Tax consequences of “Excess Distributions” for S Corporation shareholders

The “S “ election for corporations has some definite tax advantages. The election allows shareholders to report the corporate income and deductions on their personal returns. These items are taxed at the individual’s income tax rates, which are typically lower than corporate tax rates, and avoids double taxation on the corporate income.

In addition, non-dividend distributions can be taken free of dividends tax as well as self-employment tax (Which is a social security and Medicare tax primarily for individuals who work for themselves). This is not to say that all payments to shareholders can be treated as distributions.

The IRS very specifically states that S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. In other words, shareholders of S Corporations must take W-2 wages with proper withholding for social security and Medicare taxes prior to taking distributions. The IRS does have the authority to reclassify distributions as wages, which are subject to employment taxes. We recommend basing the shareholder’s compensation on industry compensation guides or RMA annual statement studies data specific to the company’s industry.

S Corporation shareholders must also be aware of the consequences of taking distributions in excess of stock and debt basis. Stock basis begins with the initial capital contribution to the S Corporation or the initial cost of the stock purchased. Stock basis is increased with profits and decreased with losses. Distributions taken in excess of the stock basis are taxed as capital gains (generally long-term) on the shareholders personal return. The current long-term capital gains rate is 15%. It is very important to consider whether or not there is basis available when taking distributions. In addition, losses of the corporation can only be deducted if there is sufficient basis to cover the loss.

Shareholder loans are considered debt basis. Debt basis is only allowed to the extent that the shareholder has personally contributed funds to the corporation. Losses in excess of stock basis can be deducted to the extent that the shareholder has made personal loans to the corporation. However, if losses are applied against the shareholder loan amount, the debt basis is reduced and any repayment to the shareholder of the loan will result in a tax consequence. If you have a question about this topic, please contact us at 630.584.4555