When it comes to S-Corporation taxes, knowing the difference between dividends and distributions is important.
It’s also good for business owners to have a clear understanding of how S-Corporation dividends or distributions are taxed. In today’s post, I’ll walk you through those differences as well as clue you in on why you might want to give yourself distributions.
Dividends vs. Distributions
The word dividends means an amount of money that is taken out of a company’s profits or reserves and paid on a regular basis to its shareholders. C corporations may choose to pay dividends to their shareholders. Then, those dividends are taxed on each shareholder’s income tax return.
On the other hand, S-Corporations don’t generally pay dividends. Instead, when an S-Corporation gives money to its shareholders, that’s called a distribution. Usually, shareholders do not pay additional taxes on those distributions.
How Distributions Are Taxed
I know I just told you that shareholders don’t pay taxes on distributions, but that doesn’t mean that Uncle Sam doesn’t get in on this money. Remember that when you’re an S-Corporation shareholder, you already pay taxes on your share of any of the profits regardless of whether the profits stay in the corporation’s bank account or find their way into your personal bank account.
When you hear that you don’t pay taxes on distributions, that means you avoid double taxation on that money. This is because an S-Corporation is a pass-through entity and you’ve already been taxed on the company’s profits.
Times When Distributions May Be Taxed
If you’ve been reading my posts long enough, you already knew there were some exceptions coming, right? One exception to the no taxes on distributions rule will happen if your S-Corporation used to be a C corporation. If that’s the case and the C corporation retained some of its profits that are now being paid out to shareholders of the S-Corporation, those distributions are actually dividends and will be taxed at the dividend rate (typically 15% or less).
The other exception doesn’t happen very often, but it occurs when an S-Corporation shareholder receives a distribution greater than that shareholder’s basis in the corporation. This is called an “in-excess-of-basis distribution” and is taxed as a capital gain (currently 15%).
Each shareholder’s stock basis in an S-Corporation is determined by the yearly completion of a Schedule K-1, which is filed along with your federal tax return. Basically, each shareholder’s stock basis begins with the amount they paid to buy stock in the company, increases to reflect the business’ income gains, and then decreases to reflect the shareholder’s portion of net losses and to reflect any distributions they’ve received from the business. If you’re not sure how this looks for your business, make sure to consult a CPA.
Wages vs. Distributions
It’s also important to understand how S-Corporation distributions are taxed because how you distribute money–either through wages or distributions–can affect how much you pay in taxes. Let me give you an example:
Lori is a 50/50 owner in a ceramics business with her friend and business partner, Kelly. They sell beautiful pieces online and in their pottery shop and they’ve designated their business as an S-Corporation. Last year, the business made $150,000 net profit, so Lori paid taxes on $75,000 of income from the business.
Lori had already determined that her reasonable compensation (salary) for the year would be $50,000. So she paid income tax and FICA taxes (Medicare and Social Security taxes) on those wages. She then put $10,000 back into the business and received the remaining $15,000 as distributions. Lori didn’t have to pay a total of 15.3% towards FICA taxes on her $15,000 in distributions, so she saved $2,295 in taxes.
If you think taking distributions from your S-Corporation makes sense for you as well, just remember that if you’re going to take distributions, you must first pay yourself a reasonable compensation in the eyes of the IRS.
If you’d like to read more articles related to this topic, here are some other posts you’ll find useful: