How Are Distributions Taxed in an S Corp?

S Corporations offer a unique tax structure that can be advantageous for small business owners. A key aspect is how distributions are taxed, differing significantly from other corporate forms. Understanding these distinctions is essential for maximizing tax efficiency and ensuring compliance with IRS regulations.

This article examines the taxation of S Corp distributions, focusing on their treatment and implications.

Flow Through Treatment

The flow-through treatment of S Corporations allows income, deductions, and credits to pass directly to shareholders, bypassing corporate taxation. Shareholders report these items on their personal tax returns, avoiding the double taxation typical of C Corporations. For example, if an S Corp generates $100,000 in net income, this amount is distributed proportionally to shareholders based on their ownership percentage and taxed at individual rates.

This flow-through structure also affects how losses are handled. Shareholders can use losses to offset other income, but only within certain limits, such as the at-risk and passive activity loss rules. These restrictions ensure deductions are limited to the shareholder’s investment in the corporation and active participation in the business. For instance, if a shareholder has a $50,000 basis in the S Corp and the corporation incurs a $60,000 loss, only $50,000 can be deducted, with the remaining $10,000 carried forward.

Distinguishing Wages From Distributions

Differentiating between wages and distributions in S Corporations is critical for both compliance and tax efficiency. Wages, subject to payroll taxes, are payments to shareholder-employees for services rendered. These are reported on a W-2 form, and the corporation must withhold federal income, Social Security, and Medicare taxes. The IRS requires shareholder-employees to receive a “reasonable” salary, determined by industry standards, job duties, and location. Noncompliance can result in penalties and reclassification of distributions as wages, leading to additional taxes and interest.

Distributions, on the other hand, represent a return on investment and are not subject to payroll taxes. They are drawn from the corporation’s accumulated earnings and profits and taxed based on the shareholder’s basis in the corporation. Distributions exceeding the shareholder’s basis are taxed as capital gains, which often have lower rates than ordinary income. For instance, if a shareholder with a $30,000 basis receives a $40,000 distribution, the excess $10,000 is taxed at capital gains rates.

Balancing wages and distributions requires careful planning. Shareholder-employees often aim to reduce wages to minimize payroll taxes while maximizing distributions, but this must align with the IRS’s reasonable compensation requirement. Consulting tax professionals and using industry benchmarks can help determine appropriate salary levels, ensuring compliance and optimizing tax outcomes.

Ordering Rules For Distributions

The ordering rules for S Corporation distributions determine how they are classified and taxed. These rules directly impact tax liabilities and retained earnings and are outlined in the Internal Revenue Code Section 1368.

Distributions first reduce the Accumulated Adjustments Account (AAA), which tracks the corporation’s income and losses since electing S Corp status. Amounts drawn from the AAA are generally tax-free, provided they do not exceed the shareholder’s basis. For example, if the AAA balance is $20,000 and a $15,000 distribution is made, it is non-taxable if the shareholder’s basis covers the amount.

If the AAA is exhausted, distributions next reduce any previously taxed income (PTI) from pre-1983 years, though this is uncommon for most S Corps. After PTI, distributions are allocated to accumulated earnings and profits (AEP), typically from prior C Corporation years. AEP distributions are treated as dividends and taxed as ordinary income.

Basis Adjustments

Understanding basis adjustments is essential for S Corporation shareholders. A shareholder’s basis, initially established by their capital contributions, is adjusted annually based on the corporation’s financial activities. These adjustments affect the taxability of distributions and the deductibility of losses. Basis increases with additional contributions and allocated income, while it decreases with distributions, allocated losses, and nondeductible expenses. Accurate record-keeping is critical for calculating basis correctly.

The IRS specifies the order of basis adjustments: income items, including tax-exempt income, increase basis before loss items reduce it. This ensures shareholders can maximize tax-free distributions and fully deduct losses without reducing the basis below zero. For example, if a shareholder receives $10,000 in income and $5,000 in losses, the basis first increases by the income, allowing the full deduction of losses.

Reporting On Personal Tax Return

S Corporation shareholders report income, losses, and distributions on their personal tax returns using Schedule K-1 (Form 1120-S). This form details each shareholder’s share of the corporation’s income, deductions, and credits, providing the necessary information for completing individual tax filings.

Distributions are not reported as taxable income unless they exceed the shareholder’s basis. Instead, they are tracked to determine their effect on basis. For instance, if a shareholder receives a $20,000 distribution and their basis is $25,000, the distribution is non-taxable but reduces the basis to $5,000. If the distribution exceeds the basis, the excess is reported as a capital gain on Schedule D.

Schedule K-1 also includes separately stated items, such as charitable contributions or Section 179 deductions, which are reported individually on personal returns. Properly incorporating K-1 information ensures compliance and reduces the risk of audits or penalties.

State Level Variations

While federal tax treatment of S Corporation distributions is consistent, state taxation varies widely. Many states conform to federal flow-through rules, allowing income and losses to pass directly to shareholders without a corporate-level tax. However, some states, like California and New York, impose taxes or fees on S Corporations, which affect the net income available for distribution.

For example, California applies a 1.5% franchise tax on net income, with a minimum annual tax of $800. In New York, S Corporations face a fixed-dollar minimum tax based on gross receipts, ranging from $25 to $200,000. These state-level taxes reduce net income for distribution but do not change federal treatment.

Some states, such as Tennessee in the past, do not recognize S Corporation status, treating these entities as C Corporations for state tax purposes. This can result in double taxation at the state level, even if federal taxes are avoided. Shareholders operating in multiple states must also navigate apportionment rules for allocating income across jurisdictions. Understanding these variations is crucial for accurate tax planning and compliance at both corporate and individual levels.