S Corporations (S Corps) offer a host of unique benefits for business owners, which is why this particular business entity is so popular among small business owners. One advantage in particular is highly valued, which relates to how profits are distributed. However, there are very rigid restrictions around this, which is why understanding S Corporation distribution rules is essential for ensuring compliance with tax laws and avoiding potential pitfalls.
What are S Corporation Distributions?
For anyone new to the idea of distributions [1], it’s important to first understand the term. S Corporation distributions refer to the portion of the company’s profits that are paid out to shareholders. So the company would “distribute” the extra money—the profits—to its shareholders. Distributions are an attractive option for S Corp shareholders who want to pull money from the business.
S Corp distributions must be made proportionally according to each shareholder’s ownership stake in the company. For example, if a shareholder owns 25% of the S Corp, they must receive 25% of the total distribution.
A shareholder’s ownership stake is typically recorded in the company’s cap table, and maintained by the company’s officers.
How are S Corp Distributions Taxed?
This is where the unique benefits of S Corps really come into play, because the taxation of S Corp distributions is one of the most highly-rated advantages of the S Corporation structure. Since S Corps are pass-through entities [2], the income is taxed at the shareholder level rather than at the corporate level. S Corps don’t pay corporate income tax. This means that distributions are not subject to corporate tax, but shareholders are still responsible for paying personal income tax on their share of the earnings.
Ordinary Income Taxation
Note that S Corp shareholders are taxed on their share of the corporation’s income regardless of whether it is distributed. This income is taxed as ordinary income on the shareholder’s personal tax return. This is why it makes good sense to do S Corp distributions; because the shareholders are going to be taxed on that income whether it stays on the S Corp’s books or whether it’s distributed to the shareholders as ordinary income. So the tax “bill” is the same. But when the money is distributed, the money goes into the shareholders’ pockets rather than staying on the S Corp’s books.
Tax-Free Return of Capital
Distributions up to the shareholder’s basis (their investment in the S Corp) are considered a tax-free return of capital. However, if distributions exceed the shareholder’s basis, the excess is generally taxed as capital gains, not as ordinary income.
Differences Between Salary and Distribution
One of the most important distinctions S Corp shareholders need to understand in order to remain compliant with the tax code is the difference between salary and distribution. Misclassifying income can lead to significant tax issues, including penalties and back taxes. Working with a CPA can help companies to avoid difficulties in this area.
Salary and Reasonable Compensation
The IRS requires that S Corp shareholders who are also employees receive a “reasonable salary” for their work. However, it’s nearly impossible for business owners to be privy to salary information from other companies and employees in order to determine how much they should pay themselves. Naturally, the salary figure is subject to payroll taxes, including Social Security and Medicare taxes. But what a “reasonable salary” means can vary depending on a lot of different factors. That’s another reason why it’s imperative to document how the salary is determined, to justify it in case of an audit, which is why it’s helpful to use report data from a 3rd party.
Distributions and Compensation
Distinguishable from salary, distributions are payments made to shareholders out of the company’s profits after salaries have been paid. These distributions are not subject to payroll taxes, making them a more tax-efficient way to compensate shareholders. Note that these distributions must be proportional to ownership stakes and under no circumstances should they be used as a substitute for reasonable compensation, lest an audit be triggered. The IRS looks very hard at S Corps for this very reason.
How to Report S Corp Distributions
Properly reporting S Corp distributions is essential for both compliance and tax purposes. Shareholders report distributions on their individual tax returns, but the S Corp must also report these distributions on its tax filings. In this way, the figures must match up. If they don’t, this could trigger an audit.
Form 1120-S and Reporting S Corp Income
S Corps files an annual tax return using Form 1120-S. This form is a reporting of the business deductions, income, and credits [3], as well as each shareholder’s share of these items. The corporation also issues a Schedule K-1 to each shareholder, which details their individual share of the S Corporation’s deductions, income, and credits.
Schedule K-1 and Reporting Shareholder Distributions
Schedule K-1 is a critical document for S Corp shareholders. Shareholders use the information from Schedule K-1 to complete their individual tax returns. Form K-1 makes it easier for shareholders who have received distributions to accurately report those distributions on their tax returns since it includes not only income and deductions but also the amount of distributions received. Shareholders should carefully review their Schedule K-1 to ensure that all distributions are accurately reported on their personal tax returns.
Common Risks and Mistakes
Here are some common risks and mistakes to avoid when operating an S Corp, making distributions to shareholders, handling payroll, and taking tax deductions.
Misclassifying Distributions as Salary
One of the most common mistakes that CPAs and auditors see is misclassifying distributions as salary or vice versa. It’s more common for salary to be counted as a distribution, but either way, it’s a mistake to be avoided. Misclassification can result in underpayment of payroll taxes, leading to penalties and interest. The IRS scrutinizes S Corps with a virtual magnifying lens for reasonable compensation issues, so it’s crucial to avoid this error.
Excessive Distributions
Taking distributions over the shareholder’s basis can trigger capital gains taxes for the shareholder, which can be quite exorbitant. Most S Corps find it beneficial to keep extremely accurate records of each shareholder’s basis to avoid this complication. Any purposeful distributions that exceed the basis should be carefully monitored and reported correctly.
S Corps are a popular choice of business entity because of the distributions and other benefits, but it’s important to use S Corporation distribution rules in the right way. To learn how to accurately determine fair salaries for your industry, turn to RCReports. Contact us today for more information.
Sources
1. S Corp Shareholder Distributions: Everything to know. (2020, June 24). UpCounsel.
S Corp shareholder distributions are the earnings by S Corporations that are paid out as dividends to shareholders and only taxed at the shareholder level.
2. Pass-through taxation. (n.d.). LII / Legal Information Institute.
Pass-through taxation refers to businesses that do not pay taxes on the entity level. Instead, the income passes to the owners of the business who pay personal income taxes for their share of the business.
3. S Corporations | Internal Revenue Service. (n.d.).
S Corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
