are taxed at the individual level. Shareholders are taxed on their share of the company’s profits whether or not those profits are actually distributed. Therefore, distributions are generally considered a return of capital or a return of income that has already been taxed at the shareholder level. The taxability of distributions is directly linked to a shareholder’s “basis” in the company, which is an important concept for S corporation owners.

The Importance of Shareholder Basis

Shareholder basis is an important component for S corporation owners, as it determines the tax treatment of distributions and the deductibility of losses. It represents a shareholder’s investment in the company for tax purposes. This basis is initially established by the shareholder’s capital contributions to the corporation, including initial investments and any loans made directly to the company.

A shareholder’s basis fluctuates over time due to the S corporation’s operations. The basis increases from items like additional capital contributions, loans made to the S corporation, and the shareholder’s share of ordinary business income and separately stated income items, such as tax-exempt interest. Conversely, the basis decreases due to distributions received, ordinary business losses, separately stated deduction items (like charitable contributions), and certain non-deductible expenses. This annual adjustment process is important, and shareholders are responsible for tracking their basis.

Distributions from an S corporation are tax-free only up to the amount of the shareholder’s basis. When distributions exceed a shareholder’s stock basis, the excess amount is generally treated as a capital gain. Stock basis cannot be reduced below zero by distributions. Form 7203 may be required to calculate a shareholder’s stock and loan basis.

Distributions and Owner Compensation

S corporation owners who perform services for the business must understand the distinction between distributions and reasonable compensation (salary). The IRS requires S corporation owners who actively work for the company to pay themselves a reasonable salary, which is subject to payroll taxes, including Social Security and Medicare.

In contrast, distributions are not subject to payroll taxes, provided they are within the shareholder’s basis. The advantage for S corporation owners lies in taking a mix of both salary and distributions. The salary component covers the payroll tax obligations, while distributions allow for the withdrawal of additional profits without incurring further payroll taxes.

Adhering to the “reasonable compensation” rule is important to avoid IRS scrutiny. The IRS defines reasonable compensation as the value that would ordinarily be paid for similar services by similar businesses under similar circumstances. Factors considered in determining reasonableness include:
The owner’s training and experience
Duties and responsibilities
Time devoted to the business
Compensation paid to non-shareholder employees
Compensation paid to comparable businesses

If the IRS determines that an owner’s salary was unreasonably low, it can reclassify distributions as wages, leading to back taxes, penalties, and interest.

Reporting S Corporation Distributions

The process of reporting S corporation distributions involves specific tax forms. S corporations file Form 1120-S, which reports the corporation’s income, deductions, and other relevant items. The S corporation itself generally does not pay federal income tax.

Instead, the income and distributions are reported to individual shareholders on Schedule K-1. On Schedule K-1, distributions are typically found in Box 16, with Code D indicating non-dividend distributions. This Schedule K-1 then flows to the shareholder’s personal tax return, Form 1040.

Non-taxable distributions that do not exceed the shareholder’s basis reduce the shareholder’s basis and do not appear as a separate line item of taxable income on Form 1040. However, any portion of a distribution that exceeds the shareholder’s basis is treated as a capital gain and is reported on Schedule D and potentially Form 8949 on the shareholder’s personal tax return. It is the shareholder’s responsibility to track their basis and correctly report these amounts.