S-Corp Dividends: Tax Rate, Distribution Options, FAQ [+ IRS Hazards ❌]

S-Corporations are a popular business structure for small businesses and startups because of their pass-through tax treatment and flexible ownership options. One of the key benefits of S-Corporations is that they allow shareholders to receive distributions of profits, known as S-Corp dividends, without paying corporate-level taxes.

This can provide a tax advantage for shareholders compared to traditional C-Corporations. In this context, S-Corp dividends play an important role in the company’s financial health and its shareholders’ wealth-building strategies.

Can S corps pay dividends?

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An S-corp distributes profits to shareholders. However, these distributions are not technically “dividends” because that term relates to cash distributions from a C-corp. Because S-Corps are flow-through entities, these cash distributions are typically not taxable.

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What is an S-Corp?

This corporation is the number one tax strategy for established businesses. The reason is that these structures offer audit protection and self-employment tax savings.

When you have a sole proprietor, all income is subject to Social Security and Medicare tax. But with an S Corp., only the wages paid to the company officers are subject to employment tax. The savings can be huge.

But remember, a W-2 needs to be issued at the end of the year. In addition, the owners will face higher tax filing fees due to Form 1120-S and related Schedule K-1.

If your business is a start-up with uncertain future income, jumping through the hoops to become an S corporation probably doesn’t make sense. But if you’re established or feel comfortable, you’ll have consistency, and Carlee, the nurse corporation, might work out great over the coming years.

What are S-Corp dividends?

Can an S corp pay dividends? First of all, let’s get one thing out of the way. There really is no such thing as S corporation dividends. Dividends have a specific tax connotation to them that is relevant to see corporations. Dividends can be qualified or nonqualified and are taxed at either a preferred dividend rate or as ordinary income.

Dividends are only issued by C corporations. As such, they do not exist in the context of an S corporation. However, many people refer to S corporation, draws, or distributions as dividends. This is where the misunderstanding occurs.

S-Corp “dividends” are distributions of the company’s profits that are made to the shareholders. S-Corporations are pass-through entities, which means that they do not pay federal income tax on their profits. Instead, the profits are allocated to the shareholders, who report them on their personal tax returns. S-Corporation dividends are not subject to payroll taxes like wages are, which can provide tax savings for the shareholders.

S-Corp Dividends

However, not all profits can be distributed as dividends. S-Corporations must first pay their officers a reasonable wage for the services they provide to the company. Only the remaining profits can be distributed as dividends. Additionally, the distribution of dividends must be made in proportion to each shareholder’s ownership percentage.

Is a dividend the same as a draw or distribution?

S-Corp dividends are reported on the shareholder’s personal tax return as part of their share of the company’s profits. They are taxed at the shareholder’s individual income tax rate, which may be lower than the corporate tax rate.

However, S-Corporation shareholders do pay self-employment tax on cash that is distributed as wages. The self-employment tax is a combination of Social Security and Medicare taxes that self-employed individuals are required to pay.

S-CorpC-CorpSole Proprietor
Officer W2 IssuedOfficer W2 IssuedSimple to File
Form 1120-SDouble TaxationSubject to Employment Tax
Form 2553 ElectionForm 1120Schedule C
Pass-Through TaxationDividend TaxIncluded on Form 1040

It’s important to note that S-Corporations have certain restrictions on their ownership structure. For example, they cannot have more than 100 shareholders, and all shareholders must be individuals or certain types of trusts. Additionally, S-Corporations cannot have nonresident alien shareholders or corporations as shareholders.

Dividends vs salary?

Is it better to pay yourself a salary or dividends? S Corp owners are responsible for paying self-employment tax on the income they receive as an employee. This means that the salary they receive from the S corp is subject to self-employment tax, just like any other income they earn as a self-employed individual.

However, S Corp owners may also take advantage of a tax-saving strategy by taking a portion of their income as a distribution rather than a salary. Distributions are not subject to self-employment tax, so this can be a way for S corp owners to reduce their tax liability.

It is important to note that S-Corp owners must receive a reasonable salary for the work they do for the company. 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.

How are qualified dividends taxed?

Are dividends from an S corp taxable? S-Corp dividends often get confused with C-Corp dividends. Qualified dividends are taxed at a lower rate than ordinary dividends. To be considered qualified, dividends must meet certain criteria, including being paid by a U.S. corporation or a foreign corporation that is eligible for U.S. tax treaties, and the shareholder must have held the stock for a certain period of time.

For most taxpayers, qualified dividends are subject to a maximum tax rate of 20%. However, the actual tax rate may be lower depending on the taxpayer’s income level. For taxpayers in the 10% or 15% tax bracket, qualified dividends are taxed at a 0% rate. For taxpayers in the 25%, 28%, 33%, or 35% tax bracket, the maximum tax rate on qualified dividends is 15%.

It’s important to note that non-qualified dividends, which do not meet the criteria for qualified dividends, are taxed at the taxpayer’s ordinary income tax rate. This means that non-qualified dividends can be taxed at rates as high as 37% for the highest income earners. Therefore, it’s important for taxpayers to understand the difference between qualified and non-qualified dividends and to plan accordingly in order to minimize their tax liability.

Distribution example

Let’s say you have an S-Corporation called ABC Inc., and you are the sole shareholder. Throughout the year, ABC Inc. generated $100,000 in net income after deducting all business expenses.

As an S-Corporation, you must pay yourself a reasonable salary for the services you provide to the company. Let’s assume you paid yourself a salary of $50,000. This salary is subject to Social Security and Medicare taxes (also known as payroll taxes).

After deducting your salary, the remaining net income of $50,000 is available for distribution. As the sole shareholder, you have the flexibility to determine the amount of the distribution. For example, you may decide to distribute $30,000 to yourself as a dividend and leave the remaining $20,000 in the company for reinvestment or future business needs.

It’s important to note that while your salary is subject to self-employment taxes (Social Security & Medicare), the dividend distribution is not subject to those taxes. However, the dividend distribution may still be subject to individual income tax at your personal tax rate.

Remember, the specific details of an S-Corporation distribution can vary based on a few factors such as the company’s profits, your salary, and the decisions made by the shareholders. Consulting with a tax professional or accountant is recommended to ensure compliance with tax laws and to optimize your tax strategy.

How to determine tax treatment

Determining how an S-Corp dividend is taxed involves several steps. Here are five key steps to consider:

  1. Determine the S-Corp’s Net Income

    Calculate the net income of the S-Corporation for the relevant tax year. This is the amount left after deducting all business expenses from the company’s total revenue. The net business profit is free to be distributed as long as the company has sufficient cash on hand to meet the company’s needs.

  2. Allocate and Pay Reasonable Salary

    As an S-Corp shareholder who provides services to the company, you must pay yourself a reasonable salary. Determine an appropriate salary based on industry standards and the value of the services you provide. This salary is subject to regular payroll taxes, including Social Security and Medicare taxes.

  3. Assess Retained Earnings

    After paying the reasonable salary, assess the remaining earnings available for distribution. These retained earnings represent the portion of the S-Corp’s net income that can be distributed to shareholders as dividends.

  4. Distinguish Between Dividend and Return of Capital

    Determine the portion of the distribution that constitutes a dividend and the portion that is a return of capital. Dividends are taxable income, while the return of capital is generally not subject to immediate taxation. The return of capital reduces the shareholder’s basis in the S-Corp stock, which can have tax implications upon the sale of the stock.

  5. Report Dividend Income on Personal Tax Return

    Any dividend income received from the S-Corp must be reported on the shareholder’s personal tax return. The net profit will be reported on Form K1 and issued to the shareholders. This will be taxed as part of the individual’s taxable income.

Final thoughts

Overall, S-Corp dividends are a way for shareholders to receive a return on their investment in the company. By following the rules and guidelines for distributing dividends, S-Corporations can provide a source of income for their shareholders while maintaining compliance with IRS regulations.

It’s important to note that not all of the profits of an S-Corporation are eligible to be distributed as dividends. S-Corporations must pay their officers a reasonable wage for the services they provide to the company. The profits paid as wages are not eligible to be distributed as dividends. Additionally, S-Corporations may have other expenses and obligations that must be paid before profits can be distributed.

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