How Are S-Corp Distributions Taxed? Finally, an Easy Answer!
Tax season brings headaches for many business owners, especially when dealing with complex business structures like S-Corporations. One question that frequently causes confusion is: "How are S-Corp distributions taxed?"
If you've been scratching your head over this issue, you're about to find an easy, SIMPLE answer about S-Corporation distribution rules.
S-Corporation distributions can be overwhelming, and many small business owners make costly mistakes simply because they don't understand how these payments work from a tax perspective.
This guide breaks down everything you need to know about S-Corp distributions in plain language.
What Is an S-Corp?
An S-Corporation isn't actually a type of business structure – it's a tax election.
If you operate as an LLC, you have the option to be taxed as an S-Corp by filing Form 2553 with the IRS.
When your LLC elects S-Corporation tax treatment:
Your business remains an LLC legally (keeping the flexible management and liability protection of an LLC).
Your taxes change - instead of reporting income as a sole proprietorship or partnership, you now pay taxes under S-Corp rules.
You gain potential self-employment tax savings, but with specific requirements on how you pay yourself.
S-Corps have specific requirements:
Must be a domestic corporation
Can't have more than 100 shareholders
Can only have one class of stock
Can't have non-resident alien shareholders
Can't be certain types of financial institutions or insurance companies
So, why would an LLC elect to be taxed as an S-Corp? The bigger reason is tax savings.
If an LLC is taxed as a sole proprietorship or partnership, all of your net business income is subject to self-employment taxes (Social Security + Medicare = 15.3%).
But when your LLC elects S-Corp taxation:
You split your income into salary and distributions.
You only pay self-employment federal taxes on your salary (not on distributions).
This can lead to thousands of dollars in tax savings.
The IRS requires S-Corp owners who work in their business to take a "reasonable salary" before taking distributions.
So, these tax benefits come with specific rules about how owners can pay themselves, which is where many entrepreneurs get confused.
Learn more about small business taxes for dummies!
The Basics of S-Corp Taxation: How LLC Owners Pay Themselves in an S-Corp
If your LLC is taxed as an S-Corp, you can take money from your business in two ways:
Salary (W-2 Paycheck): This is your official wage as an employee of your business. You must withhold payroll taxes (Social Security, Medicare, and income tax). The IRS requires that this salary be reasonable—meaning comparable to what someone else in your industry would be paid for your role.
Distributions (Profit Payouts): These are payments made from company profits after your salary has been taken. The best part? Distributions aren’t subject to self-employment taxes, only regular income tax.
For example:
Your LLC earns $120,000 in profit.
A reasonable salary for your role is $60,000 (paid through payroll).
The remaining $60,000 can be taken as a distribution, saving you 15.3% in self-employment taxes on that amount.
🚨 The IRS closely monitors S-Corp salaries. If you pay yourself too little in salary and take too much in distributions, you risk an audit, reclassification of distributions as salary, and penalties.
"Reasonable" means what you'd pay someone else to do your job in your industry and location.
If you're not sure about how to pay yourself a reasonable salary as an S-Corp owner, learn more about our services - you might benefit from a tax planning session!
How S-Corp Distributions Are Taxed
S-Corp distributions follow different tax rules than your salary, and understanding these rules can save you thousands of dollars in taxes.
First, distributions aren't automatically taxable. Their tax treatment depends on something called your "basis" in the company. Your basis is essentially your investment in the business.
Here's how S-Corp distributions are taxed:
Distributions up to your basis amount: These are generally tax-free. The IRS views these payments as simply returning your investment in the company.
Distributions that exceed your basis: These get taxed as capital gains. If you take out more money than your basis, that excess is considered a capital gain, typically at lower tax rates than ordinary income.
Your basis increases when you invest money in the company, when your business earns profits, and when you make loans to the company.
Your basis decreases when you take distributions, when your company experiences losses, and when the business repays the loans you made to it.
For example, if your initial investment was $50,000, and the company earned $70,000 in profits (which passes through to your personal return), your shareholder's basis would be $120,000. You could take up to $120,000 in distributions tax-free.
At the same time, you must pay personal income tax on all profits that pass through to you, whether or not you actually take that money out of the business.
That's why many business owners take distributions at least equal to their tax liability on the passed-through profits.
S-Corp Losses and How They Work
Many business owners switch from sole proprietorships (Schedule C) to S-Corps for tax advantages without understanding how business losses work.
With a Schedule C business, claiming losses is straightforward.
If your business loses $20,000 this year, you can generally deduct that entire amount against your other income on your personal tax return. The process is simple and offers immediate tax relief during tough years.
With an S-Corp, you can only deduct losses up to your basis amount. If your basis hits zero, you can't claim any more losses until you increase your basis again.
When your business rebounds and starts making profits again, you might want to take distributions. But if your basis is still at zero (or very low) because of previous losses, those distributions will be taxed as capital gains.
For example, you start with a $50,000 basis. Your S-Corp loses $50,000, reducing your basis to $0. Next year, your business makes $30,000, and your basis increases to $30,000.
But you take $40,000 in distributions - the first $30,000 is tax-free, but the extra $10,000 is taxed as capital gains.
Many business owners don't realize this connection between past losses and future distribution taxation. They take distributions without checking their current basis and end up with unexpected capital gains taxes.
Strategic planning with a tax professional can help you avoid mistakes and costly tax consequences.
S-Corp Distribution Mistakes to Avoid
Making mistakes with S-Corp distributions can be costly, so here are a few things that S-Corporation shareholders should watch out for:
Taking distributions without checking your basis: Many S-Corp owners simply withdraw money when they need it without verifying their current basis. This can trigger unexpected capital gains taxes if distributions exceed basis. So...don't do this!
Ignoring the reasonable compensation rule: The IRS requires S-Corp owners who work in the business to take a reasonable salary before distributions. Some owners try to minimize salary to reduce payroll taxes, but this can lead to serious problems.
Poor documentation of distributions: S-Corp distributions must be properly documented with corporate minutes and resolutions. Without proper paperwork, the IRS may flag these payments as compensation or even disallow them.
Using corporate funds for personal expenses: Nope, paying personal expenses directly from your S-Corp bank account isn't a proper distribution.
Not working with a tax professional: If you're not working with a tax professional, you're likely not keeping as much of your S-Corporation's income as you could and are handing it to the IRS instead.
Learn more about creative tax deductions that small businesses can use to save BIG!
FAQs
How Much Is S-Corp Distributions Taxed?
S-Corp distributions aren't taxed at a fixed rate. Their taxation depends on your basis in the company. Distributions up to your basis amount are generally tax-free, but distributions that exceed your basis are taxed as capital gains. Capital gains rates vary based on your income and how long you've held your investment.
You've already paid income tax on the profits that passed through to your personal return, which is why distributions up to your basis amount aren't taxed again. This avoids the double taxation that C-Corps face.
How Do I Pay Myself Distributions from S-Corp?
First, verify you have sufficient basis to take a tax-free distribution and that you've satisfied the reasonable compensation requirement by paying yourself an appropriate salary. Document the distribution with corporate minutes or a resolution, then write a check from the business account to your personal account or transfer the funds online. Record the distribution in your accounting system as a distribution - not as an expense - and track the impact on your basis for future reference.
Are S-Corp Distributions Subject to Self-Employment Tax?
No, S-Corp distributions are NOT subject to the self-employment tax (Medicare and Social Security taxes). This is one of the biggest tax advantages of an S-Corp. Your salary is subject to the self-employment taxes (15.3% total between employer and employee portions), but properly structured distributions avoid them. This is why the IRS requires you to pay yourself a reasonable salary first.
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Having the right guidance makes figuring out S-Corp distributions much easier and helps you avoid costly mistakes.
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