S-Corp Distributions
S-Corp distributions are payments of profits from an S corporation to its shareholders, which are generally tax-free up to the shareholder's adjusted basis in the company.
Key Takeaways
- S-Corp distributions are generally tax-free to shareholders up to their adjusted basis in the corporation.
- Shareholder basis is crucial for determining the taxability of distributions and is adjusted annually by income, losses, and prior distributions.
- Distributions exceeding a shareholder's basis are typically treated as capital gains, subject to taxation.
- Properly tracking shareholder basis is essential for S-Corp owners to avoid unexpected tax liabilities and ensure compliance.
- S-Corps are pass-through entities, meaning profits and losses are reported on the owners' personal tax returns, not taxed at the corporate level.
What are S-Corp Distributions?
S-Corp distributions refer to the payments of profits or assets made by an S corporation to its shareholders. Unlike C corporations, S-Corps are pass-through entities, meaning the corporation itself generally does not pay federal income tax. Instead, profits and losses are passed through directly to the shareholders' personal income tax returns, typically reported on Schedule K-1. Distributions are distinct from the taxable income reported; they represent the actual cash or property shareholders receive from the business.
How S-Corp Distributions Work with Shareholder Basis
The tax treatment of S-Corp distributions is primarily governed by a concept called 'shareholder basis.' A shareholder's basis represents their investment in the S corporation, adjusted over time. Distributions are generally tax-free to the extent of a shareholder's adjusted basis. Once distributions exceed this basis, the excess is typically treated as a capital gain, which is taxable.
Calculating Shareholder Basis
Shareholder basis is a dynamic figure that changes annually. It starts with the initial capital contribution and is adjusted by various factors:
- Increased by: Additional capital contributions, taxable income (including tax-exempt income).
- Decreased by: Distributions received, non-deductible expenses, and deductible losses or deductions.
Real-World Example: Tracking Distributions and Basis
Consider Sarah, a real estate investor who owns 100% of an S-Corp. Her initial investment (basis) in the S-Corp was $50,000. In Year 1, the S-Corp generates $30,000 in taxable income and distributes $20,000 to Sarah.
- Initial Basis: $50,000
- Add: Year 1 Taxable Income: +$30,000
- Subtract: Year 1 Distributions: -$20,000
- Ending Basis (Year 1): $50,000 + $30,000 - $20,000 = $60,000
In this scenario, the $20,000 distribution is entirely tax-free because it is less than Sarah's basis. Her basis increases to $60,000, which will carry over to Year 2. If, however, the S-Corp had distributed $70,000 in Year 1, $50,000 would be tax-free (reducing basis to zero), and the remaining $20,000 would be treated as a taxable capital gain.
Frequently Asked Questions
Are S-Corp distributions always tax-free?
No, S-Corp distributions are only tax-free up to the shareholder's adjusted basis in the corporation. Any distributions exceeding this basis are generally treated as capital gains, which are taxable income to the shareholder.
What is the difference between S-Corp income and distributions?
S-Corp income refers to the company's profits, which are passed through to shareholders and reported on their personal tax returns (via Schedule K-1), regardless of whether the cash is actually distributed. Distributions are the actual cash or assets physically paid out to shareholders. Income is a taxable event; distributions reduce basis and are only taxable if they exceed basis.
Why is tracking shareholder basis important for S-Corp owners?
Tracking shareholder basis is critical to accurately determine the taxability of distributions and the deductibility of losses. Without proper tracking, shareholders might incorrectly report distributions as entirely tax-free or fail to deduct legitimate losses, leading to potential IRS penalties or missed tax benefits. It ensures compliance and helps in tax planning.
Can an S-Corp distribute more cash than it has in income?
Yes, an S-Corp can distribute more cash than its current year's income. This might happen if the company has accumulated earnings from prior years or if it's distributing capital. However, such distributions will reduce the shareholder's basis and, if they exceed the basis, will be treated as taxable capital gains.