S-Corp Distributions: How They Are Taxed

Part of WageProof's complete guide to S-corp reasonable compensation.

A distribution is profit an S corporation pays out to its owners, and it usually adds no tax of its own. The owner already pays income tax on their share of the company's profit for the year the company earns it, whether or not the cash is ever paid out, and the company reports that share to the owner on a form called the Schedule K-1. What a distribution avoids is payroll tax. Salary paid to an owner who works in the business carries Social Security and Medicare tax (FICA), 6.2% and 1.45% on each side, 15.3% once the employee and employer halves are added together, with the Social Security part stopping at that year's wage base. That gap is the saving the S corporation election is built around, and the reason the IRS checks that the owner's salary is not set too low. The S-corp tax savings calculator estimates that saving for a given profit and salary.

What is an S-corp distribution?

A distribution leaves by check or transfer, on whatever schedule the company can afford, and payroll never touches it, so nothing is withheld from it. The company takes no deduction for it either, because the profit behind it was already reported on the company's Form 1120-S and allocated among the shareholders before any cash moved. That makes it one of two ways an owner-employee gets paid, and the company reports the year's total to each shareholder on the Schedule K-1 rather than on a W-2, which is how the figure reaches the basis schedule.

Are S-corp distributions taxable?

Under 26 U.S.C. §1366 the company's income flows through to the shareholders and is taxed on their personal returns whether or not the company distributes a dollar of it. The owner's share arrives on the Schedule K-1 the company issues, and income tax on it is paid with the Form 1040 for the year the company earned the profit. An owner allocated $80,000 of profit who leaves every dollar of it in the company's bank account still reports $80,000.

Once that tax is paid, moving the cash from the company's account to the owner's creates no second round of income tax. The bill comes due with that year's Form 1040 whether or not the cash has left the business, and a distribution taken to cover it comes out against stock basis, reducing that basis by the same amount.

How S-corp distributions are taxed: the basis rules

The stock basis starts at what was paid for the stock, plus whatever has been contributed since. 26 U.S.C. §1367 then moves it every year. Income and gains the company passes through to the owner are added, and the losses and deductions claimed come off, along with the tax-free part of each distribution taken. Basis can't go below zero.

For a company that has always been an S-corp, with no earnings left over from a C-corp life, 26 U.S.C. §1368(b) sets two steps:

1. A distribution is a tax-free return of basis to the extent there is basis to absorb it, reducing that basis dollar for dollar.
2. Anything beyond the remaining basis is taxed as a capital gain, long-term if the stock has been held more than a year.

Say an owner opens the year with $30,000 of basis and the company passes through $80,000 of profit, which lifts the basis to $110,000. The owner takes $70,000 out over the course of the year. All $70,000 is tax-free, inside basis the whole way, and basis closes at $40,000, with the ordinary income tax on the full $80,000 still due.

That closing $40,000 becomes next year's opening basis, before the following year's income and distributions move it again. Had the basis after the year's income been only $50,000 when that same $70,000 went out, only the first $50,000 would come back as a tax-free return of basis. Basis would close at zero and the last $20,000 would be taxed as a capital gain.

Money the owner lends the company creates debt basis. Under 26 U.S.C. §1366(d) it lifts the ceiling on deductible losses, but it leaves a distribution alone, since only stock basis can absorb one. If the owner has lent the company money but run stock basis down to zero, the whole distribution is capital gain.

Tracking basis with Form 7203

Basis also caps the losses deductible in a year, and Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations is where both calculations go. A shareholder files it for any year in which they receive a non-dividend distribution, claim a deduction for a share of the company's loss, dispose of stock, or receive a loan repayment from the corporation. Until the 2021 tax year, that arithmetic ran on a worksheet in the Schedule K-1 instructions that never left the shareholder's own files.

It attaches to the shareholder's personal Form 1040 and walks from the opening basis through the year's additions and reductions to the closing figure. Part I tracks stock basis and Part II debt basis, while Part III uses both to cap the loss and deduction items claimable this year. Get the opening figure wrong and every later year's closing figure carries the error.

The K-1 supplies the income, loss and distribution figures (distributions are in box 16, code D), but the starting basis and any capital put in during the year have to come from the owner's own records. Losses beyond the basis are suspended under 26 U.S.C. §1366 and carried forward until basis comes back.

How the AAA works for S-corps that converted from C-corps

The IRS recommends that every S-corp keep an Accumulated Adjustments Account, which Schedule M-2 of its Form 1120-S reports as one balance for the whole corporation. The same schedule carries any accumulated earnings and profits (E&P) left over from C-corp years, plus a separate Other Adjustments Account for tax-exempt income and the expenses tied to it. Losses can push the AAA below zero, though a distribution stops at zero and the rest of the payment falls through to the next bucket.

The ordering rules built around the AAA only change an answer at an S-corp that still carries E&P from C-corp years, which usually means a company that converted from C-corp status. Under 26 U.S.C. §1368(c), a distribution comes out of four buckets in order:

1. The AAA holds cumulative post-election income that has not yet been distributed. Whatever comes out of it is treated as a return of basis and is tax-free to the extent of stock basis.
2. Accumulated C-corp E&P comes next, as a dividend. If the owner meets the holding-period test (more than 60 days of ownership around the payment), it is a qualified dividend, taxed at the same 0%, 15% or 20% rates as long-term capital gain. It does not reduce stock basis.
3. Remaining stock basis takes the next piece and falls by the amount that comes out of it.
4. Anything past that basis is capital gain.

Take a company that converted three years ago with $100,000 of accumulated C-corp E&P still on the books. The AAA balance in the current year is $40,000, all of it post-conversion income that has not been paid out, and the shareholder takes a $90,000 distribution. The first $40,000 clears the AAA, tax-free, and reduces basis. The remaining $50,000 comes out of the C-corp E&P as a qualified dividend, reported as $50,000 of dividend income on the shareholder's 1040. That second piece leaves basis untouched, because what comes out of the E&P bucket is corporate earnings from the C-corp years. The company closes the year with the AAA at zero and $50,000 of E&P still on the books, which the next distribution runs through the same four buckets.

A converted company should carry the E&P balance on its books and tell its shareholders what it is, or clear it out with a deliberate dividend before the S election or soon after, while the balance is still small enough that the dividend tax lands in a year the shareholders picked. Left alone it sits on the books waiting for a payment large enough to run past the AAA, which in the example above is any distribution over $40,000.

The one-class-of-stock rule and pro-rata distributions (§1361)

An S-corp is permitted only one class of stock under 26 U.S.C. §1361(b)(1)(D). On distributions that means the same dollars per share to everyone. Two 50% owners take 50% each, even in a year when only one of them has a tax bill coming due.

Owners sometimes drift from that. In Maggard v. Commissioner, T.C. Memo. 2024-77, decided in August 2024, two co-owners had paid themselves more than their ownership shares, and the Tax Court held that "disproportionate distributions by themselves do not change a company's S corporation status." Under Treas. Reg. §1.1361-1(l)(2), a second class of stock turns on the corporation's governing provisions, which means the charter, the articles, the bylaws, state law, and any binding agreement about distribution or liquidation proceeds. Those documents have to give shareholders unequal rights to that money before the election is in danger. Where they do, the entity becomes a C-corporation for tax purposes back to the date the second class arose, unless the IRS grants relief for an inadvertent termination under 26 U.S.C. §1362(f).

If one shareholder needs cash the company can provide, additional salary is the clean route, though it raises its own reasonable-compensation question, and a shareholder loan is more likely to be respected as a loan when a written note and a fixed repayment schedule stand behind it. Even with the election safe, the IRS can treat a disproportionate payment to an owner-employee as compensation and assess FICA on both halves when that owner already drew some W-2 salary (with no salary at all, a reduced rate under IRC §3509 generally applies to the employee's half), and penalties, such as the one for failing to deposit payroll tax on time, can follow.

S-corp distributions vs. C-corp dividends

A C-corporation pays tax on its own profit at the flat 21% rate in 26 U.S.C. §11 when it files its Form 1120. Its shareholder pays again on the dividend that carries that profit out, at ordinary income rates or at qualified dividend rates when the conditions are met. An S-corp pays no federal income tax on its own profit, so the money reaches the shareholder having been taxed once, on the personal return where the K-1 landed.

A company that converted from C-corp status can still owe tax at the entity level, usually the built-in gains tax under 26 U.S.C. §1374, which reaches gain that accrued while the company was still a C-corporation if the company recognizes that gain, for example by selling the asset, in its first five years as an S-corp. The E&P left over from those years sits outside that treatment, and a distribution that lands in the E&P bucket is taxed as a dividend, a qualified one if the holding-period test is met.

The "S-corp distribution tax rate"

The company's ordinary business profit behind a distribution is taxed at the owner's ordinary income tax rate in the year it passes through on the K-1, and there is no separate rate on the distribution itself. It can still trigger the capital-gains rate on the portion that runs past stock basis under the §1368(b) steps above, and, at a converted company, the qualified dividend rate on the portion that comes out of old C-corp E&P.

Nothing is withheld from the pass-through profit, so the tax on it gets paid through quarterly estimated payments or by raising the withholding on the salary. Cutting the salary to save FICA also cuts that withholding, so the shortfall lands on the April return.

S-corp distribution rules: the salary comes first

Whatever is left on the distribution side still has to survive the reasonable-compensation test, and the IRS can reclassify the difference as wages when the salary was set low to make room for the distributions. TIGTA Report No. 2021-30-042 counted 266,095 single-shareholder returns for processing years 2016 through 2018 that reported profits above $100,000 and no officer compensation at all, with about $69 billion in distributions behind them.

A 60/40 split or any other fixed ratio at least puts a number on the W-2 line, and the number it puts there comes out of the ratio rather than out of what the job pays. If the IRS resets the reasonable compensation figure on audit, the FICA comes back for every open year, and failure-to-deposit penalties can follow unless the business shows reasonable cause.

How WageProof helps

WageProof handles the salary side of that split, matching the duties described to BLS wage data for the county's BLS wage area and experience level (or to other BLS data, such as the state figure, when the local figure isn't published), and the report names the BLS occupation, wage area, release and percentile behind each wage figure, so your CPA, an IRS examiner or anyone else can check it against BLS.gov. The reasonable salary calculator shows how WageProof prices each duty against BLS wage data. The page on reasonable compensation reports for S-corp owners lists what each one contains.

The methodology page walks the calculation step by step, and there is a sample report if the owner would rather see the output before building one. Building one takes about 15 minutes and costs $199, and it can be started here. Tax professionals who prepare reports for several clients can use an annual firm plan, from $499 a year for 10 reports.

This article is general information, not legal or tax advice. S-corp basis and distribution rules, especially for former C-corporations, depend on the full facts of the business; consult a qualified tax professional before relying on this.