Are Distributions from an S Corp Taxable?
When dealing with distributions from an S Corporation, the taxation implications can be quite complex. This article aims to clarify the nuances surrounding whether these distributions are taxable and what criteria apply.
Understanding S Corps and Distributions
An S Corporation (S Corp) is a type of business structure where profits and losses pass directly to the shareholders, bypassing the corporation's level of taxation. This structure allows owners to avoid the double taxation issue that affects C Corps, where both the corporation and shareholders are taxed.
Dividends and Distributions
Strictly speaking, an S Corp does not issue dividends in the traditional sense, unlike a C Corp. Dividends from an S Corp are rare and generally only occur if the corporation was previously a C Corp and still has earnings and profits. In such cases, distributions are taxed similarly to dividends received by other corporations.
The Nature of Distributions
For the majority of distributions from an S Corp, it is not dividends but rather a portion of the corporate profits that are distributed. These distributions are taxed based on the shareholder's share of corporate profits. For instance, if an S Corp with 10 shares earns $10 per share, the owner with 10 shares would be taxed on $100, regardless of whether dividends are specifically paid out or not.
Tax Implications of Distributions
The primary advantage of an S Corp is that it does not pay federal income tax. Instead, the earnings of an S Corp are taxed to the owners when those earnings are earned. Distributions of those earnings are generally not taxed, but there can be exceptions depending on the circumstances.
Excess Distributions and Taxation
Distributions in excess of accumulated earnings and profits (EP) are taxable. However, if the corporation has a positive balance in its accumulated adjustments account (AAA), any distributions up to that positive balance are tax-free. Additionally, if the corporation has a positive earnings and profits (EP) balance from its C Corp years, distributions in excess of AAA are excluded from EP and taxed as dividends.
Return of Capital vs. Dividends
When distributions exceed the shareholder’s basis, they are considered a return of capital and are not taxable. Any excess is taxed at long-term capital gains tax rates.
Does the Distribution Become Tax-Free if Properly Done?
The answer to whether S Corp distributions are tax-free often depends on the proper execution of the distribution. If the distribution is based on K-1 income, only the income on the K-1 is taxable, not the distribution amount. However, it is essential to note that the two are often linked, and whether the distribution is viewed as tax-free may vary based on individual perceptions.
Conditions for Tax-Free Distributions
If the distribution is done correctly based on the K-1 income, the distribution is not taxable, and the corporation's accumulated adjustments account (AAA) and earnings and profits (EP) play a crucial role. If the AAA and EP balances are positive, distributions within those limits are tax-free. If the balances are depleted, further distributions are taxed as capital gains.
Summary
In summary, distributions from an S Corp are not always taxable. Whether a distribution is tax-free or taxable depends on various factors such as the corporation's accumulated adjustments account (AAA) and earnings and profits (EP) account balances. Proper management and understanding of these accounts can help minimize tax liabilities.