S Corp Dividends: Tax Rate, Distribution Options, and Traps

S-Corporation taxation can be confusing, and there is a lot of misinformation out there.  To ensure your doing it correctly, read on.

Table of Contents

• What is the S Corp Distribution Tax Rate?

• How LLCs Are Normally Taxed?

• What is an S-Corp?

• Dividends vs salary?

• S Corporation Shareholders Taxation

• Assigning a Fair Salary

• The Exceptions to the Rule

What is the S Corp Distribution Tax Rate?

The simplest answer is there is none.  Zero, nada.  The term S Corp Distribution Tax Rate is fake news.  That is not to say that distributions from S-Corporations are not taxable, but there is not uniform tax rate.

S-Corporations are pass through entities which means that income or loss from the entity pass through to the individuals shareholders.  Generally, whether a shareholder actually receives distributions from the S-Corporations is irrelevant to the taxation, although there is a notable exceptions covered below in The Exceptions to the Rule.

How LLCs Are Normally Taxed?

LLC's are legal entities formed at the state level.  When you create a new LLC, you have the option to choose how you want to be taxed by the Internal Revenue Service.  State and local options vary.

There are four options:

• Sole proprietorship

• Partnership

• C-Corporation

• S-Corporation

You can read more about how to form an LLC and make tax elections in this article.

What is an S-Corp?

One of the options for LLC's is to be taxed as an S-Corporation.  S-Corporations generally pay no federal income tax, and the resulting business income or loss is reported by the individual shareholders on their individual returns.

In order to be taxed as an S Corporation, you must meet certain eligibility requirements set by the IRS.  Assuming you meet this requirements, you can elect S-Corporation status by filing Form 2553 with the Internal Revenue Service.

You can read more about the eligibility requirements and filing Form 2553 in this article.  Remember, state and local rules vary, so consult a qualified tax expert about your situation.

Dividends vs salary?

One way to lower a shareholder's individual income tax is to take money out of the corporation as a dividend instead of salary.  Shareholders should take a W-2 wage (salary) from their S-Corporation if it is profitable.  Not doing so is a big red flag for the IRS.  Wages are subject to FICA tax, the equivalent of Self Employment tax.  Dividends are not subject to SE tax for an S-Corporation.

The key is what ratio.  This is a grey area with the Internal Revenue Service.  For more information on threading that needle, read this article.

S Corporation Shareholders Taxation

Business activity from an S-Corporation are reported on Schedule K-1 of Form 1120S.  The activity flows through to the shareholder exactly as it is classified in the company.  For instance, interest income is separated from ordinary income, or rental activity.

When the individual income tax return is prepared, the various items on the K-1 are input on Form 1040 and are taxed accordingly.

It should be noted that operating income from an S-Corporation is not subject to the the net investment income tax.

Assigning a Fair Salary

The IRS says that shareholders must take a reasonable salary for the work they do for the business.  Reasonable is not defined anywhere, although the IRS does provide some guidelines.  You can read all about the subject in this article.

The Exceptions to the Rule

When you take distributions from an S-Corporation where there are no profits, you potentially run into a distribution in excess of shareholder's stock basis.  These distributions are reported on the shareholder's income tax return as income subject to capital gain.

Distributions in excess of tax basis occur when there are distributions that exceed the accumulated profits of the corporation and contributed capital  For example if  you contributed $100k to start your company, and made $200k in taxable income over the next two years, and distributions in excess of $300k would be subject to the capital gains tax.

Conclusion

S-Corporations are a great way to lower your personal tax liability, but doing so requires proper setup and careful planning.  If your business has net income of $50k and up, it is definitely a strategy worth pursuing. Make sure you use a qualified tax professional to keep from unwanted tax implications.