S Corporation Distributions
As a pass-through entity, S corporations distribute their earnings through the payment of dividends to shareholders, which are only taxed at the shareholder level. Income is taxed only once, when the income is earned by the S corporation, whether the income is reinvested or distributed. Unlike partnerships, S corporations are not subject to either the accumulated earnings tax or the personal holding company tax. Earnings are accumulated in a retained earnings account, but they are not considered earnings and profits (E&P), since the income is taxed on the individual returns of the shareholders. Every share of stock gives the holder an equal right to the retained earnings as any other share. So any rights to the distribution of retained earnings are represented by the number of shares held by a stockholder, not on any agreement, as in a partnership.
How Distributions Affect Shareholder Basis
A shareholder's basis in the stock of the S corporation initially depends on the amount of capital contributed by the shareholder. However, because the S corporation is a pass-through entity, the shareholder's basis changes every year, depending on income, losses, and other separately stated items. Initial basis is determined by the amount of cash paid to the S corporation for shares and by the fair market value of any property contributed to the corporation. If the stock was received as a gift, then the basis is the carryover basis of the donor; if the stock was inherited, then it receives a stepped-up basis. If the S corporation previously operated as a C corporation before the conversion, then the stock basis will equal the basis in the C corporation stock at the time of the conversion.
A shareholder's basis is subsequently modified by income and losses and other items every year. While every shareholder has a stock basis, some shareholders may also have a debt basis, equal to the amount of money lent to the corporation minus any repayments. A shareholder acquires debt basis by lending money directly to the corporation – personal guarantees do not count nor does any debt acquired by the S corporation from 3rd parties. If the debt is evidenced by a note, and the note is held longer than 1 year, then any repayment over the debt basis will be apportioned as a return of capital and as a long-term capital gain. So if you lend $10,000 to your corporation, formalized with a note, and your debt basis is reduced to 0, but the corporation pays the loan after 1 year, then you recognize the $10,000 as a long-term capital gain. If, instead, you reduce your debt basis to $5000 and the corporation pays $8000 of the note, then $4000 of that will be treated as a nontaxable return of basis and the remaining $4000 will be treated as a capital gain.
Capital Gain = (Note Balance – Debt Basis) ÷ Note Balance × Repayment Amount
Return of Capital = Repayment Amount – Portion Treated As Capital Gain
So, to calculate the apportionment of the capital gain and the return of capital for the above example:
- Capital Gain = ($10,000 – $5000) ÷ $10,000 × $8000 = $4000
- Return of Capital = $8000 – $4000 = $4000
Debt basis is increased by any additional loans made to the company, including any capitalized interest (i.e., not paid) and is decreased by loan repayments and by any losses or deductions exceeding the lender's stock basis.
Income and losses and other items pass through to the shareholder, but whether the shareholder can deduct those losses depends on whether the shareholder has sufficient basis, but losses may also be restricted by at-risk and passive activity limitations. Basis will also determine any gain or loss when the stock is finally disposed of.
A shareholder's stock basis is increased by:
- ordinary income
- separately stated income items
- tax-exempt income
- excess depletion.
Stock basis is decreased, but not below 0, by:
- ordinary loss
- separately stated loss items
- nondeductible expenses
- non-dividend distributions
- if applicable, depletion for oil and gas
Dividend distributions do not reduce basis because it is just the distribution of net income, which is taxed to the shareholder, whether distributed or not. Only non-dividend distributions reduce stock basis, which is reported on Form K-1 (Form 1120S), Shareholder's Share of Income, Deductions, Credits, etc.; dividend distributions are reported on Form 1099-DIV, Dividends and Distributions. The Schedule K-1 does not show how much of the distribution is taxable, because only the shareholder can determine that based on his basis.
The tax on the distribution and the deductibility of a loss depends on stock basis. However, the stock basis must be adjusted by flow-through items from the S corporation in a particular order:
- basis is increased for income items and excess depletion
- then decreased for:
- nondeductible, non-capital expenses and depletion
- loss and deduction items
The shareholder's basis in stock is always reduced by current year losses, even if such losses would be limited by at-risk or passive activity rules. In contrast to losses and deductions, the tax benefits of tax credits are not limited by basis. However, they may change basis, depending on the specific type of credit.
Loss and deduction items reduces stock basis 1st, but cannot reduce the basis below 0. If the shareholder also has a debt basis in the corporation, then that basis is reduced by loss and deduction items that could not be used to reduce the stock basis. However, if the shareholder has no debt basis in the corporation or the debt basis is reduced to 0, then the total of loss and deduction items exceeding the basis is suspended and can be carried forward indefinitely. Moreover, if the S corporation repays the debt when the shareholder has a reduced basis, then the amount of the repayment exceeding the basis to the shareholder is taxable to the shareholder. Any suspended loss and deduction items can be carried forward indefinitely, but they retain their character. When the shareholder finally disposes of the stock, all suspended loss and deduction items are lost; they cannot be used to reduce any gain on the stock. Additionally:
- Non-dividend distributions exceeding the stock basis is taxed as capital gain, which is treated as long-term if held longer than 1 year.
- Nondeductible expenses reduce basis, but cannot be carried forward.
- Because items carried forward retain their character, any loss and deduction items that exceed basis must be allocated pro rata to those particular items.
- Current year loss and deduction items are combined with suspended losses and deductions, but are listed separately on Schedule E, Supplemental Income and Loss.
Example: Distribution of S Corporation Earnings Stock basis $200,000 Pro rata share of annual corporate income $175,000 Cash distribution $125,000 Stock basis at end of tax year $250,000 = Stock Basis at Start of Year + Pro Rata Share of Income – Cash Distribution
The change of basis is usually calculated at the end of the tax year. It is the shareholder's duty to track basis. If the shareholder does not track basis every year, then eventually some event will occur, such as selling the stock or terminating the corporation, where the basis will need to be calculated to determine taxable income. If basis is not continually tracked, then reconstructing basis may be a very tedious process, especially if the shareholder held the stock for a number of years. If the basis must be reconstructed, then the shareholder must review all previous Schedules K-1 plus capital contributions to calculate basis. Even if the S corporation maintains records of the stock basis for each shareholder, each shareholder should also maintain their own records to ensure their accuracy.
Do S Corporations Pay Dividends?
Not really. Although an S corporation can pay a distribution anytime, that payment is quite unlike the dividends paid by a C corporation. A dividend from a C corporation is 1st declared by the Board of Directors and when the shareholders receive it, it is taxed as ordinary income, or, if it is a qualified dividend, as a long-term capital gain.
Shareholders must pay tax on dividends received from a C corporation only when they receive it. By contrast, S corporation shareholders must pay tax on all income earned by the S corporation when it is earned, regardless of whether it was received as a distribution. As a pass-through entity, shareholders of an S corporation are always entitled to their share of the earned profits.
Shareholders of an S corporation who also work for the corporation are employees of that corporation, not self-employed, so the S corporation must pay ½ of their employment taxes, just as a C corporation would.
By contrast, because a sole proprietorship is not a separate business entity, it cannot own property separately from its owner. Therefore, all income earned from the sole proprietorship is business income subject to self-employment tax. If the business owner happens to own tax-exempt income bonds or has other streams of revenue subject to different tax rates, then they are reported separately by the business owner, not by the business.
On the other hand, a partnership or limited liability company is a separate entity that can own financial securities and other property that may be taxed at different rates. Although distributions from a partnership or limited liability company may consist of capital gains or tax-free income earned from securities held by the business entity or from the return of invested capital, all the income earned by the business through the efforts of its owners are taxed as self-employment income.
However, many S corporation owners, even if they are sole owners who also worked for the corporation, do not pay all their net income as wages, so that some income will not be subject to employment taxes. It is this portion that is often called a "dividend". As a pass-through entity, all income flows through to the shareholders when it is earned and retains its character. Thus, distributions from an S corporation may consist of several components taxed at different rates:
- ordinary income
- capital gains income
- tax-exempt interest earned from tax-exempt financial instruments, such as bonds
- dividends paid by investments held by the S corporation, which may include qualified dividends that are taxed more favorably
- the nontaxable return of invested capital, or
- the return of income already taxed.
These distributions are not subject to employment taxes, because the tax code allows shareholders who also work for the corporation to designate a portion of their income, within limits, as a dividend instead of having to treat all income as wages, as other pass-through entities must do. Of course, the share of income allocated to S-corporation shareholders who do not work as employees of the corporation is not subject to employment taxes, but, as already stated, the deductibility of losses may be limited by at-risk and passive activity rules.
How Distributions Affect the S Corporation
Distributions from S corporation earnings are identical to the rules governing partnership distributions. Taxes must be paid on income when it is earned, regardless of whether it is distributed to the shareholders. Undistributed S corporation earnings are placed in a special account called the accumulated adjustments account (AAA). Any subsequent distributions from the AAA will be tax-free to the shareholders because the taxes already been paid.
Income retained by the corporation for which the shareholders already paid the tax are held in the AAA. If the S corporation previously operated as a C corporation, then there may have been accumulated earnings and profits (AEP), which is kept in a separate AEP account. Because dividends paid by a C corporation are taxable to the shareholders, any distributions from the AEP account is taxable. However, any distributions paid to shareholders are 1st deemed distributed from the AAA rather than the AEP, until the AAA is depleted, unless the shareholders choose the AAA bypass election to eliminate the balance in the AEP account. An S corporation will also have an other adjustments account (OAA) that is increased by tax-exempt income and reduced by related nondeductible expenses.
Distributions must 1st be distributed out of the AAA. When the AAA is depleted, then additional distributions come out of AEP until the AEP is depleted. Any excess over that amount is considered a nontaxable return of paid-in capital.
If the S corporation has a net loss for the year, and it pays a distribution out of AAA, then the distribution is 1st subtracted from AAA before the losses are subtracted.
|Income and Distributions||AAA||Accumulated E&P|
|Balance at start of Year 1||$800,000||0||$800,000|
|Balance at end of Year 1||$50,000||$800,000|
|Distribution||$185,000||($125,000)||($60,000)||A distribution cannot decrease AAA below zero, but a loss can. |
If distribution > AAA, then AAA is reduced to 0, then any remaining amount is subtracted from accumulated E&P.
|Balance at end of Year 2||$0||$740,000|
|Income and Distributions||AAA||Accumulated E&P|
|Balance at start of Year 1||$275,000||$25,000||$250,000|
|Balance at end of Year 1||$40,000||$225,000|
|Distribution||$10,000||($10,000)||Note that the distribution is subtracted before the loss, which is done at the end of the tax year.|
|Balance at end of Year 2||($10,000)||$225,000||Here, the loss decreases AAA below zero.|
A distribution from the AAA reduces the basis in the stock, but a distribution out of E&P as a dividend has no effect on basis. Since the AAA is necessary to segregate undistributed S corporation earnings from accumulated E&P, an S corporation that never operated as C corporation does not have to maintain this account. However, if the corporation ever becomes involved in a corporate merger, then it must segregate its earnings as an S corporation into an AAA.
S Corporation Earnings Distributed by a C Corporation
Sometimes the owners of an S corporation will want to convert to a C corporation, such as when they want to increase the number of shareholders beyond what is allowed for an S corporation or to issue preferred stock. In such a conversion, any undistributed earnings from the S corporation are considered a return of investment during a 1-year grace period from the date of the conversion. Afterwards, any distribution from the S corporation's retained earnings will be treated as a taxable dividend that does not affect the basis of the stock. Distributions from accumulated E&P are treated as taxable dividends.
Property distributions from an S corporation are treated like those from a C corporation, in that if the fair market value (FMV) exceeds the corporation's tax basis, then the corporation must recognize the gain as if it sold the property to the shareholder. If the FMV exceeds the corporation's basis in the property, then the excess is recognized as a capital gain, but if the basis is less than FMV, then the corporation cannot deduct the loss. In either case, the shareholder recipient's basis in the property = FMV.
Example: Tax Effects of a Property Distribution by an S Corporation
An S corporation distributes land to its sole shareholder.
|Original Tax Basis of Shareholder's Stock in Corporation||$300,000|
|Adjusted Basis of Land||$130,000|
|S corporation recognizes long-term capital gain on distribution: Land FMV – Adjusted Basis =||$70,000||Reported by the corporation as a separately stated item on Schedule K-1. Since the gain is recognized by a pass-through entity, the gain is taxed on Schedule D, on the shareholder's tax return.|
|Tax basis of distributed land for the shareholder =||$200,000||= FMV of Land|
|Tax Basis of Shareholder's Stock||$100,000||= Original Stock Basis – Land FMV|