How Are S Corp Dividends and Distributions Taxed?

S corporations are a popular business structure offering distinct tax treatment for their owners. These entities allow for the advantages of corporate legal protection while providing a unique approach to how business income is taxed. Understanding the tax implications of distributions from an S corporation can be complex. This article clarifies how these distributions are taxed, providing insights into the specific rules that govern them.

Nature of S Corporation Distributions

S corporations operate under a system where corporate income, losses, deductions, and credits are passed directly to the shareholders. This arrangement means the business itself generally avoids paying federal income tax, thereby preventing the double taxation typically associated with C corporations, where profits are taxed at both the corporate level and again when distributed to shareholders. Instead, shareholders report their share of the company’s income or losses on their personal tax returns, where it is taxed at their individual income tax rates.

A “distribution” refers to cash or property that a shareholder takes out of the business. Unlike dividends from C corporations, which represent a payout of after-tax corporate profits, S corporation distributions are generally considered a return of the shareholder’s capital investment. This means that, in most cases, these distributions are not immediately taxable to the shareholder. However, the tax-free nature of distributions depends significantly on the shareholder’s investment in the company and the source of the funds being distributed.

Shareholder Basis and Its Role

Shareholder basis represents a shareholder’s investment in the S corporation for tax purposes, much like the cost basis of an asset. This figure determines the taxability of distributions received by a shareholder and the deductibility of any losses passed through from the S corporation. Tracking basis accurately is the responsibility of the individual shareholder, not the S corporation.

Initial basis is established by the amount of capital contributed by the shareholder, which can include cash or property transferred to the S corporation in exchange for stock. This investment is subject to annual adjustments based on the company’s financial activities and transactions between the shareholder and the corporation. Factors that increase a shareholder’s basis include additional capital contributions, their share of the S corporation’s income (including tax-exempt income), and the excess of depletion deductions.

Conversely, factors that decrease basis include distributions received by the shareholder, their share of S corporation losses and deductions, and certain non-deductible expenses. Distributions reduce a shareholder’s basis, and they are generally tax-free up to the amount of that basis. If distributions exceed a shareholder’s basis, the excess amount is treated as a capital gain, which becomes a taxable event for the shareholder.

Tax Treatment of Distributions

While S corporation distributions are generally tax-free up to a shareholder’s basis, the specific tax treatment depends on the source of the distribution, particularly for S corporations that may have a history as a C corporation or possess accumulated earnings and profits (E&P). The Internal Revenue Code establishes an ordering rule for distributions to determine their tax character, prioritizing them from various accounts.

The first source of distributions is the Accumulated Adjustments Account (AAA). The AAA is a cumulative tally of the S corporation’s taxable income that has already been passed through to and taxed by its shareholders, minus previous distributions and certain expenses. Distributions from the AAA are generally tax-free to the extent of a shareholder’s stock basis, as these amounts represent income that has already been taxed at the individual level.

If an S corporation has accumulated E&P from a period when it was a C corporation, distributions that exceed the AAA are then deemed to come from this E&P. Distributions sourced from E&P are treated as taxable dividends, similar to those from a C corporation, and they do not reduce a shareholder’s basis.

After distributions exhaust both the AAA and any E&P, any further distributions are then applied against the shareholder’s remaining basis as a return of capital. Once a shareholder’s basis is reduced to zero, any subsequent distributions are treated as gain from the sale or exchange of stock. This gain is taxed as a capital gain, which can be either long-term or short-term depending on the shareholder’s holding period for the stock.

Reporting S Corporation Distributions

S corporations are required to report their financial activities, including income, deductions, credits, and distributions, to the Internal Revenue Service (IRS) on Form 1120-S, U.S. Income Tax Return for an S Corporation. This form serves as the corporate tax return for the entity. The information relevant to each shareholder’s personal tax situation is then detailed on a Schedule K-1 (Form 1120-S).

Each shareholder receives a Schedule K-1, which provides the necessary figures for them to complete their individual tax returns. Distributions of cash or property from the S corporation are reported in Box 16 of the Schedule K-1. Shareholders then use the information from their Schedule K-1 to report their share of income, losses, and distributions on their personal Form 1040, U.S. Individual Income Tax Return. If distributions received exceed their stock basis, the excess amount is reported on Schedule D, Capital Gains and Losses, as a capital gain.