How are S-Corp Distributions Taxed? An Easy Guide [+ 1 Simple Rule]

While S-Corp distributions offer many benefits, some rules and guidelines must be followed to distribute them properly. The IRS has specific requirements on how S-Corp distributions are taxed.

In addition, S-Corporations may have their bylaws and agreements that dictate how shareholders distribute profits. In this article, we will explore the critical aspects of S-Corp dividends, including how they are distributed, their tax implications, and the rules and guidelines that must be followed to ensure compliance.

What is an S corporation?

An S corporation can be an actual corporation or an LLC that elects to file form 2553 to be taxed as such. This is a relatively simple process, and it can be terminated at some point in the future if desired.

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S-Corps will save business owners’ unemployment taxes. The business’s profits are not subject to Social Security and Medicare tax like a sore proprietor is. However, business owners and officers must pay themselves a reasonable wage for the work they do for the company.

If you plan on having your business for years to come with reasonable profits, an S corporation might work out well for you. But remember you need to have a wage on form W-2, and you will need to file form 1120-S with the IRS. The tax return is an information-only filing, and the S corporation will not pay any tax itself. But it is a record of income and expenses and the remaining profit allocated to the owner.

Discuss the pros and cons of an S corporation before considering the star versus business or converting your existing business to a more efficient tax structure. An S corporation may work out great for you.

How are S-Corp Distributions Taxed?

S-Corp distributions are taxed differently depending on whether they are considered dividends or return of capital. Dividends are distributions of the corporation’s earnings and profits and are taxable to the shareholder in the year they are received. Dividends are taxed at the shareholder’s individual income tax rate, ranging from 0% to 37%, depending on their income level.

Return of capital distributions, however, are not taxable to the shareholder in the year they are received. Instead, they reduce the shareholder’s basis in the corporation’s stock. When the shareholder sells their stock, the return of capital distribution is subtracted from the shareholder’s basis in the stock, which may result in a capital gain or loss. If the return of capital distribution exceeds the shareholder’s basis in the stock, the excess is taxed as a capital gain.

S-Corp shareholders need to keep accurate records of their basis in the corporation’s stock, as this will affect the tax treatment of distributions and the calculation of capital gains or losses upon the sale of the stock. S-Corp shareholders should also work with their tax advisors to ensure that they comply with IRS rules and regulations and take advantage of all available tax benefits related to S-Corp distributions.

S Corp Owner’s Compensation

One of the key decisions that S corp owners must make is how to pay themselves. Owners of S corps can take a salary, an owner’s draw, or a combination of both. It is important to note that S corp owners who work for the company must receive a reasonable salary.

The IRS requires that S Corp owners receive reasonable compensation for their services, just like any other employee. This requirement is in place to prevent business owners from taking advantage of the pass-through tax structure to avoid paying payroll taxes.

Final thoughts

In conclusion, S-Corp distributions are critical to the corporation’s financial health and its shareholders’ wealth-building strategies. Understanding the tax implications of these distributions is essential for S-Corp shareholders to make informed decisions about their finances. By keeping accurate records of their basis in the corporation’s stock and working with their tax advisors, S-Corp shareholders can ensure compliance with IRS rules and regulations and maximize the tax benefits associated with S-Corp distributions.

It’s worth noting that the tax treatment of S-Corp distributions can be complex, and there may be additional factors to consider depending on the specific circumstances of the distribution and the shareholder’s tax situation. Therefore, S-Corp shareholders should always seek guidance from qualified tax professionals to ensure they make informed decisions and comply with all relevant tax laws and regulations. By doing so, S-Corp shareholders can maximize the benefits of their distributions and support the long-term success of their business.

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