How to Take a Distribution From an S Corp

An S corporation passes its income, losses, deductions, and credits through to its shareholders. This structure avoids the double taxation of traditional C corporations, where profits are taxed at the corporate level and again when distributed as dividends. For S Corp owners, understanding how to take money out of the business is important for managing personal finances and business operations. Distributions allow shareholders to access company profits in a tax-efficient manner.

Fundamentals of S Corporation Distributions

An S corporation distribution is a payment to a shareholder that reduces the corporation’s equity. These distributions are generally not a deductible expense for the S corporation. Instead, they are typically a return of capital or previously taxed income to shareholders, affecting their personal tax situation rather than the corporation’s taxable income.

Distributions must be distinguished from other payments, such as shareholder salaries and loan repayments. Shareholder salaries, also known as reasonable compensation, are deductible business expenses for the S corporation and are subject to payroll taxes. Loan repayments are simply the return of funds previously lent to the corporation by a shareholder and do not represent income or a distribution of profits.

Shareholder basis limits how much can be received tax-free. It represents the owner’s investment in the S corporation, including direct capital contributions and the shareholder’s share of the S corporation’s income. Basis also increases with additional capital contributions and certain debt obligations the shareholder has personally guaranteed for the corporation. Conversely, basis is reduced by the shareholder’s share of corporate losses, non-deductible expenses, and distributions received.

Maintaining accurate records of shareholder basis is important because distributions are tax-free only to the extent of this basis. Any distributions exceeding a shareholder’s basis are typically treated as taxable capital gains. The Internal Revenue Service (IRS) requires shareholders to track their basis annually on their personal tax returns, although a formal form for this specific calculation is not typically filed with the return itself.

Types of Distributions and Their Taxation

S corporation distributions are paid out in a specific order from different accounts, each with distinct tax implications. The Accumulated Adjustments Account (AAA) is the primary pool for most S corporation distributions. The AAA tracks the cumulative total of an S corporation’s taxable income and gains passed through and taxed to shareholders, less any previously distributed amounts.

Distributions from the AAA are received tax-free by shareholders, as the income has already been taxed at the shareholder level. This account reflects income earned and taxed since the S corporation election took effect. S corporations must track their AAA balance annually, as it directly impacts the taxability of distributions.

Beyond the AAA, S corporations may also have an Other Adjustments Account (OAA) and Previously Taxed Income (PTI). The OAA holds tax-exempt income, such as life insurance proceeds where the S corporation is the beneficiary, and related non-deductible expenses. Distributions from the OAA are tax-free, similar to AAA distributions, as they represent non-taxable amounts.

PTI applies to S corporations that previously operated as C corporations and had accumulated earnings and profits (E&P). When an S corporation makes a distribution, it comes from the AAA first, then from PTI if applicable, and then from accumulated E&P. Distributions from accumulated E&P are taxed as dividends, similar to C corporation dividends, and are subject to ordinary income or qualified dividend tax rates.

Distributions exceeding the AAA, OAA, PTI, and accumulated E&P are treated as a return of capital, reducing the shareholder’s basis. Once basis is reduced to zero, further distributions are considered capital gains, subject to capital gains tax rates. Understanding this ordering rule is important for shareholders to assess the tax consequences of their distributions and plan accordingly.

Steps for Taking a Distribution

Taking a distribution from an S corporation involves several steps for financial management and compliance. The process begins with a formal decision to make a distribution, which should be documented. For multi-shareholder S corporations, this typically involves a board resolution or shareholder vote to approve the distribution amount and timing. Even for a single-owner S corporation, it is advisable to create a written record, such as an owner’s resolution, authorizing the distribution.

Once the decision is made, the distribution must be recorded in the company’s accounting books. This involves debiting the appropriate equity account, such as retained earnings or the AAA, and crediting the cash account. This record-keeping is important for maintaining accurate financial statements and for future tax reporting.

Taking a distribution involves transferring funds from the S corporation’s bank account to the shareholder’s personal bank account. This transfer can be made via check, electronic funds transfer, or wire. It is important to ensure the S corporation has sufficient cash flow to cover the distribution without jeopardizing its operational needs. Distributions can be taken at any time, but many S corporation owners choose to take them periodically, such as monthly or quarterly, or as a lump sum at year-end.

Distribution timing can be influenced by the need to cover the shareholder’s tax liability on the S corporation’s pass-through income. Since S corporation income is taxed to the shareholder even if not distributed, owners often take distributions to pay estimated taxes. It is advisable to consult with an accountant to determine the optimal timing and amount of distributions based on the S corporation’s profitability, cash position, and the shareholder’s individual tax situation.

Ongoing Record Keeping and Reporting

Maintaining accurate records is important for S corporations, particularly concerning distributions and their impact on shareholder accounts. The S corporation must track its Accumulated Adjustments Account (AAA) balance throughout the year. This tracking involves adjusting the AAA for income, losses, non-deductible expenses, and distributions. A precise AAA balance is important for determining the taxability of future distributions.

Shareholders are responsible for tracking their individual stock basis annually. This involves adjusting their initial investment for their share of S corporation income, losses, and distributions. While the S corporation provides distribution information, the ultimate responsibility for calculating and maintaining accurate shareholder basis lies with the individual shareholder for personal tax filings. This basis calculation is important for determining the tax-free portion of distributions and any potential capital gains.

For tax reporting purposes, S corporations report distribution information on Schedule K-1 (Form 1120-S) for each shareholder. Schedule K-1 details the shareholder’s share of the S corporation’s income, deductions, credits, and distributions. Distributions are reported in Box 16, Code D, indicating the total amount distributed during the tax year. This information is used by the shareholder to complete their individual income tax return, Form 1040.

Beyond tax forms, S corporations should retain all supporting documentation related to distributions. This includes board resolutions or owner approvals, general ledger entries showing the debit to equity and credit to cash, bank statements reflecting the transfer of funds, and other relevant financial records. Record-keeping ensures compliance with IRS regulations and provides a clear audit trail should the S corporation or its shareholders be subject to an examination.