Wednesday, November 21, 2007

ASK THE TAX PRO – TAXING SUB-S CORP DISTRIBUTIONS

Q. Are the distributions from an S Corporation taxed as a qualified dividend at 15% or at the shareholders’ marginal tax rate? Is there any way for an S Corporation distribution to be taxed as a qualified dividend or capital gain?
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A. “Distributions” from a "Subchapter S" corporation are generally tax-free, as they usually represent a payment of “previously taxed income”.
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Sub-S distributions are not considered to be dividends. For tax purposes they are treated as “drawings” from the shareholders’ “capital account” (called here an "Accumulated Adjustments Account”), similar to a way distributions from a partnership are treated.
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The income and expenses of a Sub-S corporation are passed-through to the shareholders. Shareholders are taxed on the income of the corporation whether or not they actually receive a distribution. The income is taxed when it is earned by the corporation, and not when it is distributed to the shareholder. Again, this is basically the same tax treatment as a partnership.
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The income and deductions passed through from a Sub-S corporation are reported on the Form 1040 of the shareholders, and are taxed based on the individual nature of the item. Ordinary business income is passed through as ordinary income on Schedule E and is taxed at ordinary “marginal” income tax rates. Interest, dividends, capital gains dividends and short and long term capital gains from the sale of assets that are received by a Sub-S corporation are taxed by the shareholder as interest, dividends and capital gains, and are reported on Schedule B or Schedule D.
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Interest is taxed as ordinary income, dividends are taxed as either ordinary income or qualified dividends (at lower capital gain rate) depending on the original source of the dividend, capital gain dividends are taxed as long-term gains, short-term capital gains are taxed as ordinary income and long-term gains are taxed at the appropriate capital gains rate.
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Similarly, any charitable contributions, investment expenses and Section 179 expense from the corporation are “separately stated” on the appropriate 1040 schedule or form, as are “tax preference items” that affect the dreaded Alternative Minimum Tax.
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The only possible way a distribution from a Sub-S corporation could be taxed as a qualified dividend, at the lower capital gain rate, is if the corporation had “earnings and profits” (E&P) from prior tax years during which it operated as a “C” corporation. For example, the corporation was formed in 2000, but did not elect Sub-S status until 2004, and it had accumulated net profits from the period of operation as a “regular” corporation. A distribution from E&P could be taxed as a “qualified dividend”.
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The IRS has “ordering rules” to determine how a distribution made by a Sub-S corporation with E&P is taxed. Distributions are first considered to be from the “Accumulated Adjustments Account” (AAA) – income generated by the Sub-S corporation that has been previously taxed to the shareholders. These distributions are tax-free. Any distribution in excess of AAA is considered first to be from E&P and taxed as dividends.
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Under IRC 1368(e)(3) you can make a special election to take distributions first from E&P instead of AAA. The election is made on a year-by-year basis.

The only time a distribution from a Sub-S corporation could be treated as a capital gain is if the distribution is in excess of the taxpayer’s "basis" in the Sub-S corp. This is last on the list in the “ordering rules”.
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As mentioned above, qualified dividends earned by the Sub-S corporation that are passed through to the shareholder are taxed at the special capital gain rates, as are passed-through capital gain dividends and long-term capital gains.
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BTW, todays posting to ANYTHING BUT TAXES contains lots of interesting "stuff".

TTFN

5 comments:

Anonymous said...

Pretty clear.

Anonymous said...

Hi, I would really appreciate some guidance!

I formed an S-Corp in 2007. For the year 2007, I took a salary of a $45K, and the company has a profit of $10K. So, for the year 2007, I understand that I will pay ordinary income tax on the $55K. What forms should I request from (or expect to be given by) my tax professional in order to file the company's tax returns? Should I be getting a Form 1120S? And what other forms?

Next, in Feb. or Mar. *2008*, I wish to take a distribution from the company. Let's assume that in 2008 in addition to my salary I will take a distribution of $10K (within my basis). How do I make sure that I do *not* get taxed on the $10K of distribution (which was already taxed as the company's profit in 2007) ? How will this $10K appear on my 1040 and are there any other necessary forms?

Thank you in advance for your time in assisting an S-Corp newbie!

Robert D Flach said...

Newbie-

1) THE WANDERING TAX PRO deals with 1040 issues only. It does not deal with corporation or partnership tax issues. I discuss sub-S corporations only as the pass-throughs affect the 1040. The above posting deals with how sub-S distributions are taxed on the 1040.

2) The income and expenses of a sub-S corporation are reported on federal Form 1120-S. Part of the 1120-S filing is a Form K-1 for each shareholder, which reports the individual items of income and deduction and tax credits that are “passed-through” to the shareholder’s Form 1040 and other information that may be necessary in filing the shareholder’s federal and state tax returns.

3) Shareholders can take distributions of “previously taxed income” from the sub-S tax free. Shareholders are taxed on W-2 earnings if they are an employee of the corporation. As the post mentions, shareholders are also taxed on the net earnings of the corporation when earned by the corporation and not when distributed to the shareholder. This is income that is reported on the Form K-1 and passed-through to the Form 1040 Schedule E. If you have moneys built up in your “Accumulated Adjustments Account” (AAA – not the auto club here) you can take a distribution from this account at any time. The distribution will not be taxed on your federal Form 1040. In your case a $10,000 distribution from AAA will not be reported anywhere on your Form 1040. It is a “basis adjustment” that is reported on the Form K-1.

4) Your tax professional will know what to do (presumably). Just make sure you let him/her know that the $10,000 is a distribution of "previously taxed income" from your AAA account.

(5) You should direct your sub-S questions to your tax professional.

TWTP

Anonymous said...

Hi Wandering Tax Pro, I really appreciate your reply to my posting. It does indeed clarify some doubts I had in mind (regarding some of the Tax Forms that come into the picture). I shall follow-up further about the Sub-S questions with my tax professional. I appreciate your time, and thank you. -Newbie

Robert D Flach said...

Newbie-

Glad to be of help.

TWTP